i
Understanding
Financial Accounting
Third Canadian Edition
CHRISTOPHER D. BURNLEY
Vancouver Island University
The first edition of Understanding Financial Accounting was based on
Financial Accounting: A User Perspective, Sixth Canadian Edition
R O B ERT E. H OS K IN
University of Connecticut
M AU R E EN R. FIZZELL
Simon Fraser University—Retired
D O N A L D C. CHERRY
Dalhousie University—Retired
D E D I C AT I O N
Dedicated with love and gratitude to my father, Donald Burnley,
for being such a wonderful role model in all that is important in life and
for guiding me down the accounting path.
Vice President, Editorial and Product Management: Michael McDonald
Associate Editorial Director: Zoë Craig
Assistant Editor: Natalie Muñoz
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Senior Manager Course Development and Production: Karen Staudinger
Senior Product Marketing Manager: Christina Koop Minarik
Senior Course Production Operations Specialist: Joanna Vieira
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Cover Image: © Christopher Burnley
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ISBN 978-1-119-71511-5 (ePub)
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Image by Dirk Heydemann of HA Photography
About the Author
C HRI STO PH E R BU RN L E Y, FC PA, FCA, is a professor in
the Accounting Department at Vancouver Island University’s
Faculty of Management. Prior to his full-time academic career,
Chris worked
for 12 years in public practice and also audited
© Dirk Heydemann
federal government departments and United Nations agencies
with the Office of the Auditor General of Canada. Chris also
teaches in the CPA Professional Education Program for the
CPA Western School of Business.
At Vancouver Island University (VIU), Chris has developed
a number of new courses, served as departmental chair,
and served two terms as an elected faculty representative
on the university’s board of governors. He is active internationally, teaching and delivering guest lectures at VIU’s
partner institutions in Europe, Asia, and the South Pacific.
He has been awarded numerous internal and external
grants in support of his academic work and has presented
at national conferences. Chris also teaches in the Master of
Professional Accounting Program at the Edwards School of
Business at the University of Saskatchewan, where he has
been recognized multiple times by the university with the
Chartered Professional Accountants of Alberta’s Teaching
Excellence Award.
Chris has received a number of awards from the Canadian
Academic Accounting Association for his academic work,
including awards for case authoring and developing innovative ideas in accounting education.
Chris is active in the accounting profession, serving on the
board of the Canadian Academic Accounting Association.
He has also served as a director on the board of the Chartered
Professional Accountants of British Columbia and is a past
chair of the board of the Chartered Professional Accountants’
Education Foundation of BC. In 2007, Chris was awarded the
Ritchie W. McCloy Award for CA Volunteerism. Chris is also
a co-author of the textbook Financial Accounting: Tools for
Business Decision-Making, published by John Wiley & Sons
Canada, Ltd.
v
Preface
The aim of Understanding Financial Accounting is to introduce students to the core concepts of financial accounting by
illustrating the relevance of the material to a wide variety of
decision-making contexts. The focus is on providing students
with the tools to help them understand the rationale behind
the numbers. If students can develop an understanding of the
language of accounting, grasp what the accounting information means, and appreciate what managers are saying when
they present the financial information, they will have laid a
foundation they can build upon in whatever position they hold
in the future.
The material is written at a level meant to be understandable for all students who put the time into working through it.
It is based on 22 years of teaching the material to thousands
of students with a wide variety of backgrounds, the majority
of whom have been non-accounting majors, but also to others
who have gone on to medal on national professional accounting exams.
Emphasis on Sustainability
Sustainability reporting is now the norm for public companies
in Canada. Financial statement users, especially institutional
investors, are demanding sustainability information from companies. The primary focus has been on climate-related issues,
and climate-related risks are a key consideration. Investors and
other stakeholders have pressed for expanded and more consistent disclosure of these risks and also want to understand
the impact that climate change is having (or could have) on a
company’s financial statements. Our students are very aware of
climate change issues, with many engaged in varying degrees
of climate change activism, yet the financial statement impacts
of climate change are almost never discussed in introductory
accounting texts. It is critical that we begin these conversations so that our students are aware of how climate change
can impact financial reporting, but also with the view that this
awareness may help change behaviours. To these ends, a series
of 10 ­Climate Change Impact features have been developed
for this edition. They can be found in six of the chapters and
have been authored to tangibly link chapter content and specific financial statement line items with the impacts of climate
change. Presenting this information in box features provides
faculty with flexibility in how this material is used.
Emphasis on Analytics
Today’s companies have access to unprecedented volumes of
data, drawn from multiple sources, that can be analyzed and
used to inform business decisions. Accountants are leveraging
these data, and the insights derived from their analysis, to make
vi
better decisions themselves and to present financial information to other decision makers through data visualizations. These
visualizations present financial information in interesting new
ways that go well beyond the traditional financial statements
and spreadsheets. They use a wide variety of images to help
users better understand the information more readily. They also
allow users to identify patterns in the data and connect information from multiple contexts more easily. For this edition, four
Analytics in Action cases have been developed to help pique
students’ interest in this exciting area and to begin to develop
their skills in interpreting data visualizations to inform their
decisions, as well as to start to think about what other types
of data and visualizations might be useful. A number of other
visualizations have also been added to help illustrate various
concepts in several chapters.
Analytics in Action cases associated with chapters 4, 6, 7,
and 9 offer students the opportunity to use interactive data visualizations based on Excel and Tableau to solve realistic accounting and business problems. Each visualization case includes
multiple-choice and short-answer questions, accompanied by
visualizations presented in the form of interactive graphics. Students are required to interpret the visualizations and think critically about how the visualizations and the underlying data can
be used to inform decision-making. The visualizations are also
an excellent resource for small-group or seminar discussions
and are sophisticated enough to allow faculty to develop their
own questions for students to discuss and solve.
In addition to the Analytics in Action cases, an accounting-­
specific data analytics module with interactive lessons, case
studies, and videos is part of the online courseware. The module has been prepared using industry-validated content to
help students develop the professional competencies needed
for the Common Final Examination (CFE) and the changing
workforce.
Emphasis on Excel
This edition of the text also includes content to help students
develop their Excel skills in a number of ways.
1. New Gradable Excel Questions for each chapter give
students an opportunity to practise Excel skills in the context of solving accounting problems. These questions are
identified with an Excel word mark in the end-of-chapter
material.
2. Excel Function Videos have been added to provide students with step-by-step examples of how to use a selection
of key Excel functions (for example, determine the amount
of blended loan payments and the present value of bonds).
Excel Templates in the online courseware also enable students to work on selected problems in Excel.
Preface
Expanded Content
This edition of the text also includes three new appendices featuring additional content:
• A
ppendix B provides coverage of the basics of long-term
revenue recognition using both the percentage-of-completion and zero-profit methods.
vii
For Example features that illustrate key chapter content in
the context of the financial statements of public companies,
Ethics in Accounting features that highlight ethical issues
that must be dealt with in relation to all kinds of accounting
situations, Conceptual Framework features that discuss
the theory behind accounting practices, and new Climate
Change Impact features.
• A
ppendix C introduces students to the asset revaluation method, including both the proportionate and asset
adjustment approaches.
Unparalleled Review and Practice
Opportunities
• A
ppendix D covers investments, both strategic and
non-strategic.
This content, requested by faculty, has been added as appendices to allow greater flexibility in terms of whether it is assigned
or not. Each appendix includes all of the standard features
found in the main chapters, such as For Example features, Take
5 videos, and end-of-chapter problems.
This new material helps students bridge the content
gap between their introductory and intermediate accounting
courses, providing them with resources of value regardless of
whether or not they are assigned.
Concise and to-the-point chapter summaries recap the key
points covered by each learning objective. Chapter End
Review Problems and Online Demonstration Problems with
accompanying Take 5 videos walk the student through the
steps required to solve complex problems.
Each chapter includes a variety of assignment material,
enabling faculty to choose the level of breadth and depth at
which they want to assess students. This includes Discussion
Questions, Application Problems (now expanded and divided
into two sets), unique Work in Progress problems, User Perspective Problems, Reading and Interpreting Financial Statements problems, and short Cases.
Continuing Features
Key Enhancements
Cohesively Structured Content
This third edition of Understanding Financial Accounting
builds on the strength of the previous editions. All content
has been carefully reviewed and revised to maximize student
understanding. Significant work has gone into enhancing the
reading content, the assessment material, and the material
available in Wiley’s online courseware.
The text continues to be structured around a series of core
questions that give students the context for the related content. If, after reading the content, they are able to answer these
questions, they will have achieved the learning objectives.
With this approach, the material that follows each question
becomes more relevant to the students and provides them with
a clear picture of why they need to understand it. The text also
walks students through the basic mechanical elements of
financial accounting, because it is very difficult for students
to understand accounting information if they lack an understanding of the system used to generate it.
The Take 5 Videos
Each chapter includes a series of whiteboard screen capture
Take 5 videos covering all major topic areas in the chapter. Students can preview the videos before coming to class or use them
for review after. These videos are a great tool for instructors who
like to flip their classroom. They also provide ready content for
faculty who need to pivot their course delivery from in-person to
online, as so many have had to do in recent semesters. The third
edition has approximately 120 Take 5 videos that focus on concept walk-throughs and take the student through online demonstration problems as well as end-of-chapter practice problems.
Opportunities for Classroom Discussion
Each chapter of the text includes features that can form the
basis for classroom discussions. These include more than 120
Tightened Linkages between the
Reading Content and the Course
We continue to digitize the course material and have added
some new features to help navigate the continuously changing
landscape of accounting education. Understanding Financial
Accounting, Third Canadian Edition, is completely integrated
with Wiley’s online courseware, featuring a suite of digitized
teaching and learning resources. The courseware allows students to create a personalized study plan, assess their progress
along the way, and access the content and resources needed to
master the material. It includes new integrated adaptive practice that helps students build proficiency and use their study
time most effectively. This new assignment type pinpoints
knowledge gaps and offers personalized just-in-time support,
targeted instruction, and detailed explanations of solutions.
This edition makes a clear link between the reading content and the wealth of pedagogical material available in the
course. The Assess Your Understanding boxes at the end of
many chapter sections direct students to the relevant Chapter End Review Problems and related Online Demonstration
Problems, doubling the opportunities for students to practise
working through problems with accompanying solutions.
viii
P reface
Augmented End-of-Chapter Material
Revisions based on faculty and student usage
data. Much of the all-important end-of-chapter material
has been revised and refreshed. These revisions were datadriven. The questions most frequently assigned by faculty
and those most often attempted by students were identified,
and new questions of a similar nature have been added. The
number of popular end-of-chapter questions has continued to
increase, and there are now just under 1,000 questions available in the end-of-chapter material, with additional questions
added to the online courseware as well.
We continue to group the Application Problems into two
sets, A and B, whose topics mirror each other, so they can be
assigned separately or together for extra practice. The Application Problems are also organized by learning objective to
better test students’ understanding of each objective and to
make it easier for faculty to quickly identify relevant problem
material.
Unique Work in Progress problems.
The Work in
Progress problems are unique to this text. These problems
enhance students’ critical thinking and communication skills
by requiring them to correct or improve a statement about key
concepts in the chapter. The number of these problems has
been increased by 20% in this edition.
Other additions and changes. The number of Discussion Questions and User Perspective Problems has been
increased by roughly 5%. Finally, all 70 of the Reading and
Interpreting Published Financial Statements problems have
been revised to reflect the most recent publicly available financial statements.
Current Accounting Standards
This edition has been revised to reflect current financial
reporting standards, such as IFRS 9 (Financial Instruments),
IFRS 16 (Leases), and IAS 41 (Biological Assets). Chapter 6
was revised to reflect the expected credit loss model, including
an expanded discussion of credit risk factors. The text includes
in-depth coverage of the five-step revenue recognition model,
the most comprehensive revenue recognition coverage of any
introductory financial accounting text.
Increased Real-World Context
The number of For Example feature boxes has been increased
to provide students with even more real-life examples to illustrate key concepts. This edition includes more than 120 of
these features, including more than 70 that are new or have
been revised to reflect the most recent financial statements of
the featured companies.
directs students to the Chapter End Review Problems and
Online Demonstration Problems relevant to that topic and
learning objective. This makes it much easier for students to
know what material they should attempt to ensure that they
understand the related content. A number of new Chapter
End Review Problems have been added in this edition. There
are now 50 such problems and an equivalent number of similar Online Demonstration Problems for students to work
through. Fully annotated solutions are provided for all of the
Chapter End Review Problems and Online Demonstration
Problems, and additional Take 5 videos have been created to
support students by walking them through the most difficult
of these.
Specific Chapter Enhancements
The following are the notable revisions, additions, and improvements to the chapters in this third edition.
Chapter 1. Overview of Corporate Financial Reporting
• T
he discussion of public listings and financial disclosures
was expanded. Definitions of some financial statement
elements were updated.
• A
dded Climate Change Impact feature (ESG investment
decisions/Extent of climate-related information in financial statements).
• A
dd Ethics in Accounting feature (Sustainability Accounting Standards Board’s standard for various industries).
Chapter 2. Analyzing Transactions and Their Effects on
Financial Statements
• C
ontent related to prudence and the going concern assumption was added to the conceptual framework discussion.
• A
dded context for the presentation of both cost of goods
sold and interest expense on the statement of income.
• A
dd Analytics in Action feature (Using visualizations to
present financial information in alternative ways).
Chapter 3. Double-Entry Accounting and the Accounting Cycle
• A
dded content on accounting systems within ERP
systems.
• Added content related to adjusting journal entries.
• A
dded content related to what it means if a company has
a balance in its retained earnings account.
• A
dded content on how gain and loss accounts affect closing entries.
Chapter 4. Revenue Recognition and the Statement of
Income
Enhanced Self-Assessment Opportunities
• I nformation and an example were added related to
returned goods.
This edition has strengthened the opportunities for students
to assess their mastery of the content. At the end of many
sections is the Assess Your Understanding feature, which
• A
dded Analytics in Action case (Revenue analysis to
identify the most profitable products, sales channels, and
sales territories).
Preface
Chapter 5. The Statement of Cash Flows
• Added context for and examples of cash equivalents.
• Explanation added for the treatment of interest.
• A
dded rationale for the use of the direct and indirect
methods.
• R
eplaced cash flows to total liabilities ratio with the operating cash flow ratio.
• Added two cash flow visualization features.
Chapter 6. Cash and Accounts Receivable
• Expanded discussion of collusion.
• P
ortion of the chapter on accounts receivable was substantially rewritten to reflect the expected credit loss
model. Expanded discussion of credit loss risk factors.
ix
Chapter 9. Current Liabilities
• C
onsolidated discussion of short-term loans with bank
indebtedness.
• R
emoved the discussion of loyalty programs in which
points are redeemed by another party.
• Expanded discussion of standard and extended warranties.
• A
dded Analytics in Action case (Using data visualizations
to identify key suppliers and assess the utilization of the
credit periods provided by suppliers).
• A
dded Climate Change Impact feature (Impacts of climate change on assurance-type warranties).
Chapter 10. Long-Term Liabilities
• Expanded discussion of provisions.
• D
iscussion of the percentage of sales method for estimating credit losses was removed.
• A
dded lease liabilities to the definition of interest-bearing
debt.
• Added discussion of instalment payment services.
• A
dded Climate Change Impact feature (Bonds with an
ESG focus, including green bonds, blue bonds, sustainability bonds, and social bonds).
• A
dded Analytics in Action case (Using various data visualizations to assess credit risk and determine expected
credit losses).
• A
dded Climate Change Impact feature (Impact of climate
change on credit risk).
Chapter 7. Inventory
• Added examples of internal controls to safeguard inventory.
• Added content related to returned goods.
• A
dded a discussion of ways in which companies can
increase their gross margins.
• A
dded content about using inventory ratios to determine
the capital that could be freed up by improving inventory
turnover.
• A
dded Analytics in Action case (Inventory analysis to
assess product profitability, turnover and the need for a
NRV adjustment).
• A
dded Climate Change Impact features (Sustainability
measure related to the efficiency with which inventory is
converted into biological assets).
• A
dded Climate Change Impact feature (The impacts of
climate change on the net realizable values of inventory).
Chapter 8. Long-Term Assets
• Added content related to right-of-use and biological assets.
• A
dded three visualizations depicting each depreciation
method.
• A
dded Climate Change Impact feature (The impact of
climate change on the estimated useful lives and residual
values of assets).
• A
dded Climate Change Impact feature (The impacts of
climate-relate weather events on asset impairments).
• A
dded Climate Change Impact feature (Consideration of
climate change effects when determining the fair value of
biological assets).
• A
dded Climate Change Impact feature (Climate-related
contingent liabilities).
Chapter 11. Shareholders’ Equity
• Expanded discussion of special voting rights.
• E
xpanded discussion on the board of directors’ consideration of cash flow in relation to declaring dividends.
• U
pdated ex-dividend date content to reflect current
timelines.
Chapter 12. Financial Statement Analysis
• U
pdated auditor’s report content to reflect key audit
matters.
• A
dded content about the four categories of performance
measures, including content related to operational
­measures. Included information about CSA guidance in
this area.
Appendix A. Specimen Financial Statements: Dollarama
Inc.
• U
pdated to reflect Dollarama Inc.’s most recent financial
statements.
Appendix B. Revenue and Long-Term Contracts
• A
dded content related to the percentage-of-­completion
and zero-profit methods of long-term revenue recognition.
Appendix C. Long-Term Assets
• A
dded content related to the asset revaluation model,
including the proportionate and asset adjustment methods.
Appendix D. Investments
• A
dded content related to accounting for strategic and
non-strategic investments.
x
P reface
Acknowledgements
The text’s cover photo, taken on Middle Beach in Tofino on the west
coast of Vancouver Island, features a flock of migrating western sandpipers. These tiny birds are among the best travelled of the Earth’s
creatures. Each year, their northern migration takes them thousands
of kilometres along the Pacific Flyway as they travel from their winter habitats along coastlines from California to Peru to their summer
breeding grounds in Alaska and Siberia. They then repeat the journey
in reverse a few months later. Tens of thousands of these amazing little
birds spend time on the beaches around Tofino to rest and refuel on
their journey. Sandpipers, the variety of factors that drive their migration journeys, and the impacts of climate change on their migration
routes and breeding grounds are a wonderful metaphor for this edition
of the text in several ways.
This edition continues to draw on the strengths of the first two
editions of the text. I would like to thank the students and faculty
who provided feedback to improve this edition. This text’s core is also
strengthened as a result of the problem material that has been drawn
from Financial Accounting: A User Perspective. I am indebted to Maureen Fizzell, Donald Cherry, and Robert Hoskin for authoring such
rich, diverse material. The Hoskin text was one of the books I used
when I began teaching financial accounting, and it helped inform and
shape the way I continue to present this material. These teachings
continue to be reflected in this text.
The migration schedules of the western sandpiper are closely
timed to ensure optimal conditions, including available food
resources, tide patterns, temperatures, and wind patterns. The writing
journey also requires the right conditions. I have been fortunate to
work with a group of colleagues at Vancouver Island University who
have supported my teaching and writing over the past 22 years. I have
learned from each of them and would like to thank them, especially
Gordon Holyer, Tracy Gillis, Colin Haime, Sameer Mustafa, Erin Egeland, Jeremy Clegg, Vanessa Oltmann, Laurie Dean, and Steve Purse.
I have also been fortunate to have worked with a number of very supportive deans of the Faculty of Management: Ian Ross, Mike Mann,
David Twynam, and Bryan Webber. Each helped create the ideal conditions needed for my writing journey.
I am indebted to a number of accounting academics without
whom I would never have considered authoring a text. The efforts of
Sandy Hilton, especially at the Canadian Academic Accounting Association, to create venues to support teaching and learning for faculty
made a significant difference to me. Sandy also supported my case
authoring efforts for years and provided excellent advice at the outset
of this project. Peter Norwood has created numerous opportunities
for me to broaden my participation in the academic community and
also willingly shared wisdom garnered from his years as a successful
author. Scott Sinclair’s feedback throughout the development of the
first edition resulted in a much improved text. I am also thankful for
the advice and encouragement of Irene Gordon, Gary Spraakman,
and Eldon Gardner in my earliest efforts as an author.
Before western sandpipers begin their northern migration, they
gather in large flocks that will travel together along the Pacific coast.
This text has been enriched by the contributions of many people and I
am grateful to be part of their flock. Vito Di Turi, with whom I began
my accounting journey some 33 years ago, has continued to make a
significant contribution to the text by developing much of the new
problem material. Jeremy Clegg has continued to enhance the video
resources related to the text. Scott MacEachern is new to the flock this
edition, and his energy and expertise gave wings to the data visualization cases. Ilene Gilborn and Cecile Laurin also made noteworthy
contributions to the text and the end-of-chapter material. Laurel
Hyatt’s research work has made for interesting opening vignettes. The
editorial contributions of Amy Haagsma and Zofia Laubitz are greatly
appreciated. The project management expertise and editorial talents
of Leanne Rancourt are also greatly valued. I consider myself so fortunate to be part of the Wiley family. Their dedicated team provided
outstanding support each step of the way. I am indebted to Zoë Craig
for helping frame the initial vision and for her continuous encouragement throughout the process. Dela Hirjikaka’s efforts kept the project
on track, bringing the numerous parts together in a seamless fashion.
I am also thankful for the support of Elsa Passera, Karen Staudinger,
Christina Koop Minarik, and Joanna Vieira.
A number of faculty have also worked hard to develop the supplements that accompany this text:
Maria Belanger, Algonquin College
Jeremy Clegg, Vancouver Island University
Ilene Gilborn
Debra Lee Hue, Centennial College
Rosalie Harms, University of Winnipeg
Amy Hoggard, Camosun College
Chris Leduc, Laurentian University
Cecile Laurin, Algonquin College
Laura De Luca, Fanshawe College
Scott MacEachern, Simon Fraser University
Kirstyn McGauley, Algonquin College
Debbie Musil, Kwantlen Polytechnic University
Gabriela Schneider
Joel Shapiro, Ryerson University
Marie Sinnott
Andrea Stupino, York University
Vito Di Turi, University of Ottawa (Sessional)
Cheryl Wilson, Durham College
Over the years, many other faculty members reviewed the text
at various stages of development, providing advice and constructive
criticism that resulted in a better offering. I would like to thank them
for their insights.
Ibrahim Aly, Concordia University
George Boland, Queen’s University
Robert Campbell, John Molson School of Business, Concordia
University
Brenda Collings, University of New Brunswick Saint John
Erin Egeland, Vancouver Island University
Maureen Fizzell, Simon Fraser University (Burnaby Campus)
Steve Gibson, Simon Fraser University (Burnaby Campus)
Else Grech, Ryerson University
Len Hostin, McMaster University
Srinivas Inguva, George Brown College
Sohyung Kim, Brock University
Jennifer Li, Brock University
Anne Macdonald, Simon Fraser University
Robert Madden, St. Francis Xavier University
Julie McDonald, Ryerson University
Jaime Morales, Trent University
Peter Norwood, Langara College
Sandy Qu, York University
Scott Sinclair, University of British Columbia
Sara Wick, University of Guelph
Preface
Just as the great migrations of creatures like the western sandpiper are a marvel, the transformative journeys of students are also a
wonder to witness. Much of what is best about this text has resulted
from classroom interactions with students. The echoes of the hundreds of introductory accounting classes and seminars I have taught
over the past 22 years can be heard throughout the pages of this
text. So much of what I have learned about presenting this material
is thanks to the thousands of students from these classes. I am so
thankful for the shared learning experience and I continue to learn
from it.
Sandpipers live in groups known as binds. I am grateful for a
wonderful collection of family and friends who form the bind that I
am part of. My mother, Bernette, and my sister, Faith, have continually provided me with support throughout my work as an author. My
children, Jacob and Erin, have been a constant source of inspiration
xi
and joy. Their patience and understanding of the significance of the
writing process to me means so much. I am most indebted to my partner and best friend, Caroline. She has always encouraged me to take
on new challenges, providing constant and unwavering support. Caroline has inspired so much of what is wonderful in my life and this
book is just another example of that. I cannot imagine a better partner
for the journey.
I hope that the text will help you to develop your own strong
understanding of financial accounting. Feedback and suggestions
for improving future editions are welcome. Please email them to
­BurnleyAuthor@gmail.com.
CHRIS BURNLEY
Vancouver Island University
November 2021
Brief Contents
PRE FAC E
1
vi
Overview of Corporate Financial Reporting 1-1
2
Analyzing Transactions and Their Effects on Financial
Statements 2-1
3
Double-Entry Accounting and the Accounting Cycle
3-1
4
Revenue Recognition and the Statement of Income
4-1
5
The Statement of Cash Flows 5-1
6
Cash and Accounts Receivable 6-1
7
Inventory
8
Long-Term Assets 8-1
9
Current Liabilities 9-1
7-1
10
Long-Term Liabilities 10-1
11
Shareholders’ Equity 11-1
12
Financial Statement Analysis 12-1
APPE N D I X A
Specimen Financial Statements: Dollarama Inc. A-1
APPE N D I X B
Revenue Recognition and Long-Term Contracts B-1
APPE N D I X C
Long-Term Assets C-1
APPE N D I X D
Investments
GLOSS ARY
xii
D-1
G-1/ CO MPA N Y IN D EX
C-1/ S U BJ E CT INDE X
S-1
Contents
1 Overview of Corporate Financial
Reporting
1.1
1.2
1.3
1.4
1.5
1-1
2.3
Dollar Store Business Is No Small Change 1-1
Introduction to Financial Accounting 1-2
What Is Financial Accounting? 1-3
Users and Uses of Financial Accounting 1-3
Who Needs an Understanding of Financial
Accounting and Why? 1-4
Forms of Business Organization 1-8
What Is a Corporation? 1-8
What Differentiates a Corporation from Other Forms
of Business? 1-9
Activities of a Business 1-10
What Are the Three Categories of Business
Activities? 1-10
What Are Examples of Financing Activities? 1-11
What Are Examples of Investing Activities? 1-12
What Are Examples of Operating Activities? 1-12
Financial Reporting 1-13
What Information Is Included in a Set of Financial
Statements? 1-13
What Is the Reporting Objective of the Statement of
Income? What Does It Include? 1-14
What Is the Reporting Objective of the Statement of
Changes in Equity? What Does It Include? 1-17
What Is the Reporting Objective of the Statement of
Financial Position? What Does It Include? 1-18
What Is the Reporting Objective of the Statement of
Cash Flows? What Does It Include? 1-23
What Type of Information Is in the Notes to a
Company’s Financial Statements? 1-25
2 Analyzing Transactions and Their
Effects on Financial Statements
2.1
2.2
A Growing Appetite for Financial
Transparency 2-1
Introduction 2-3
Accounting Standards 2-3
What Are Accounting Standards? 2-3
Do All Canadian Companies Use the Same
Accounting Standards? 2-3
Who Sets the Accounting Standards Used in
Canada? 2-4
Qualitative Characteristics of Financial
Information 2-5
2-1
2.4
2.5
2.6
2.7
How Do the Standard Setters Determine What
Constitutes Useful Financial Information? 2-5
Accrual Versus Cash Basis of Accounting 2-9
What Is the Difference between the Cash Basis of
Accounting and the Accrual Basis of Accounting? 2-9
The Accounting Equation Template
Approach 2-11
What Is the Accounting Equation Template Approach
to Recording Transactions? 2-11
Using the Accounting Equation Template Approach
to Analyze and Record Transactions 2-13
How Is the Accounting Equation Used to Analyze and
Record Transactions? 2-13
What Are the Limitations of the Accounting Equation
Template Approach? 2-25
Financial Statements 2-26
How Do We Know If the Company Was Profitable
during the Accounting Period? 2-26
How Can We Tell If the Equity Position of
Shareholders Changed during the Accounting
Period? 2-27
How Do We Determine the Company’s Financial
Position at the End of the Accounting Period? 2-28
How Can We Tell If the Company’s Cash Position
Changed during the Accounting Period? 2-28
Using Ratios to Analyze Financial Statements 2-32
How Do We Determine the Company’s Profit
Margin? 2-32
How Do We Determine How Effective the Company
Has Been at Generating a Return on Shareholders’
Equity? 2-33
How Do We Determine How Effective the
Company Has Been at Generating Profits Using Its
Assets? 2-34
3 Double-Entry Accounting and the
Accounting Cycle
3.1
3.2
3.3
3-1
Balancing the Books When Bartering 3-1
The Double-Entry System 3-3
How Does the Double-Entry Accounting System Work
and How Does It Overcome the Limitations of the
Template Method? 3-3
The Normal Balance Concept 3-4
What Is the Normal Balance Concept and How Is It
Used? 3-4
Understanding the Accounting Cycle 3-8
What Are the Steps in the Accounting Cycle? 3-8
xiii
xiv
3.4
3.5
3.6
3.7
3.8
Contents
The Chart of Accounts 3-9
What Is the Chart of Accounts? 3-9
Can Companies Change Their Chart of Accounts and
What Are the Implications If They Do? 3-10
Opening Balances 3-11
What Is the Difference between Permanent and
Temporary Accounts? 3-11
Transaction Analysis and Recording 3-11
How Are Transactions Identified? 3-11
How Are Transactions Recorded in the General
Journal? 3-12
Why Are Transactions Also Recorded in the General
Ledger? 3-19
What Is the Purpose of Preparing a Trial Balance? 3-21
Adjusting Entries 3-22
What Are Adjusting Entries and Why Are They
Necessary? 3-22
What Is the Purpose of Preparing an Adjusted Trial
Balance? 3-28
Preparing Financial Statements and Closing
Entries 3-29
What Are Closing Entries and Why Are They
Necessary? 3-29
What Do We Know If a Company Has Retained
Earnings? 3-34
What Is Meant by Earnings per Share, and How Is It
Calculated? 4-23
5 The Statement of Cash Flows
5.1
5.2
5.3
4 Revenue Recognition and the
Statement of Income
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4-1
Competing in the Revenue Game 4-1
Revenue and Its Significance 4-2
What Is Revenue and Why Is It of Significance to
Users? 4-3
Why Is Understanding How a Company Recognizes
Revenue of Significance to Users? 4-4
Revenue Recognition 4-5
When Are Revenues Recognized? 4-5
Other Revenue Recognition Issues 4-13
How Do Rights of Return, Warranties, Consignment,
and Third-Party Sale Arrangements Affect Revenue
Recognition? 4-13
Statement of Income Formats 4-16
How Does a Single-Step Statement of Income Differ
from a Multi-Step Statement of Income? 4-16
Statement of Comprehensive Income 4-19
What Is Comprehensive Income and How Does It
Differ from Net Income? 4-19
Presentation of Expenses by Nature or by
Function 4-20
How Does a Statement of Income Presenting
Expenses by Function Differ from One Presenting
Expenses by Nature of the Items? 4-20
Financial Statement Analysis 4-22
5.4
5.5
5.6
5.7
The Dash for Cash 5-1
Introduction 5-3
How Is “Cash” Defined? 5-3
Why Is the Statement of Cash Flows of Significance to
Users? 5-4
Differences between the Statement of Cash Flows
and the Statement of Income 5-5
How Does the Statement of Cash Flows Differ from
the Statement of Income? 5-6
Understanding the Statement of Cash Flows 5-7
What Are the Categories of Cash Flows Presented in
the Statement of Cash Flows and What Are Typical
Transactions Included in Each Category? 5-7
Why Is So Much Significance Placed on Cash Flows
from Operating Activities? 5-8
What Is the Difference between the Direct and
Indirect Methods of Preparing Cash Flows from
Operating Activities? 5-9
What Are the Options for Classifying Cash Flows
Related to Interest and Dividends Paid and
Received? 5-11
Are There Investing and Financing Activities That Do
Not Appear on the Statement of Cash Flows? 5-12
Preparing the Statement of Cash Flows Using the
Indirect Method 5-12
How Is a Statement of Cash Flows Prepared
Using the Indirect Method for Operating
Activities? 5-13
Preparing the Statement of Cash Flows Using the
Direct Method 5-24
How Is a Statement of Cash Flows Prepared Using
the Direct Method for Operating Activities? 5-24
Interpreting Cash Flow Information 5-26
How Can the Information Presented in a
Statement of Cash Flows Be Used to Manage a
Company? 5-26
What Can Cash Flow Patterns Tell Us? 5-28
Financial Statement Analysis 5-30
How Do We Determine What Portion of a Company’s
Current Liabilities Could Be Met with Cash Flows
from Operating Activities? 5-30
How Do We Determine How Much Net Free Cash Flow
a Company Generates? 5-31
6 Cash and Accounts Receivable
6.1
5-1
Will That Be Cash or Credit? 6-1
Introduction 6-3
6-1
Contents
Why Are Cash and Accounts Receivable of
Significance to Users? 6-3
6.2 Cash 6-4
What Is Included in the Definition of “Cash”? 6-4
At What Amount Is Cash Reflected on the Statement
of Financial Position? 6-4
6.3 Internal Control 6-4
Who Is Responsible for an Organization’s Internal
Controls? 6-4
What Are the Main Principles of Internal Control? 6-5
What Are the Limitations of Internal Control? 6-7
6.4 Bank Reconciliation 6-7
What Is the Purpose of a Bank Reconciliation and
Why Must It Be Prepared? 6-7
How Is a Bank Reconciliation Prepared? 6-8
6.5 Accounts Receivable 6-12
What Are Accounts Receivable? 6-12
Why Do Companies Sell on Account? 6-12
Are There Any Additional Costs from Selling on
Account? 6-13
6.6 The Carrying Amount of Accounts Receivable 6-14
At What Amount Are Accounts Receivable Reflected
on the Statement of Financial Position? 6-14
6.7 The Allowance Method 6-16
What Is the Allowance Method of Accounting for
Credit Losses? 6-16
6.8 Estimating Expected Credit Losses under the
Allowance Method 6-20
What Are the Various Risk Characteristics That Could
Be Used to Group Receivables? 6-20
How Does Management Determine the Company’s
Expected Rate of Credit Losses? 6-21
How Does a Company Quantify Its Allowance for
Expected Credit Losses? 6-22
6.9 The Direct Writeoff Method 6-24
What Is the Direct Writeoff Method and When Is It
Acceptable to Use It? 6-24
6.10 Cash-to-Cash Cycle 6-25
How Do Companies Shorten Their Cash-to-Cash
Cycle? 6-25
6.11 Financial Statement Analysis 6-27
What Is Liquidity and How Is It Assessed? 6-27
How Effective Has the Company Been at Collecting
Its Accounts Receivable? 6-29
7 Inventory
7.1
7.2
7-1
Pivoting in a Pandemic 7-1
Introduction 7-3
What Is Inventory? 7-3
Why Is Inventory of Significance to Users? 7-3
Types of Inventory 7-5
What Are the Major Classifications of Inventory? 7-5
7.3
7.4
7.5
7.6
7.7
7.8
7.9
What Goods Are Included in a Company’s
Inventory? 7-7
Inventory Systems 7-8
What Is a Periodic Inventory System? 7-8
What Is a Perpetual Inventory System? 7-10
What Are the Key Distinctions between Periodic and
Perpetual Inventory Systems? 7-11
How Does Management Decide Which Inventory
System to Use? 7-12
Cost Formulas 7-13
What Costs Are Included in Inventory? 7-13
What Are Cost Formulas and Why Are They
Necessary? 7-14
How Are Cost of Goods Sold and Ending Inventory
Determined Using the Specific Identification,
Weighted-Average, and First-In, First-Out Cost
Formulas under a Perpetual Inventory System? 7-17
How Do Companies Determine Which Cost Formula
to Use? 7-19
Inventory Valuation 7-20
At What Value Is Inventory Reflected on the
Statement of Financial Position? 7-21
How Is the Lower of Cost or Net Realizable Value
Applied to Inventory? 7-22
What Types of Inventory Valuation Errors Can
Happen and What Impact Do They Have on the
Financial Statements? 7-23
Gross Margin 7-24
What Is Gross Margin and Why Is It a Key
Measure? 7-25
Internal Controls and Inventory 7-26
What Principles of Internal Control Can Be Applied to
Inventory? 7-26
Financial Statement Analysis 7-27
How Often Does the Company Sell through Its
Inventory? 7-27
How Many Days Did It Take to Sell through the
Company’s Inventory? 7-28
How Can Inventory Amounts Be Estimated? 7-30
Appendix: Inventory Cost Formulas under the
Periodic Inventory System 7-31
How Are Cost of Goods Sold and Ending Inventory
Determined Using the Specific Identification,
Weighted-Average, and First-In, First-Out Cost
Formulas under a Periodic Inventory System? 7-31
8 Long-Term Assets
8.1
xv
8-1
A Canadian Icon’s Long-Term Assets 8-1
Introduction 8-3
What Are the Various Types of Long-Term Assets? 8-3
Why Are Long-Term Assets of Significance to
Users? 8-4
xvi
8.2
Contents
Valuation of Property, Plant, and Equipment 8-5
At What Amount Are Property, Plant, and
Equipment Reflected on the Statement of Financial
Position? 8-5
What Is Included in “Cost”? 8-6
What Happens When a Company Purchases Multiple
Assets for a Single Price? 8-7
How Do We Account for Costs Subsequent to
Purchase? 8-8
Can a Company Carry Property, Plant, and
Equipment at Their Fair Values? 8-8
8.3 Depreciation 8-9
Why Do We Depreciate Property, Plant, and
Equipment? 8-9
8.4 Depreciation Methods 8-10
What Are the Methods Used to Depreciate Property,
Plant, and Equipment? 8-10
How Do We Choose a Depreciation Method? 8-19
How Do We Record Depreciation Expense? 8-19
Does an Asset’s Carrying Amount Tell Me What It Is
Worth? 8-20
How Do We Determine Depreciation for Partial
Periods? 8-20
Is Depreciation Expense Recorded Every Period for
Each PP&E Asset? 8-20
Does the Choice of Depreciation Method Affect
Corporate Income Taxes? 8-21
8.5 Changes in Depreciation Methods 8-21
Can We Change Depreciation Estimates and
Methods? 8-21
8.6 Impairment 8-25
What Does It Mean If an Asset Is Impaired? 8-25
8.7 Disposal of Property, Plant, and Equipment 8-27
How Do We Account for Disposals of Property, Plant,
and Equipment? 8-27
8.8 Intangible Assets 8-29
What Are Intangible Assets? 8-29
At What Amount Are Intangible Assets Reflected on
the Statement of Financial Position? 8-31
How Is Accounting for Intangible Assets Different
from Accounting for Property, Plant, and
Equipment? 8-32
8.9 Goodwill 8-32
What Is Goodwill? 8-32
At What Amount Is Goodwill Reflected on the
Statement of Financial Position? 8-34
How Is Goodwill Treated Differently from Other LongTerm Assets? 8-35
8.10 Other Long-Term Assets 8-35
What Are Right-of-Use Assets? 8-35
At What Amount Are Right-of-Use Assets Reflected on
the Statement of Financial Position? 8-35
What Are Biological Assets? 8-36
At What Amount Are Biological Assets Reflected on
the Statement of Financial Position? 8-36
8.11 Financial Statement Analysis 8-37
How Do We Determine the Relative Age of the
Company’s Long-Term Assets? 8-37
How Do We Assess How Effectively the Company Has
Used Its Long-Term Assets? 8-37
9 Current Liabilities
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9-1
Booking Revenue for Gift Cards 9-1
Introduction 9-3
Why Is the Distinction between Current and NonCurrent Liabilities of Significance to Users? 9-3
Valuation Methods 9-4
At What Amount Are Current Liabilities Reflected on
the Statement of Financial Position? 9-4
Current Liabilities Arising from Transactions with
Lenders 9-4
What Current Liabilities Arise from Transactions with
Lenders? 9-5
Current Liabilities Arising from Transactions with
Suppliers 9-8
What Current Liabilities Arise from Transactions with
Suppliers? 9-8
Why Are Accounts Payable Sometimes Considered
“Free Debt”? 9-8
Current Liabilities Arising from Transactions with
Customers 9-9
What Current Liabilities Arise from Transactions with
Customers? 9-9
How Are Deferred Revenues Accounted For? 9-9
How Are the Liabilities Related to Gift Cards
Accounted For? 9-10
How Are the Liabilities Related to Loyalty Programs
Accounted For? 9-12
How Are Warranties Accounted For? 9-13
Current Liabilities Arising from Transactions with
Employees 9-16
What Current Liabilities Arise from Transactions with
Employees? 9-16
How Are Payroll Costs Accounted For? 9-17
Why Are a Company’s Wage Costs Greater Than What
It Pays Its Employees? 9-19
Current Liabilities Arising from Transactions with
the Government 9-20
What Current Liabilities Arise from Transactions with
Government? 9-20
When Are a Company’s Taxes Due? 9-21
Current Liabilities Arising from Transactions with
Shareholders 9-21
What Current Liabilities Arise from Transactions with
Shareholders? 9-21
Contents
9.9
Financial Statement Analysis 9-22
How Do We Determine How Long a Company Takes
to Pay Its Suppliers? 9-22
10 Long-Term Liabilities
10-1
Avoiding Pension Turbulence 10-1
10.1 Introduction 10-3
Why Are Long-Term Liabilities of Significance to
Users? 10-3
10.2 Long-Term Liabilities Arising from Transactions
with Lenders 10-4
What Long-Term Liabilities Arise from Transactions
with Lenders? 10-4
How Are Long-Term Loans and Mortgages Accounted
For? 10-4
What Are Bonds and How Do They Differ from LongTerm Loans? 10-7
How Are Bonds Priced in the Marketplace? 10-10
How Does the Pricing of Bonds Affect a Company’s
Interest Expense? 10-11
10.3 Long-Term Liabilities Arising from Transactions
with Other Creditors 10-14
What Long-Term Liabilities Arise from Transactions
with Other Creditors? 10-14
Why Do Companies Lease Capital Assets? 10-14
How Are Leases Accounted For? 10-14
10.4 Long-Term Liabilities Arising from Transactions
with Employees 10-16
What Long-Term Liabilities Arise from Transactions
with Employees? 10-16
What Are the Differences between Defined
Contribution, Defined Benefit, and Hybrid Pension
Plans? 10-17
What Are Other Post-Employment
Benefits? 10-20
10.5 Long-Term Liabilities Arising from Differences
between Accounting Standards and the Income
Tax Act 10-21
What Long-Term Liabilities Arise as a Result of
Differences between Accounting Standards and the
Income Tax Act? 10-21
10.6 Commitments and Guarantees 10-22
How Are Contractual Commitments and Guarantees
Reflected in the Financial Statements? 10-22
10.7 Contingencies 10-23
What Are Contingent Liabilities and How Are They
Accounted For? 10-23
10.8 Financial Statement Analysis 10-25
How Do Users Assess a Company’s Degree of
Leverage? 10-25
How Do Users Assess a Company’s Ability to Service
Its Long-Term Debt Obligations? 10-28
11 Shareholders’ Equity
11.1
11.2
11.3
11.4
11.5
11.6
11.7
xvii
11-1
Investors Warm up to Owning Shares in Canada
Goose 11-1
Introduction 11-3
Why Is Shareholders’ Equity of Significance to
Users? 11-3
The Shareholders’ Equity Section 11-3
What Is Included in the Shareholders’ Equity Section
of the Statement of Financial Position? 11-3
Types of Shares 11-6
What Types of Shares Is a Company Allowed to
Issue? 11-6
What Is the Difference between Authorized, Issued,
and Outstanding Shares? 11-7
Why Would a Company Repurchase Its Own
Shares? 11-7
What Are the Differences between Common Shares
and Preferred Shares? 11-8
Dividends 11-18
Do Companies Have to Pay Dividends? 11-18
What Are the Different Dates Involved in Declaring
and Paying a Dividend? 11-19
How Are the Declaration and Payment of Dividends
Recorded? 11-20
What Is the Difference between a Cash Dividend and
a Stock Dividend? 11-21
Stock Splits 11-24
What Is a Stock Split? 11-24
Why Would a Company Split Its Shares? 11-25
Financial Statement Analysis 11-26
What Is the Price/Earnings Ratio? 11-27
What Other Ratios Measure the Return the
Shareholders Are Earning? 11-28
Financing with Equity 11-30
What Are the Advantages and Disadvantages of
Financing with Equity? 11-30
12 Financial Statement Analysis
12-1
Student Stock Analysts Try to “Beat the
Street” 12-1
12.1 Introduction 12-3
What Is Financial Statement Analysis? 12-3
What Is the Process for Analyzing Financial
Statements? 12-4
12.2 The Contexts for Financial Statement
Analysis 12-5
What Are the Common Contexts for Financial
Statement Analysis? 12-5
Why Is an Understanding of Context Essential to the
Analysis? 12-5
12.3 Understanding the Business 12-6
xviii
12.4
12.5
12.6
12.7
Contents
Why Is It Essential to Understand the Business Being
Analyzed? 12-6
Business Information 12-7
What Information Is the Financial Statement Analysis
Based On and Where Is It Found? 12-7
Financial Statement Analysis Perspectives 12-11
What Is the Difference between Retrospective and
Prospective Analysis? 12-11
What Is the Difference between Trend Analysis and
Cross-Sectional Analysis? 12-11
Financial Statement Analysis Techniques 12-16
What Is Common-Size Analysis? 12-16
How Is Ratio Analysis Used to Analyze Financial
Statements? 12-18
What Are the Common Categories of Ratios? 12-19
Ratio Analysis 12-22
What Liquidity Ratios Are Commonly Used? 12-22
What Activity Ratios Are Commonly Used? 12-24
What Solvency Ratios Are Commonly Used? 12-28
What Profitability Ratios Are Commonly
Used? 12-30
What Equity Analysis Ratios Are Commonly
Used? 12-33
12.8 Limitations of Ratio Analysis 12-37
What Are the Limitations of Ratio Analysis? 12-37
12.9 Use of Non-IFRS Financial Measures and Other
Performance Measures 12-39
What Non-IFRS Financial Measures and Other
Performance Measures Are Commonly Used by
Investors? 12-39
Why Should We Be Cautious When Using Non-IFRS
Financial Measures and Other Performance
Measures? 12-40
Specimen Financial Statements:
Dollarama Inc. A-1
A P P E NDIX A
Revenue Recognition and LongTerm Contracts B-1
A P P E NDIX B
A P P E NDIX C
Long-Term Assets C-1
A P P E NDIX D
Investments
D-1
G LO SS A RY G-1/ CO M PA NY INDE X
INDE X S-1
C-1/ SUBJECT
kevin brine/Shutterstock.com
CHAPTER 1
Overview of Corporate
Financial Reporting
Dollar Store Business Is No
Small Change
When Salim Rossy opened a general store in Montreal in
1910, he financed it with his earnings from peddling items like
brooms and dishcloths in the countryside around Montreal.
By the time Rossy’s grandson Larry took charge in 1973, S.
Rossy Inc. had grown into a chain of 20 five-and-dime stores,
with most items priced at either 5 or 10 cents. In 1992, the
company opened its first Dollarama store, selling all items for
$1. Today, the business, now called Dollarama Inc., is Canada’s
largest dollar store chain. It operates more than 1,300 stores in
all provinces and now sells goods at between $1 and $4.
How do large companies such as Dollarama finance
growth? Like many businesses that reach a certain size, Dollarama eventually became a public company, issuing shares
that trade on the Toronto Stock Exchange (TSX). The company’s initial public offering, in 2009, raised $300 million, which
was used to open new stores. The company’s growth has been
steady ever since. By 2011, it had more locations than Canadian Tire, and recently it has opened an average of one new
store a week. It plans to operate 2,000 locations across Canada
by 2031—an increase over its previous plan of 1,700 stores by
2027.
In its 2021 fiscal year ended January 31, 2021, the company
had more than $4.0 billion in sales—an increase of more than
$200 million over the previous year. The company reported
that just over 60% of this growth was increased sales at existing stores, with the balance being sales at new stores opened
during the year. The company was even able to increase its
dividend—the money it pays to shareholders out of its profits.
On March 31, 2021, Dollarama announced that its board of
directors had approved a 7.0% increase in the quarterly cash
dividend to holders of common shares, from $0.047 to $0.0503
per common share.
Management at all companies is constantly looking for
ways to increase sales, often using marketing campaigns featuring sale prices on certain products. This isn’t the case for
Dollarama. Given the fixed price points of the company’s
products, there are no sale prices or markdowns to advertise.
Instead, the company uses almost all of its marketing budget to
advertise new store openings. Accepting credit cards as a form
of payment is one way that Dollarama has also been able to
increase its sales. It has found that the average transaction size
for customers using credit cards is twice as large as the average
cash transaction. Not only does this help increase sales, but it
also makes processing the transaction faster and contactless.
Shareholders and other stakeholders, such as banks and
suppliers, use a company’s financial statements to see how the
company has performed and what its future prospects might
be. Shareholders use them to make informed decisions about
things such as whether to sell their shares, hold onto them, or
buy more. Creditors use financial statements to assess a company’s ability to service its debts (pay interest and repay principal), while suppliers may use them to determine whether to
allow the company to purchase on credit. Companies communicate all this information through financial reporting, and the
tool used to prepare financial information is accounting.
Whether or not Dollarama achieves the revenue, profit,
and store growth it hopes for will be reported in the company’s
future financial statements. These financial statements will
tell the story of whether Dollarama got the best bang for its
buck.1
1-1
1-2
CH A PT ER 1
Overview of Corporate Financial Reporting
CORE QUESTIONS
If you are able to answer the following questions, then you
have achieved the related learning objectives.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Introduction to Financial Accounting
1. Define financial accounting and understand its
relationship to economic decision-making.
• What is financial accounting?
Users and Uses of Financial Accounting
• Who needs an understanding of financial accounting
and why?
2. Identify the main users of financial accounting
information and explain how they use this information.
Forms of Business Organization
• What is a corporation?
• What differentiates a corporation from other forms of
business?
3. Describe the major forms of business organization
and explain the key distinctions between them.
Activities of a Business
• What are the three categories of business activities?
• What are examples of financing activities?
• What are examples of investing activities?
4. Explain the three categories of business activities
and identify examples of transactions related to each
category.
• What are examples of operating activities?
Financial Reporting
• What information is included in a set of financial
statements?
• What is the reporting objective of the statement of
income? What does it include?
5. Identify and explain the content and reporting
objectives of the four basic financial statements and
the notes to the financial statements.
• What is the reporting objective of the statement of
changes in equity? What does it include?
• What is the reporting objective of the statement of
financial position? What does it include?
• What is the reporting objective of the statement of
cash flows? What does it include?
• What type of information is in the notes to a
company’s financial statements?
1.1
Introduction to Financial Accounting
LEARNING OBJECTIVE 1
Define financial accounting and understand its relationship to economic decision-making.
The opening story is an example of how a large company grows. Whether a business is
­borrowing money for a start-up or expansion, restructuring the organization, or deciding
whether to purchase or lease equipment, it needs to have accounting information to make the
best decisions. You, too, will use accounting information to help you make decisions, whether
Users and Uses of Financial Accounting 1-3
it’s determining if you should buy a company’s shares, apply for a job there, or enter into a
contract with it.
What Is Financial Accounting?
Financial accounting is the process by which information on the transactions of an organization is captured, analyzed, and used to report to decision makers outside of the organization’s
management team. Financial accounting is sometimes referred to as external financial reporting
due to its focus on providing accounting information to external decision makers. These external
decision makers are often referred to as financial statement users and include the owners
(normally referred to as investors) and those who have lent money to the organization (normally referred to as creditors). The primary purpose of financial accounting information is to aid
these users in their economic decision-making relative to the organization. Because these users
are generally outside of the organization and are not involved in its day-to-day operations, the
financial accounting information they receive is often their only “window” into the organization.
Users inside the organization (management) also use financial accounting information,
but they generally require the information at a different level of detail. For example, managers in
a national retail chain may need information for a particular store rather than for the organization
as a whole. Managers may need different information altogether, such as information needed to
develop forward-looking budgets rather than to report on past transactions. It is important to note
that management has access to all of the organization’s financial information, including information that is never shared with those outside of the organization. This information is known as
managerial accounting and will be the basis for another course in your business studies.
Management prepares two broad types of accounting reports:
• Reports for internal use only (for use by management): This is known as managerial
accounting. Its purpose is to inform decision-making.
• Reports for external use (for use by others outside the organization): This is known as
financial accounting. Its purpose is to help external users make decisions.
Financial accounting, the focus of this textbook, can be as simple as determining the
daily sales of a food truck or as complex as recording and reporting on the economic condition
of your university, a multinational corporation, or the Government of Canada. All of these
entities need to know economic information in order to continue to operate efficiently and
effectively. Financial accounting provides vital financial information that enables people and
organizations to make decisions. Because it is very likely that you will be a financial statement
user in some way, it is important that you have at least a basic understanding of what financial
accounting is (and is not), what it is trying to accomplish, and how it does so.
The focus of this book is the financial accounting information produced by profit-oriented organizations, although we will occasionally refer to not-for-profit organizations or
governments. We will concentrate on the financial statements, which are management’s
reports to the company’s owners that are produced at the end of each accounting period, such
as every quarter or every year. The annual financial statements are included in the company’s
annual report together with the management discussion and analysis (MD&A) of the
company’s results for the year. The annual report is made available to the company’s owners,
but many other parties, such as lenders, financial analysts, credit-rating agencies, securities
regulators, and taxing authorities, also use it.
1.2
Users and Uses of Financial Accounting
LEARNING OBJECTIVE 2
Identify the main users of financial accounting information and explain how they
use this information.
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Overview of Corporate Financial Reporting
Who Needs an Understanding of Financial
Accounting and Why?
Before we answer these questions, let’s take some time to think a little about the game of hockey.
(Yes, hockey. After all, what’s a Canadian textbook without a hockey reference?) Whether
you have lived in Canada your whole life or you are here studying from some other part of
the world, chances are good that you have seen a professional hockey game on television or
perhaps even in person. During the game, the TV commentary or the conversations of those
around you would have included terms like icing, charging, slashing, five-hole, hash marks, neutral zone, and so on. These would have been confusing terms the first time you heard them, but
once they were explained to you, your ability to follow the game and understand it at a deeper
level would have improved. The same thing is true of financial accounting. Through the text’s
12 chapters, we will learn the language of financial accounting and how to interpret financial
accounting information so you can come away with a deeper understanding of the subject.
So, let’s rephrase our opening question and think about “Who needs to understand the
rules of professional hockey?” Many groups likely come to mind fairly quickly, including:
• players (including their agents and players’ union)
• coaches and general managers
• referees, linesmen, and off-ice officials
• fans
• TV commentators, arena announcers, and sports journalists
• league officials
• team owners
• suppliers, advertisers, and landlords
We can call these people stakeholders because they have a stake in understanding hockey.
Now, let’s take this list of hockey stakeholders and find the parallel business stakeholders who
would have a similar stake in a business, as shown in Exhibit 1.1.
EXHIBIT 1.1 Similarities between Hockey Stakeholders and Business Stakeholders
Hockey Stakeholders
Parallel Business Stakeholders
Players, including their agents and players’
union
Employees, unions
Coaches and general managers
Management
Referees, linesmen, off-ice officials
Auditors, federal and provincial government
departments, legislators
Fans
Potential investors, customers
Announcers, TV analysts, sports journalists
Stock analysts, brokers, financial advisors,
business reporters
League officials
Stock exchange regulators
Team owners
Shareholders, board of directors
Suppliers, advertisers, landlords
Creditors, suppliers, landlords
Now, let’s consider some of the questions that each of the stakeholders in a business may
be trying to answer about that business that would require an understanding of financial
accounting, as shown in Exhibit 1.2.
These groups of business stakeholders are often known as financial statement users.
Throughout this book, we will be looking at the information needs of many of these users and
Users and Uses of Financial Accounting 1-5
EXHIBIT 1.2 Questions That Stakeholders in a Business May Be Asking
Business Stakeholders
Potential Questions They May Be Trying
to Answer about the Business
Employees, unions
Is the business profitable? Will I earn a bonus this
year? Can the company afford to negotiate increased
wages? Is the company pension plan in decent
shape?
Management
How do this year’s sales compare with last year’s?
How do they compare with the budget? Are we
maintaining our profit margins on certain product
lines? How much do we owe our employees and
suppliers?
Auditors, federal and provincial
government departments, legislators
Has the company presented its financial
information fairly? How does the company’s
financial information compare with the information
submitted for taxation or payroll purposes?
Potential investors, customers
What are the long-term prospects for this company?
Has the management team done a reasonable
job? Will this company be around to honour its
warranties?
Stock analysts, brokers, financial
advisors, business reporters
What are the company’s trends? What are the
prospects for this company? How has this company
performed relative to expectations?
Stock exchange regulators
Has the company complied with the financial
reporting standards and listing requirements?
Shareholders, board of directors
Has the company generated a sufficient return on
our investment? How effectively has management
used the resources at their disposal? Does the
company generate enough income to be able to pay
dividends?
Creditors, suppliers, landlords
Should we extend credit to this company? Is this a
credible and successful company that we want to
attach our brand to? Should we enter into a lease
with this company?
discussing how they use financial accounting information in making a variety of decisions.
The breadth of this list of users illustrates that, no matter which path you take in your ­business
studies, having a basic understanding of accounting information will be essential to business
success or could be a job requirement. As we move through the chapters, try to see yourself
in one or more of these roles and think about the ways in which you can make use of the
accounting information that you will no doubt come across.
The primary goal of this book is to help you become an intelligent user of ­accounting
information by enhancing your ability to read and understand corporate financial statements.
You may become a manager, accountant, banker, or financial analyst, and even if you do
not end up working directly in the finance industry, you will invest in the shares or bonds
of a company at some point in your life. If you work in a company, whether in sales, human
resources, or other areas, your decisions will likely have an impact on what is reported to owners. Whatever your business role, you will make decisions about companies, such as whether
to invest in their shares, lend them money, or sell them goods or services on credit. In making
these decisions, it will be important for you to understand the information that is presented in
corporate financial statements. You must know what each piece of information tells you about
the company, but also what it does not tell you. You should also understand that some information that is useful in making certain decisions is not contained in the financial statements.
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This book has been written for a broad readership, understanding that many of you will
play multiple roles as owners (shareholders), creditors, and managers of companies. It starts
with the assumption that you know little or nothing about accounting. It also assumes that
you are not training to be an accountant, although that may be your objective. Therefore, this
book does not emphasize accounting procedures. Instead, it emphasizes the underlying concepts of accounting and the analysis of financial statements. However, it is not really possible
to have a knowledgeable understanding of the end result of the accounting process without
first having an overall view of how the accounting system works. For this reason, the first
three chapters present the basic mechanics of the accounting system. The remaining chapters
are then devoted to more detailed accounting issues and concepts, and to a more in-depth
analysis of financial statements.
We will now explore the financial statement users in more detail. Exhibit 1.3 lists the
various financial statement users, categorizing them as either internal or external users.
EXHIBIT 1.3 Users of
Financial Statement
Information
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Internal users:
Management
External users:
Shareholders, the board of directors, and potential investors
Creditors (for example, financial institutions and suppliers)
Regulators (for example, a stock exchange)
Taxing authorities (for example, the Canada Revenue Agency)
Other corporations, including competitors
Securities (stock) analysts
Credit-rating agencies
Labour unions
Journalists
Since the focus of financial accounting is reporting to external users, let’s look at these
users and their information needs in greater detail.
Shareholders, the Board of Directors, and Potential Investors
KEY POINTS
Shareholders are
investors who have
invested resources into a
company in exchange for
a share of its ownership.
A company is owned by its shareholders, who have invested resources in the company in
exchange for a share of its ownership. As noted in the Key Points, because these investors
own a share of the company, they are referred to as shareholders.
There may be a single shareholder in the case of a private company or many thousands
of shareholders in the case of a public company. We will discuss the distinctions between
private and public companies a little later in the chapter, so for now it is just important to
understand that companies are owned by their shareholder(s). In situations where there are
numerous shareholders, they elect a board of directors to represent their interests. The
board of directors is given the responsibility of overseeing the management team that has
been hired to operate the company.
The board of directors, individual shareholders, and potential investors all require information to enable them to assess how well management has been running the company. Just
like hockey fans look at the arena scoreboard to see how their team is doing in terms of the
score, shots on goal, and so on, stakeholders in a business look at a company’s financial
reports to determine how it’s doing in a number of areas. Business stakeholders want to make
decisions about buying more shares or selling some or all of the shares they already own
(similar to a hockey team’s general manager deciding whether to acquire a star player or trade
an underperforming one). They will analyze the current share price (as reflected on the stock
exchange) and compare it with the original price that they paid for the shares. Are the shares
now worth more or less? They will also be comparing the share price with the company’s
underlying value, which is reflected in the financial statements and other sources of information they have about the company.
Users and Uses of Financial Accounting 1-7
Individual shareholders will also want to assess whether the current board of directors
has effectively carried out its oversight role. They will seek to answer questions such as:
• Is the company heading in the right direction (that is, has the strategic direction approved
by the board resulted in increased sales, profits, and so on)?
• Is it making decisions that result in increased value to the shareholders?
• Is the company generating a sufficient return on the resources invested in it by the
shareholders?
Creditors
Creditors are those who lend money or otherwise extend credit to a company rather than
invest in it directly as investors do. There are two major groups of creditors:
1. Financial institutions and other lenders
2. Suppliers, employees, and the various levels of government
Financial institutions, such as banks and credit unions, lend money to companies. They do
so seeking to generate a return on these loans in the form of interest. Of course, the lenders also
want to ensure that the money they lend out will eventually be repaid (that is, the loan ­principal
will be repaid). Loans can either be short-term or extend over several years. These lenders need
financial accounting information to assess the company’s ability to service the loan. One of the
ways this is done is by looking at the cash flows the company generates through its operations.
They are also generally interested in the amount of the company’s inventory, equipment, buildings, or land, because these may be pledged as security by the borrowing company in the event
that it cannot repay the loan. Large companies also enter into long-term borrowing arrangements by issuing corporate bonds. Rather than borrowing from a single lender, companies that
issue bonds borrow from many lenders. Nevertheless, these lenders are also concerned about
the company’s ability to service the debt (pay interest and repay principal) over the term of the
bond, and their financial accounting information needs are similar to those of other lenders.
The other group of creditors includes suppliers, employees, and various levels of government. These groups often sell goods or provide services prior to receiving payment. For
example, a supplier may agree to sell goods or provide services to a company and agree to wait
30 days for payment. Employees are another common creditor as they normally work for the
company and then receive payment after the fact, such as at the end of every two weeks or
at the end of a month. Different levels of government may also be creditors of a company as
they wait to receive tax payments or payroll deduction amounts. These users may focus on the
amount of cash in the company because they are concerned about being paid.
Regulators
The regulators who are interested in financial statements are numerous. For example, the
federal and provincial governments have regulations related to how companies report their
financial information and are interested in ensuring that these regulations are followed. The
stock exchanges, on which the shares of public companies are traded, have regulations about
the timing and format of information that companies must convey to them and to investors.
Companies not complying with these regulations can be delisted, meaning their shares cease
to trade on the exchange, which greatly affects their ability to raise capital.
For Example
Heath Korvola/Getty
Korvola/GettyImages
Images
Heath
Wildflower Brands Inc. (formerly Wildflower ­Marijuana
Inc.) is a BC-based company that focuses on building reputable brands and quality products that incorporate the
synergistic effects of plants and their extracts. It is a publicly traded company whose shares trade on the Canadian
Securities Exchange (CSE). On February 3, 2021, the British Columbia Securities Commission announced a cease
trade order on Wildflower’s shares as a result of the company failing to file its audited annual financial statements
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by the filing deadline. The company explained that the delay was due to challenges with the audit
of the company’s 2019 financial statements, which prevented the audit of the company’s 2020
financial statements, which, in turn, meant that they could not be submitted to the securities
regulator. The company noted that it was continuing to work with the British Columbia Securities
Commission to determine the steps needed for it to move forward in a manner that would result
in a resumption of trading for the company’s shares.2
Taxing Authorities
The Canada Revenue Agency (CRA) is the federal taxing authority in Canada and is
responsible for federal tax collection. Corporate taxes are primarily based on taxable income,
which is calculated based on accounting net income. As such, the CRA is another key user of
a company’s financial accounting information.
Other Users
Additional users of financial statement information include other companies, securities analysts, credit-rating agencies, labour unions, and journalists. Other companies may want information about the performance of a company if they are going to enter into contracts with
it. If it is a direct competitor, they may seek information that will help assess the competitor’s strength and future plans. Securities analysts and credit-rating agencies use the financial statements to provide information about the strengths and weaknesses of companies to
people who want to invest. Labour unions need to understand the company’s financial health
in order to negotiate labour contracts with management. Companies often give journalists
news releases that disclose financial information such as expected earnings. The journalists
may refer to the actual financial statements to validate the information they were given and to
supplement the original information.
It is important to understand that all of these users are using the same set of financial
statements in spite of the diversity of their information needs. The bodies that establish the
international and domestic standards for financial reporting are aware of all of these users,
but have taken the position that they will emphasize the needs of investors and creditors in
the determination of standards. As such, many pieces of information that particular users may
want cannot be found in the financial statements, and these users must look to other sources
of information as well.
The types of financial information gathered and made available to stakeholders vary
depending on the form of organization a business has, which we discuss next.
1.3
Forms of Business Organization
LEARNING OBJECTIVE 3
Describe the major forms of business organization and explain the key distinctions
between them.
What Is a Corporation?
Businesses can be operated in a number of different forms, including as a corporation, as a
proprietorship, or as a partnership. Most businesses of any significant size operate as corporations and, as such, this text will focus on the accounting information related to that form of
business. However, most of the accounting issues that we will identify in the text also apply
in some degree to the other forms of business. If you have a good understanding of corporate
Forms of Business Organization
accounting, it is not a big challenge to understand the nuances of accounting for proprietorships or partnerships.
As previously mentioned, corporations are owned by shareholders, with the initial shareholders having provided cash or other assets to a corporation in exchange for share certificates.
These shares are called common shares. One of the key distinctions between corporations
and other forms of business is that corporations are separate legal entities; that is, they are
legally distinct from their owners. This is where the “Limited” or “Ltd.” that you see in the
names of many corporations comes from; it refers to the fact that the company has limited
legal liability. Since the corporations are separate legal entities, they can enter into contracts
and be sued. In the event the company fails, the liability of shareholders is limited to their
investment in the corporation.
There are two main types of corporations: public companies (which are also known as
publicly traded companies) and private companies (which are also known as privately held
companies). The distinction between the two is whether or not the company’s shares are listed
on a public stock exchange. Public companies are companies whose shares are listed on public stock exchanges such as the Toronto Stock Exchange (TSX), the TSX Venture Exchange
(TSXV), or the Canadian Securities Exchange (CSE). Public companies are also referred to
as listed companies. The shares of private companies trade privately and are not listed on
public exchanges. The shares of public companies are often widely held, meaning that they
are owned by a large number of individuals or entities. Some portion of their ownership will
usually change hands every day. On the other hand, shares of a private company are often
narrowly held, meaning that they are owned by a relatively small number of people. It is not
as easy to transfer ownership in a private company.
Shareholders are not typically involved in the day-to-day operations, except in small private corporations. Given that public companies have a large number of shareholders who
are not involved in day-to-day activities, the shareholders typically elect a board of directors to represent them. The board of directors has the authority to hire (and fire if necessary) the management team who will manage the company’s day-to-day operations. These
senior executives, along with the other managers they hire, are known as management. To
keep shareholders informed of the performance of their investment in the company, management reports periodically to the shareholders. Financial statements are normally prepared for
shareholders quarterly (every three months). Annual financial statements are also produced
and are included in the company’s annual report. It is these annual financial statements that
we will be focusing on.
For Example
There are more than 1.32 million businesses operating in Canada. More than 800,000 of these are
corporations. The vast majority of these are small, privately held companies. In fact, there were
only 3,289 public companies trading on Canada’s two largest stock exchanges, the TSX and TSX
Venture Exchange, as of February 2021. While the number of public companies may be small,
their value is very significant. These 3,289 public companies were valued at $3,477.1 billion,
according to the quoted market value of their shares.3
What Differentiates a Corporation from Other
Forms of Business?
There are a number of key distinctions between corporations and the other forms of business:
partnerships and proprietorships. Exhibit 1.4 outlines a number of the key distinctions to
help you understand them. It is important to be aware of these differences, but also to understand that there are circumstances in which it makes sense to organize a business using each
of these three main forms of business.
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EXHIBIT 1.4 Key Distinctions between the Forms of Business
Distinguishing
Feature
Corporation
Proprietorship
Partnership
Number of owners
Can be a single owner
or multiple owners
Single owner
Multiple owners
Separate legal entity?
Yes, shareholders’
personal assets are not at
risk in the event of legal
action against company
No, owner’s
personal assets are
at risk in the event
of legal action
No, partners’
personal assets are at
risk in the event of
legal action
Owner(s) responsible for
debts of the business?
Only to extent of
investment
Yes
Yes
Taxed?
Yes, taxed separately
No, profits taxed in No, profits taxed in
hands of owner
hands of owners
Costs to establish
Most expensive
Least expensive
Moderately expensive
Cost to maintain
Most expensive
Least expensive
Moderately expensive
Must make their financial Yes, on a quarterly and No
information available
annual basis
1.4
No
Activities of a Business
LEARNING OBJECTIVE 4
Explain the three categories of business activities and identify examples of transactions related to each category.
What Are the Three Categories of Business
Activities?
To understand the information in financial statements, it is useful to think about the fundamental types of activities that all businesses engage in and report on. As illustrated in
Exhibit 1.5, all of the activities of businesses can be grouped into three categories: (1) financing activities, (2) investing activities, and (3) operating activities. Each of these involves
inflows and outflows of cash into and out of the company.
Now, let’s explore each category.
EXHIBIT 1.5 The Three
Categories of Business
Activities
Financing
activities
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Business
activities
cycle
Operating
activities
Investing
activities
Activities of a Business 1-11
What Are Examples of Financing Activities?
The first activities of all companies involve obtaining the funding (or financing) needed to
purchase the equipment or buildings they need to start operations. At the outset of the business, funding may also be required to pay for the initial purchase of inventory, pay a landlord
a deposit on rented space, pay for advertising, and so on. While these activities are a necessity
for new companies, they also continue as companies grow and expand. Companies obtain
funding from two primary sources: (1) investors and (2) creditors, as explained in the Key
Points.
Companies obtain funding from investors by issuing them shares (common shares) in the
company in exchange for cash or other assets. These shares represent the investor’s ownership
interest in the company. For example, if the investor owns 10% of the shares issued by the
company, they normally own 10% of the company. Since investors own, or hold, shares in the
company, we normally refer to them as shareholders. Shareholders purchase shares seeking
to generate a return, which may be realized in two different ways. First, they hope to receive
dividends. These are payments made by a company that distribute a portion of the company’s
profits to shareholders. The other way shareholders seek to make a return is by being able to
sell their shares to other investors for more than they paid for them. This gain, or increase in
value, is known as capital appreciation. Of course, when the sale occurs, investors may also
experience a loss if they receive less than the initial amount paid for the shares. The funds that
flow into the company from the initial issuance of shares to its shareholders form part of what
is called shareholders’ equity. The issuance of shares is a financing activity. Sales of shares
by one investor to another investor do not impact the company’s cash flows.
KEY POINTS
A company’s financing
comes from two sources:
• investors, through the
issuance of shares;
• creditors, through
taking out loans or
making purchases on
credit.
For Example
Companies often try to establish a pattern of declaring and paying dividends in order to make
their shares attractive to investors. The Bank of Montreal holds the record among Canadian
public companies for the longest continuous stretch of paying dividends to its shareholders,
­having done so each year since 1829!4
Once a company has some shareholders’ equity, it is then able to seek funding from the second primary financing source, creditors. Creditors are entities that lend money to a company.
Banks are the most common example of a creditor. Creditors seek a return from the money
they lend to a company. This return is the interest they receive for the time they have allowed
the company to use their money. Of course, creditors also expect to get their money back. This
is known as a return of principal. As noted in the Key Points, investors and creditors are each
looking for two types of return.
If a company is operating profitably, it has an internal source of new funding because
generally not all of those profits are being paid out to shareholders as dividends. Any profits
that are kept or retained by the company are known as retained earnings. If a company’s
retained earnings are less than the funding it requires to grow (such as money to purchase
additional equipment or carry new lines of inventory), the only way it can expand is to obtain
more funds from investors (existing shareholders or new investors) or to borrow from creditors. How much to borrow from creditors and how much funding to obtain from investors are
important decisions that the company’s management must make. Those decisions can determine whether a company grows, goes bankrupt, or is bought by another company. Exhibit 1.6
shows examples of financing activities.
Typical Financing Activities
Inflows: Taking out a loan (borrowing money)
Issuing shares
Outflows: Repaying loan principal
Paying dividends
KEY POINTS
While the nature of the
returns are different,
both investors and
creditor are looking for
two types of returns.
• Investors seek
dividends and capital
appreciation;
• Creditors seek interest
and a return of capital.
EXHIBIT 1.6 Typical
Financing Activities
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KEY POINTS
A company’s investing
activities are related to
two things:
• buying and selling
property, plant, and
equipment;
• buying and selling
the shares of other
companies.
EXHIBIT 1.7 Examples of
Typical Investing Activities
What Are Examples of Investing Activities?
Once a company obtains funds, it must invest them to accomplish its goals. Most companies
make both long-term and short-term investments in order to carry out the activities that help
them achieve their goals. Most short-term investments (such as the purchase of raw materials
and inventories) are related to the day-to-day operations of the business and are therefore
considered operating activities. Many long-term investments are related to the purchase of
property, plant, and equipment that can be used to produce goods and services for sale. Companies can also invest in the shares of other companies, and these may be either long-term
or short-term investments. The Key Points summarize the two types of investing activities.
Exhibit 1.7 shows examples of investing activities.
Typical Investing Activities
Inflows: Proceeds from the sale of property, plant, and equipment
Proceeds from the sale of shares of other companies
Outflows: Purchase of property, plant, and equipment
Purchase of shares of other companies
What Are Examples of Operating Activities?
Operating activities are all of the activities associated with developing, producing, marketing,
and selling the company’s products and/or services. While financing and investing activities
are necessary to conduct operations, they tend to occur on a more sporadic basis than operating activities. The day-to-day ongoing activities of a company are generally classified as operating activities, as explained in the Key Points.
Exhibit 1.8 shows examples of operating activities.
EXHIBIT 1.8 Examples of
Typical Operating Activities
Typical Operating Activities
Inflows: Sales to customers
Collections of amounts owed by customers
Outflows: Purchases of inventory
Payments of amounts owed to suppliers
Payments of expenses such as wages, rent, and interest
Payments of taxes owed to the government
KEY POINTS
A company’s operating
activities are related to
the company’s revenues
and expenses, which fall
into two basic categories:
• inflows from sales to
and collections from
customers;
• outflows related to
payment of the expenses
of the business.
Of the three categories of activities, operating activities are considered the most critical
to a company’s long-run success or failure. If the company is not successful at generating cash
flows from its operations, it will ultimately run out of cash, as financing sources will dry up
because it will be unable to attract new investors or lenders. It would then have to sell the
property, plant, and equipment that it uses to generate its revenues, which would mean it
would not be able to continue operating.
Exhibit 1.9 illustrates the principal inflows and outflows associated with the three categories of business activities.
The financial statements provide information about a company’s operating, financing,
and investing activities. By the end of this book, you should be able to interpret financial
statements as they relate to these activities. To help you become a successful user of financial statement information, in Appendix A at the back of the book, we present the financial
statements of Dollarama Inc., which were included in the company’s 2020 annual report.
As noted in the feature story, Dollarama is a Canadian retailer. Let’s walk through the various
types of information contained in this part of Dollarama’s annual report.
Financial Reporting 1-13
Payment of
dividends
Borrowing
(loan)
Issuing
shares
Repayment
of loan
Financing
activities
Business
activities
cycle
Operating
activities
All revenues
and expenses
Investing
activities
Proceeds from selling
land/building/
equipment
Purchase of
land/building/
equipment
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 1-1
• Demonstration Problem 1-1 in Wiley’s course resources
1.5
Financial Reporting
LEARNING OBJECTIVE 5
Identify and explain the content and reporting objectives of the four basic financial
statements and the notes to the financial statements.
What Information Is Included in a Set of Financial
Statements?
The components of the financial statements are shown in Exhibit 1.10.
Let’s look at each component of the financial statements in detail, including what it sets
out to do and what information it includes.
EXHIBIT 1.9 The Three
Categories of Business
Activities: Key Inflows and
Outflows
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Overview of Corporate Financial Reporting
EXHIBIT 1.10 Components of
the Financial Statements
Components of the Financial Statements
Statement of income
Statement of changes in equity
Statement of financial position
Statement of cash flows
Notes to the financial statements
What Is the Reporting Objective of the Statement
of Income? What Does It Include?
The objective of the statement of income is to present the results of the company’s operating activities for a month, a quarter, or a year (Exhibit 1.11). The sum of these operating
activities is known as the company’s profit, which is determined by subtracting the expenses
incurred in the period from the income earned during the same time period. Profit, which is
also known as net income, net earnings, or earnings, is a standard measure of corporate
performance. Of course, it is possible to have a net loss, which would mean that the expenses
for the period exceeded the income earned.
EXHIBIT 1.11 Alternative
Names for the Statement of
Income
The Statement of Income Is Also Known as the …
Statement of operations
Statement of net earnings
Statement of earnings
Statement of profit or loss
Income (which includes both revenues and gains) is defined as increases in economic
resources other than those contributed by shareholders. Revenues result when resources flow
into the company from its ordinary activities, such as sales of goods and services. Gains results
from activities that are outside its normal course of operations. An example is when a company sells some of its equipment that it has finished using and the proceeds of sale are greater
than the amount the equipment is recorded at by the company.
Expenses are defined as decreases in economic resources, other than distributions to
shareholders. They are more commonly thought of as the money or other resources that flow
out of the company in the course of generating revenues. Expenses include things like the
cost of the goods the company sells or the wages that are paid to the employees making these
sales. A company can incur losses on sales that are outside its normal course of operations.
An example is when a company sells equipment that it has finished using, but the proceeds of
sale are less than the amount the equipment is recorded at by the company. As both gains and
losses are outside of the company’s normal operations, they are presented separately from revenues and expenses on the statement of income, so that the users of the financial statements
are able to make this distinction.
Refer to the consolidated statement of net earnings and comprehensive income for
Dollarama in Appendix A. It is called a consolidated financial statement because it consolidates the financial information for the main or parent company plus the financial information of all the other companies that it controls (known as the subsidiary companies).
The time period of the statement is indicated at the top, where it reads “January 31, 2021, and
February 2, 2020.” Companies are required to provide comparative information (the results
of both the current period and preceding period) so that users can assess the changes from the
previous period. As noted above, this statement reports on the company’s operating perform­
ance for the year ended January 31, 2021. This period is also known as the company’s fiscal
year. You may be wondering why Dollarama’s fiscal years ended on different days in 2021 and
2020 (that is, January 31 in 2021 and February 2 in 2020). This is because the company has
established that its fiscal year ends on the Sunday closest to January 31 each year. Finally, it is
Financial Reporting 1-15
also important to note that the numbers in Dollarama’s financial statements are presented in
thousands of Canadian dollars. Some Canadian companies, whose shares trade on U.S. stock
exchanges, report in U.S. dollars instead of Canadian dollars.
For Example
Canada Goose Holdings Inc. is a Toronto-based
company that designs, manufacturers, and sells premium outdoor apparel. The company’s shares are
listed on both the Toronto Stock Exchange and the
New York Stock Exchange. While a substantial portion
of the company’s revenues, inventory purchases, and
expenses are in foreign currencies, including U.S. dollars, euros, and British pounds sterling, the company
prepares its financial statements in Canadian dollars.
Canada Goose is an example of a company
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that changed its fiscal year. In 2019, Canada Goose
changed its year end to the Sunday closest to March 31, rather than using a calendar basis of 12
months ending March 31, which it had historically used. This means that, rather than every fiscal
year ending on March 31, it will end on the Sunday closest to that, date. For example, the company’s 2020 fiscal year ended on March 29. The company explained that the change will result in the
company having 52- or 53-week reporting cycles.5
Revenue
From the statement, we can see that Dollarama generated revenues (or sales) of more than
$4.0 billion during its 2021 fiscal year. This would be the sales from all 1,356 stores that the
company owned and operated across Canada as of January 31, 2021. From the comparative
information, we can see that the company’s sales increased 6.3% over the prior period. This
trend is positive, and we could read the management discussion and analysis (MD&A) section
of the company’s annual report to get additional details regarding the change in revenues. As
the name implies, the MD&A section is where senior management discusses and analyzes the
financial statements. (We will explore more aspects of an MD&A later in the chapter.) A look
at Dollarama’s MD&A tells us that, while overall sales grew 6.3% over the previous year, sales
grew 3.2% in existing stores (which Dollarama refers to as “organic growth”) and the balance
of the growth resulted from the company opening 65 new stores during the year. The MD&A
also indicates that 73.7% of the sales resulted from products priced higher than $1.25. We can
also see that Dollarama’s sales are somewhat seasonal: 27.4% of sales occur in the fourth quarter, with December being the biggest month. Other holidays, such as Easter, St. Patrick’s Day,
Valentine’s Day, and Halloween, are also periods of increased sales. As you can see, while the
information presented in the statement of income is useful, it often needs to be supplemented
with other information in order to carry out meaningful analysis.
Expenses
Expenses are also presented under various categories, including cost of goods sold (or cost of
sales, or cost of merchandise sold); selling, general, and administrative expenses (or operating
expenses); interest expense; and income tax expense (or provision for income taxes). As you
would expect, cost of sales is a significant expense for a company like Dollarama. As a retailer,
it purchases finished goods to sell in its stores. The other significant cost would be the wage
costs for all of the company’s employees, whether they work at the retail locations, warehousing and distribution operations, or at the company’s head office. The cost of operating store
locations would also be a significant expense. These costs are included in general, administrative, and store operating expenses. Dollarama provides some additional information on the
makeup of cost of sales and general, administrative, and store operating expenses in Note 17
to the financial statements. This is another example of providing information in addition to
that presented in the statement itself so users can fully understand the financial information.
1-16
C H A PTE R 1
Overview of Corporate Financial Reporting
Gross Profit
Gross profit (or gross margin) is another very important number presented on the statement
of income for all companies that sell goods. It is equal to the difference between the revenue
received from the sale of the goods and the amount these goods cost the seller. From Dollarama’s statement of net earnings, we can see that this amounted to almost $1.78 billion in 2021.
It is often more meaningful to express gross profit as a percentage of revenue than as a dollar
figure. For Dollarama, the gross profit percentage was 43.8% in 2021. This means that, for
every dollar in sales revenue, the company had just under $0.44 after paying for its products.
This gross profit must then be used to cover the rest of the company’s operating costs, such as
wages, utilities, and advertising. Another way of looking at this is to consider that, on average,
the products Dollarama sells for $1 cost the company just over $0.56 to purchase.
Net Earnings
Net earnings (net income or profit) is the amount of the company’s revenue that remains after
paying all of its expenses, such as product costs, wages, store operating costs, interest, and
income taxes. In the case of Dollarama, the company had net earnings of $564 million for
2021. If we reflect this as a percentage of sales, we can see that for every $1 in sales revenue,
Dollarama earned about $0.14 in net earnings. In other words, for every $1 in sales revenue,
Dollarama incurred total expenses of about $0.86.
Earnings per Share
At the bottom of the statement of income is an earnings per share disclosure. Basic earnings
per share is the company’s net income divided by the average number of common shares that
are outstanding (owned by shareholders of the company) during the year. Shareholders find this
calculation useful since it puts the performance of their investment into perspective. In other
words, a shareholder who holds 10,000 shares of Dollarama can determine his or her share of
the earnings during the period. In the fiscal year ended January 31, 2021, Dollarama’s basic
earnings per share were $1.82. Therefore, that investor’s share of the earnings for 2021 would
be $18,200. The board of directors determines how much of the company’s earnings, if any, will
be paid to shareholders as dividends. Dollarama’s board paid declared quarterly dividends (paid
every three months) to its shareholders in 2021. These ranged from $0.044 to $0.047 per share. As
Dollarama had an average of 311 million shares issued in 2021, dividends totalling $55.6 million
were declared in fiscal 2021. This means that Dollarama’s board distributed just over 10% of the
company’s earnings as dividends and retained and reinvested the balance to grow the company.
On some statements of income, there will also be a diluted earnings per share amount,
which is normally lower than the basic earnings per share. Dollarama has indicated that its
diluted earnings per share were $1.81. Diluted earnings per share reflects the earnings per
share figure that would have been determined if all of the securities that can be converted
into shares actually had been converted. More advanced financial accounting courses discuss
diluted earnings per share in more detail.
Exhibit 1.12 lists of some of the items you can expect to see on the statement of income.
EXHIBIT 1.12 Common
Statement of Income Items
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Common Statement of Income Items
Sales revenues
Other income
Cost of goods sold
Selling, general, and
administrative expense
Depreciation expense
(amortization expense)
Interest expense
Income tax expense
(provision for taxes)
The total amount of sales of goods and/or services for the period.
Various types of revenues or income to the company other than
sales, including interest or rental income.
The cost of the inventory that was sold during the period.
The total amount of other expenses (such as wages and utilities)
during the period that do not fit into any other category.
The allocation of part of the cost of long-lived items such as
equipment or a patent.
The amount of interest incurred on the company’s debt during the
period.
The taxes levied on the company’s profits during the period.
Financial Reporting 1-17
Ethics in Accounting
Accounting standards allow companies to choose among different
measurement methods. These choices can affect the information
on financial statements and provide management with the opportunity to select methods that can raise or lower income and report
revenues and/or expenses at different times. When management selects accounting methods to achieve a specific reporting
objective, it is called earnings management. Most times, managers will use earnings management legitimately, but as a user of
the financial statement information, it is important that you recognize the circumstances that make it possible for earnings to be
managed in an unethical way.
What Is the Reporting Objective of the Statement
of Changes in Equity? What Does It Include?
The statement of changes in equity provides details on how each component of shareholders’ equity changed during the period (see Exhibit 1.13). As we begin thinking about
the concept of equity, it can help to use the example of home ownership to illustrate that
equity is a “net” number. For example, if we were trying to determine the equity that a person
had in their home, we would calculate it as the value of their home (what they could sell it
for) less the amount of any mortgage(s) that would have to be paid off if the home were sold.
This difference would be the person’s equity in the home, also known as homeowner’s equity.
Continuing with this example, we can see that the homeowner’s initial equity in the home
would be equal to their down payment. We can also see that their equity would be increased
by both increases in the value of the home and repayments of the mortgage. Since the shareholders of a company are its owners, we can use a similar approach when thinking about their
equity in the company. It includes the amount put into the company by shareholders when the
company initially issued shares and any income generated by the company that has not been
distributed to shareholders as dividends. We call these amounts share capital and retained
earnings, which are the earnings or income that have been “retained” by the company and
reinvested into the business. There are a couple of other components of equity that can appear
in the statement of equity, including contributed surplus and accumulated other comprehensive income. We will ignore these in the early part of the book in order to concentrate on share
capital and retained earnings. These other components will be discussed in later chapters.
The Statement of Changes in Equity Is Also Known as the …
Statement of shareholders’ equity
Statement of changes in shareholders’ equity
Statement of equity
The objective of the statement of changes in equity is to illustrate the changes to a number of different components of equity. For example, this statement will explain changes to
each class of shares issued by the company if the company issued additional shares during the
year or repurchased and cancelled others. The statement will also explain the changes in the
company’s retained earnings during the year, which will be equal to the net income for the
period less any dividends that the company’s board of directors declared during the period;
that is, the amount of earnings that has been retained rather than distributed. Of course, it is
possible that a company has a net loss rather than net income. If the loss exceeds the opening
retained earnings balance, then retained earnings would be negative. If a company’s retained
earnings balance is negative, it is referred to as a deficit.
If we refer to Dollarama’s consolidated statements of changes in shareholders’ equity in
Appendix A, we can see the changes to the company’s share capital. During the year ended
January 31, 2021, the company received $32.4 million when it issued 1.7 million common
shares. We can also see that the company repurchased 1.6 million of its shares during the
year and cancelled them. The company had received $2.4 million when it had initially issued
the repurchased shares, so this amount was removed from share capital when they were
EXHIBIT 1.13 Alternative
Names for the Statement of
Changes in Equity
1-18
C H A PTE R 1
Overview of Corporate Financial Reporting
repurchased. The balance of the price paid to repurchase the shares, which was an additional $84.6 million, increased the company’s deficit (which has the same effect as if it were
deducted from retained earnings) because it is treated like a dividend. It is another way of
returning profits to shareholders.
Looking at the changes to Dollarama’s retained earnings, we can see that the other significant change in shareholders’ equity was the company’s net earnings of $564.4 million,
which was also reported on the company’s statement of earnings. We will come back to the
changes in retained earnings frequently throughout the book, so it will be important for you to
understand that the retained earnings of a company are determined as shown in Exhibit 1.14.
EXHIBIT 1.14 How to
Calculate Retained Earnings
Retained Earnings =
Opening Retained Earnings
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+ Net Income
− Dividends Declared
Ending Retained Earnings
As previously mentioned, the two components of shareholders’ equity that we will be
focusing on throughout the early parts of the textbook are listed in Exhibit 1.15.
EXHIBIT 1.15 Common
Shareholders’ Equity
Components
Common Shareholders’ Equity Components
Share capital
Represents the funds received when the shares were initially issued by
the company to investors. There can be different types of shares (common
shares and preferred shares). There can also be different classes of shares;
in other words, shares that have different rights and privileges.
Retained earnings The company’s earnings (as measured on the statement of income) that
have been kept (retained) and not paid out as dividends. If retained
earnings has a negative balance, meaning that net losses have exceeded net
income, it is referred to as a deficit.
What Is the Reporting Objective of the Statement
of Financial Position? What Does It Include?
Ask
Is liquid same
as current?
Illiquid same
as non current?
The statement of financial position is also known as the balance sheet. The term financial
position indicates that this statement presents the company’s financial status at a particular
point in time. The consolidated statement of financial position for Dollarama is shown in
Appendix A. In the case of Dollarama, the information presented is as at January 31, 2021,
and February 2, 2020, which are the dates the company’s fiscal years ended, also known as its
year end. This means that the amounts in the statement are those that existed on those dates,
which are considered to be the beginning and end points of the current accounting period. In
the transition from one accounting period to the next, the ending balances of one accounting
period become the beginning balances of the next accounting period. The statement of financial position is often described as a snapshot of a company’s financial position at a particular
point in time.
The format of this statement of financial position is known as a classified statement of
financial position and is typical of most Canadian statements of financial position, which
present information in order of liquidity. Liquidity refers to how soon something will be
received, realized, or consumed, or else settled or paid. Canadian companies use a 12-month
period to distinguish between items that are current and those that are non-current.
­Current items are those that will be received, realized, or consumed, or else settled or paid
within 12 months from the year end. Those that are non-current will not be received, realized,
Financial Reporting 1-19
or consumed, or settled or paid within 12 months from the year end. It is important to note
that other formats can be used to present a company’s financial position, but all of them will
reflect this notion of liquidity because it is critical for financial statement users to be able to
assess a company’s liquidity.
Throughout the book, we will learn about a number of ways that liquidity is commonly
assessed. One of the most common measures of liquidity is working capital. This is quantified as the difference between a company’s current assets (assets that are cash or will become
cash within the next 12 months) and its current liabilities (liabilities that must be settled
within the next 12 months). It measures a company’s ability to meet its short-term obligations
using its short-term assets. The working capital equation is shown in Exhibit 1.16.
Working Capital
EXHIBIT 1.16 Working
Capital Equation
Working Capital = Current Assets − Current Liabilities
Using this equation, we can determine that Dollarama’s working capital at January 31,
2021, was negative $220.8 million ($1,100.4 million − $1,321.2 million), meaning that the
company did not have sufficient current assets to settle it current liabilities. This means the
company will need to use some of its future earnings, find additional funds by taking on debt
or issuing shares, or sell some assets in order to settle its current liabilities.
So what makes up the company’s financial position? Individuals, if asked about their own
financial position, would probably start by listing what they own, such as a car, a computer, or
a house, and then listing what they owe to others, such as bank loans and credit card balances.
What is owned less what is owed would be a measure of an individual’s net worth (wealth or
equity) at a particular point in time. A company lists exactly the same types of things in its
statement of financial position. They are referred to as assets, liabilities, and shareholders’
equity. These are the three components of the accounting equation, which provides the
structure to the statement of financial position (see Exhibit 1.17).
The Accounting Equation
Assets = Liabilities + Shareholders’ Equity
EXHIBIT 1.17 The
Accounting Equation
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Assets
When asked for a simple definition of an asset, many people reply that it is something of value
that the company either owns or has the right to use. In fact, the accounting definition of an
asset is very similar. Assets must meet three criteria, shown in Exhibit 1.18.
Characteristics of an asset
1. It is an economic resource controlled by an entity.
2. The company expects future economic benefits from the use or sale of the resource.
3. The event that gave the company control of the economic resource has already happened.
The assets that Dollarama lists on its statement of financial position include:
• cash, accounts receivable, prepaid expenses, prepaid income taxes, and inventories
• right-of-use assets (which are assets being leased)
• property, plant, and equipment (often called capital assets)
• intangible assets (intangible assets lack physical form)
• goodwill
EXHIBIT 1.18 Characteristics
of an Asset
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C H A PTE R 1
Overview of Corporate Financial Reporting
While later chapters discuss in more detail how each of these assets meets the criteria
of control and future economic benefits, we can look at Dollarama’s inventory as an ­example
for now. Control of the inventory is proven either by possession of the goods or by legal
­documentation. The inventory has future economic benefits because the company can later
sell it and receive cash in the amount of the selling price. The presence of the inventory or the
underlying documents of the purchase indicates that the event that gave the company control
has already happened.
The total assets of Dollarama as at January 31, 2021, were $4.22 billion. Exhibit 1.19 lists
the assets normally found on a statement of financial position.
EXHIBIT 1.19 Assets Found
on a Statement of Financial
Position
Common Assets
Current assets
Cash
Short-term investments
Accounts receivable
Inventory
Prepaid expenses and deposits
Non-current assets
Property, plant, and equipment
Right-of-use assets
Intangible assets
Goodwill
The amount of currency that the company has, including
amounts in bank accounts.
Short-term investments in shares of other companies.
Amounts owed to the company by its customers as a
result of credit sales.
Goods held for resale to customers.
Amounts that have been paid by the company but the
underlying service has not yet been used. Common
examples include insurance premiums or rent paid in
advance.
Land, buildings, equipment, vehicles, and so on that the
company purchases to use to generate revenues in the
future; they are not purchased to resell.
Land, buildings, equipment, vehicles, and so on that the
company is leasing or renting to use to generate revenues
in the future.
Licences, patents, trademarks, copyrights, computer
software, and other assets that lack physical form. These
are also acquired to generate revenues in the future.
A premium that has been paid on the acquisition of
another company related to factors such as management
expertise and corporate reputation that will result in
higher future earnings.
Liabilities
A simple definition of liabilities might be amounts that the company owes to others. (They are
also known as debt and obligations.) The accounting definition of liabilities encompasses this
concept and refers to items that will require the outflow or sacrifice of economic resources in
the future to settle an obligation that exists as a result of a transaction that has already taken
place. In most cases, the economic resource that will be sacrificed is cash, but a company can
also settle liabilities by providing services or goods. For example, most of you will pay your
university the full amount of the semester’s tuition before or at the beginning of the semester. The university has a liability to you for this amount, which it will settle by providing the
related course instruction over the semester. Alternatively, a warranty liability for a washing
machine could be satisfied with a new part or by providing the services of a repair person.
Liabilities must meet three criteria, as shown in Exhibit 1.20.
EXHIBIT 1.20 Characteristics
of a Liability
Characteristics of a Liability
1. It is a present obligation of the entity.
2. The company expects to settle it through an outflow of economic resources.
3. The obligation results from an event that has already happened.
Financial Reporting 1-21
The liabilities that Dollarama lists on its statement of financial position include:
• accounts payable and accrued liabilities (representing amounts owed to suppliers, unpaid
wages, unpaid taxes, or estimates of warranty obligations)
• dividends payable (representing dividends that the board has declared but that have yet
to be paid to shareholders)
• income taxes payable (representing amounts owing to federal or provincial governments)
• lease liabilities (representing the outstanding estimated principal portion of lease payments for leases of right-of-use assets)
• long-term debt, including the current portion (representing the principal that remains to
be repaid to lenders)
The total liabilities of Dollarama as at January 31, 2021, were $3.89 billion. Exhibit 1.21
includes some of the more common liabilities found on the statement of financial position.
Common Liabilities
Current liabilities
Bank indebtedness
Accounts payable (trade
payables)
Deferred revenue
Dividends payable
Accrued liabilities
Income taxes payable
Non-current liabilities
Notes payable
Lease liabilities
Long-term debt
Deferred income taxes
Amounts owed to the bank on short-term credit.
Amounts owed to suppliers from the purchase of goods on account
(on credit).
Amounts owed to customers for advance payments until the related
goods or services have been provided.
Amounts owed to shareholders for dividends that have been
declared by the board of directors.
Amounts owed related to expenses that are not yet due, such as
interest and warranty expense.
Amounts owed to taxing authorities.
EXHIBIT 1.21 Common
Liabilities Found on a
Statement of Financial
Position
Amounts owed to a creditor (bank or supplier) that are represented
by a formal agreement called a note (sometimes called a promissory
note). Notes payable often have an interest component, whereas
accounts payable usually do not.
Amounts owed to creditors (landlords or lessors) related to leased
assets (right-of-use assets).
Amounts owed to creditors due beyond one year.
Amounts representing probable future taxes the company will have
to pay.
Shareholders’ Equity
The last major category in the statement of financial position is the section called shareholders’ equity. This section captures the amount of the shareholders’ interest in the assets of the
company. Shareholders’ equity is often referred to as the net assets of the company or the
shareholders’ residual interest in the company’s assets. This is the amount of assets that would
remain after all of the company’s liabilities were settled. If the accounting equation is re­­
arranged (as in Exhibit 1.22), you can see that shareholders’ equity is equal to the company’s
assets less its liabilities.
The Accounting Equation (Rearranged)
Assets − Liabilities = Shareholders’ Equity (Net Assets)
EXHIBIT 1.22 The
Accounting Equation
(Rearranged)
1-22
C H A PTE R 1
Overview of Corporate Financial Reporting
If there are no liabilities, shareholders’ equity would be equal to the company’s assets.
When there are liabilities, shareholders’ equity is equal to the company’s assets less those
liabilities.
It is important to understand that this amount is determined using the values of the assets
and liabilities as they are reflected on the statement of financial position. These values will
often differ from those in the current market. Throughout the text, we will explore the reasons
why these values differ. For now, let’s consider a company’s inventory. It is reflected on the
company’s statement of financial position at its cost to the company, but this amount will
differ from what the company would sell it for. The selling price would also differ if it were an
urgent or distress sale (that is, if the company desperately had to sell the goods) rather than a
sale in the ordinary course of its operations.
Based on Dollarama’s statement of financial position, shareholders’ equity at January 31,
2021, was $330 million.
Assets − Liabilities = Shareholders’ Equity
$4.22 billion − $3.89 billion = $330 million
Note that the market value of the shares held by a company’s shareholders is another
measure of the shareholders’ wealth in the company. By market value, we mean the price
at which the shares are trading in the stock market. This value is likely very different from
the amount of shareholders’ equity reported on the statement of financial position because it
reflects the market’s expectations of future earnings and events.
One of the objectives of the statement of financial position is to enable financial statement users to assess the relative proportions of liabilities and shareholders’ equity to better
understand a company’s financing strategy. For Dollarama as at January 31, 2021, total liabilities were $3.89 billion and total shareholders’ equity was $330 million, relative to total assets
of $4.22 billion. The proportion of liabilities is 92.2% ($3.89 billion ÷ $4.22 billion), which
means that Dollarama has financed virtually all of its assets using debt rather than the equity
of shareholders. Specifically, it gets 92.2% of its financing from creditors. This high percentage of debt to equity demonstrates that the company has grown its operations using external
financing (debt) rather than internal financing (equity). While the use of debt can be a good
thing, generally the higher the proportion of debt to equity, the greater the financial risk facing
the company. We will discuss the concept of leverage—using other people’s money to make
money—in Chapter 10.
Most North American companies present liabilities before shareholders’ equity when
preparing their statements of financial position, which presents a net asset perspective. This
emphasizes that the creditors to whom these liabilities are owed have a priority claim on
the company’s assets, while the claims of the shareholders are secondary. Companies are
not required to follow this presentation format, and some companies present shareholders’
equity before liabilities, which presents a net debt perspective. Others reverse the order in
which assets are presented, reporting non-current assets before current assets. When reading a statement of financial position, it is important to note the presentation format being
used.
As discussed in the section on the statement of changes in shareholders’ equity, equity is
usually composed of a number of components. For now, we will focus on two: share capital
and retained earnings. The first component, share capital (some companies use the term common shares), records the amount that the investors originally paid (invested) for the shares
that the company issued. The second component, retained earnings, keeps track of the company’s earnings less any amounts that the company pays to the shareholders in dividends. As
mentioned previously, we will ignore the other components of shareholders’ equity until later
in the text.
Exhibit 1.23 illustrates how information flows between the first three financial statements. The statement of income is generally prepared first in order to determine net income.
This statement is then used when preparing the statement of changes in equity. Finally,
the share capital and retained earnings balances are used when preparing the statement of
­financial position.
Financial Reporting 1-23
EXHIBIT 1.23 Information
Flows between the First Three
Financial Statements
1 Statement of Income
Revenues
A
– Expenses
B
Net Income
C
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2 Statement of Changes in Equity
Share Retained
Capital Earnings
Opening Balance
D
E
+ Net Income
C
– Dividends Declared
F
+ Shares Issued
G
Ending Balance
H
I
3 Statement of Financial Position
Assets
Cash
Accounts Receivable
Property, Plant, & Equipment
Total Assets
J
Liabilities
Accounts Payable
Taxes Payable
J=M
Total Liabilities
K
Shareholders’ Equity
Share Capital
Retained Earnings
H
I
Total Shareholders’ Equity
L
Total Liabilities and Equity
M=K+L
What Is the Reporting Objective of the Statement
of Cash Flows? What Does It Include?
The statement of cash flows (sometimes called the cash flow statement) presents the flows
of cash related to the three categories of business activities, which we discussed earlier in the
chapter. The reporting objective of this statement is to enable financial statement users to
assess the company’s inflows and outflows of cash related to each of these activities, so they
can see where the company’s cash came from and how it was used.
Dollarama’s consolidated statement of cash flows in Appendix A presents the company’s
inflows and outflows of cash for the years ending January 31, 2021, and February 2, 2020. This
statement differs from the statement of income in that it measures cash flows during the period
rather than the revenues and expenses for the period, which may not be received or paid in cash.
Cash is very important to the company’s operations and this statement is critical to a user’s evaluation of a company. Given the importance of this statement, Chapter 5 of the text is focused on how
the statement is prepared and used. For now, we will review the basic content of the statement.
The cash flow statement has three sections that report the sources and uses of cash and
cash equivalents for the three categories of business activities described earlier: operating,
financing, and investing (see Exhibit 1.24).
Subsections of the statement of cash flows
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
EXHIBIT 1.24 Subsections of
the Statement of Cash Flows
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1-24
C H A PTE R 1
Overview of Corporate Financial Reporting
Operating activities include all inflows and outflows of cash related to the sale of goods
and services. They are the activities that the company performs in its normal operations. The
starting point in this section is frequently net earnings (or net income or profit) from the statement of income. There are adjustments to this amount because the recognition (recording) of
revenues and expenses does not necessarily coincide with the receipt and payment of cash, as
we will see in future chapters. For instance, sales could be either cash sales or sales on account.
That is, customers can pay at a later date, resulting in an account receivable rather than cash.
Expenses may also be paid later if the company is given credit by its suppliers, which would
result in an account payable. Because operating activities are the backbone of the company, a
positive cash flow from operations is essential to the company’s long-term health. Dollarama
generated an inflow of cash of $889.1 million from its operating activities in the fiscal year
ended January 31, 2021, compared with an inflow of $732.5 million in the previous year.
Investing activities generally involve the purchase and sale of long-term assets such as
property, plant, and equipment, and investments in other companies. In the case of Dollarama, we can see the company purchased property, plant, and equipment costing $140.0
million and intangible assets costing $27.8 million during the year ended January 31, 2021. It
sold a small amount of long-term assets during the period, which generated $593,000 in proceeds. It also made an investment in another company for $97.2 million. This resulted in net
cash outflows of $264.5 million for the period. Companies that are growing, and even those
that are just maintaining their current operations, normally have negative cash flows from
investing activities. This results from them spending more cash to purchase new long-term
assets than they are receiving as proceeds from the sale of long-term assets that they have
finished using in their operations.
Financing activities are transactions that either result from new funds being received from
investors or creditors or from the return of funds to these two groups. Typical activities in this category are the issuance of shares, the proceeds of new borrowings, the repayment of debt, or the payment of dividends. Dollarama’s cash flow from financing activities was an outflow of $275.9 million
for the year ended January 31, 2021. We can see from this that the company obtained little new
funding from either shareholders or creditors. The company did borrow $300 million from creditors during the period, repaid $463.8 million to creditors, and actually returned funds to shareholders through the repurchase of the company’s shares ($87.0 million) and the payment of dividends
($54.8 million), which exceeded the $32.4 million received from issuing new common shares.
Overall, we can see that Dollarama had a net increase in cash of $348.7 million during the
year ended January 31, 2021. This is the sum of the cash flows from the three categories of business activities ($889.1 − $264.5 − $275.9 = $348.7). This explains why the company’s cash balance increased from $90.5 million at the start of the year to $439.2 million at the end of the year.
Exhibit 1.25 provides a summary of the financial statements.
EXHIBIT 1.25 Summary of
the Financial Statements
Summary of the Financial Statements
Statement of income
Statement of changes in equity
Statement of financial position
Statement of cash flows
Measures the operating performance of a company over a
period of time.
Measures the changes in the company’s equity over a period
of time, differentiating between changes that result from
transactions with shareholders and those resulting from the
company’s operations.
Measures the resources controlled by a company (assets) and
the claims on those resources (by creditors and investors) at
a given point in time.
Measures the change in cash flow through operating,
financing, and investing activities over a period of time.
Assess Your Understanding
Attempt the following problems and review the solutions provided:
Take5 Video
• Chapter End Review Problems 1-2 and 1-3
• Demonstration Problem 1-2 in Wiley’s course resources
Financial Reporting 1-25
What Type of Information Is in the Notes to a
Company’s Financial Statements?
You may have noticed that some of the items in the financial statements directed the user to
specific notes. These notes to the financial statements are a critical part of the financial
statements. In them, management gives more detail about specific items, such as the ­various
types of inventory held by the company and its long-term assets. By including additional
explanations in notes rather than in the financial statements, management keeps the company’s statements simple and uncluttered. Note disclosures help to increase the usefulness of
the financial statements and enhance the user’s understanding of the various components of
the statements.
A full discussion of notes will be left to succeeding chapters, but some attention should
be paid to two notes that normally appear at the beginning of the notes to the financial statements. These are the note explaining the basis on which the financial statements have been
prepared and the note outlining the significant accounting policies used in the preparation of
the statements. Dollarama presented this information in the second and third of 19 notes that
were included with the company’s financial statements.
From these two notes, we can see that Dollarama’s financial statements were prepared
using International Financial Reporting Standards (IFRS), which are the accounting
standards that must be followed by Canadian public companies. From these notes, we can
also learn more about the choices and judgements made by management in applying these
reporting standards. As you progress through the book, you will learn that these choices have
important implications for how to interpret the statements. Comparing two companies that
have made two different choices and judgements would pose difficulties. To help users compare various companies, management must therefore disclose in this note the major accounting principles that it uses.
Climate Change Impact
Financial statement users are increasingly interested in information about how climate change could impact a company’s financial
statements. In Canada, the majority of all professionally managed
investments, including those managed by the Canada Pension
Plan Investment Board, the Caisse de dépôt et placement
du Québec, the Ontario Teachers’ Pension Plan, and numerous Canadian universities require that environmental, social, and
governance (ESG) issues be considered in their investment decision-making process. While IFRS standards do not make specific
mention of climate-related issues, climate change is something
that the preparers of financial statements have to consider when
applying a number of standards.
Climate-related financial reporting, together with other ESG
disclosures, is an area undergoing significant change. In March
2021, the IFRS Foundation announced that it planned to establish
a Sustainability Standards Board that will set sustainability reporting standards. The Foundation noted that, given the urgent need
for better information about climate-related matters, these standards will initially focus on climate-related reporting. The goal is
to provide a single set of global sustainability reporting standards,
much like IFRS are for financial reporting, which will result in
more consistent and comparable sustainability reporting.
A study by the Chartered Professional Accountants of
­ anada that looked at the financial statements and other public
C
disclosures of 75 Canadian public companies found that 79% of
them had some form of the climate-related disclosures, while 21%
of them did not make any climate-related disclosures. Of the companies with climate-related disclosures, only 14% had climate-­
related disclosures reported in the financial statements. The study
also found that there were “significant inconsistencies” in terms
of the climate-related disclosures, “making it difficult for users to
compare companies and analyze trends. Users [were] also challenged to locate relevant information” as there were no consistent
practices in terms of where the information was being presented.
These are exactly the issues that it is hoped the Sustainability
Standards Board will address.
Climate change impact features have been added throughout
the text to identify areas of the financial statements impacted by
climate-related reporting issues. Having this increased awareness
is key to understanding how these issues may impact the decisions
of financial statement users. It is also a starting point for thinking
more deeply about what ESG information should be reported by
companies and how this could be done.6
While not part of the financial statements, all publicly traded companies are required to
include a management discussion and analysis (MD&A) section in their annual reports. The
MD&A section provides readers with senior management’s perspective on the information
contained in the financial statements. It provides very useful context for users of the financial
statements.
1-26
C H A PTE R 1
Overview of Corporate Financial Reporting
In addition to management’s perspectives on the company’s financial results for the prior
year, the MD&A provides a discussion of the risks facing the company and information about
future plans. Often information is presented from the perspective of the company’s various
divisions. It also includes information on significant events and about sales, profits, and cash
flow during the year. The discussion focuses on the financial aspects of the business, including
pricing strategies, expenses, earnings, liquidity, environmental and corporate social responsibility, expansion and future development, taxes, events after the end of the current year, and
executive compensation policies.
Ethics in Accounting
Average hourly wage and percentage of
employees earning minimum wage, by region
Restaurants
Total amount of waste, percentage of food waste,
and percentage diverted from landfills
Total percentage of packaging made from
recycled and/or renewable materials
Agricultural
products
Number of incidents of non-compliance
associated with water quality and/or standards
and regulations
Number of recall issues and total amount of food
product recalled
Alberto Masnovo/Shutterstock.com
The role of accountants is expected to continue to evolve and
expand in the areas of environmental and social reporting.
Company managers, investors, and creditors are considering an
increasing number of issues in their decision-making, including
climate change, employment and pay equity, water and energy
usage, ecological impacts, and employee health. In January 2021,
the Chartered Professional Accountants of Ontario issued a paper
titled CPAs and the New Social Contract: The Rise of the Warrior
Accountant. The term warrior accountant was coined in 2020 by
Financial Times columnist Gillian Tett, who wrote that “the Warrior Accountant will do more to change the world on green issues
than activists.” The expertise that accountants have in measurement, disclosure, and auditing is viewed as being critical to ensuring that ESG reporting is rigorous, consistent, and comparable
between companies and across periods.
Some companies are already reporting ESG information. To
give you an example of the types of sustainability standards that are
currently being reported by some companies, let’s look at a sample
of some of the standards that the Sustainability Accounting Standards Board has developed for a number of different industries:
Industry
Sustainability Standard
Hotels and
lodging
Total energy consumed and percentage of
renewable energy
Total water usage
Food retailers Fleet fuel consumed and percentage renewable
Revenue from products labelled and/or marketed
to promote health and nutrition
Percentage of refrigerants consumed with zero
ozone-depleting potential
Maple Leaf Foods Inc. reports some of these items in its annual
sustainability reports, including energy and water consumption,
landfill diversion, and packaging recycling. Canadian companies
are also reporting other social metrics. For example, in its 2020
Environmental, Social and Governance Report, The Toronto-­
Dominion Bank reports on the number of mortgages issued to
low-income people, accessibility services provided for people with
disabilities, LGBTQ2+ programs, and initiatives to serve Indigenous peoples.
In its paper, CPA Ontario concluded that “CPAs, armed with
the information and tools to make sense of the changes taking
place, should embrace the warrior accountant mission.” This is
an exciting area, especially for students beginning their accounting studies, and one that continues to evolve together with the
traditional financial reporting that is currently the focus of the
profession (and this text). This area may provide the next generation of accountants with a real opportunity to make an impact on
sustainability and social justice issues.7
Now that you know what corporate financial reporting involves and what the main financial statements contain, in the next chapter we’ll look at how users can analyze them.
Ethics in Accounting
Shareholders hire an independent external auditor to review the
financial statements presented to them by the company’s management. The auditor must maintain their independence from the
company’s management team throughout the audit. In order to
ensure their independence and encourage ethical behaviour, the
accounting profession has developed codes of professional conduct.
Summary
1-27
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 1-4
Take5 Video
• Demonstration Problems 1-3 and 1-4 in Wiley’s course resources
Review and Practice
Summary
Define financial accounting and understand its
relationship to economic decision-making.
1
• Financial accounting is the process by which information on
the transactions of an organization is captured, analyzed, and
reported to external decision makers.
• These decision makers are referred to as financial statement
users and include investors and creditors.
• The primary purpose of financial accounting information is
to aid these users in making economic decisions related to the
reporting organization, such as whether to invest in it or lend it
money.
Identify the main users of financial accounting
information and explain how they use this information.
2
• The main users of financial accounting information include
shareholders, the board of directors, potential investors, creditors (bankers and suppliers), regulators (stock exchanges), taxing authorities (governments), securities analysts, and others.
• Shareholders, the board of directors, and potential investors
will use financial accounting information to enable them to
assess how well management has run the company; determine
whether they should buy, sell, or continue to hold shares in the
company; assess the company’s share price relative to the financial accounting information; and so on.
• Creditors will use financial accounting information to determine whether they should lend funds to the company, establish
credit terms for it, assess a company’s ability to meets its obligations, and so on.
• Regulators will use financial accounting information to determine whether a company has met its listing requirements.
• Taxing authorities will use this information in assessing the
taxes owed by the organization.
• There are public corporations (whose shares trade on a public
stock exchange and are widely held) and private corporations
(whose shares do not trade on a public exchange and are generally owned by a small number of people).
• Corporations are separate legal entities, whereas proprietorships
and partnerships are not. This means the personal assets of
owners are protected in the event of legal action against corporations, whereas they are at risk in the case of proprietorships
and partnerships. It also means corporations file separate tax
returns, whereas the income from proprietorships and partnerships is reported on the personal tax returns of their owners.
Explain the three categories of business activities
and identify examples of transactions related to each
category.
4
• The three categories of business activities are: (1) operating, (2)
investing, and (3) financing activities.
• Operating activities are related to the company’s revenues and
expenses, such as sales to customers, collections from customers, purchases of inventory, and payments of wages and other
expenses.
• Investing activities include buying and selling property, plant, and
equipment and buying and selling the shares of other companies.
• Financing activities include borrowing money, issuing shares,
repaying loan principal, and paying dividends.
Identify and explain the content and reporting
objectives of the four basic financial statements and the
notes to the financial statements.
5
• There are four basic financial statements: (1) the statement of
income, (2) the statement of changes in equity, (3) the statement
of financial position, and (4) the statement of cash flows.
Describe the major forms of business organization
and explain the key distinctions between them.
• The objective of the statement of income is to measure the company’s operating performance (its profit) for a period of time.
This is measured by subtracting the expenses incurred during the
period from the income earned (revenues) in the same period.
• There are three major forms of business organization: (1) proprietorships, (2) partnerships, and (3) corporations.
• The objective of the statement of changes in equity is to provide
details on how each component of shareholders’ equity changed
during the period. The components of shareholders’ equity
3
1-28
C H A PTE R 1
Overview of Corporate Financial Reporting
include share capital (the shares issued by the company) and
retained earnings (the company’s earnings that have been kept
and not distributed as dividends).
Shareholders’ equity represents the shareholders’ interest in the
assets of the company and is referred to as net assets. Examples
include common shares and retained earnings.
• The objective of the statement of financial position is to present information on a company’s assets, liabilities, and shareholders’ equity at a specific date. Assets must be controlled by
the company and embody a future benefit. Examples include
cash; accounts receivable; inventory; property, plant, and equipment; land; and so on. Liabilities are obligations of a company
that will result in an outflow of resources. Examples include
accounts payable, deferred revenue, long-term debt, and so on.
• The objective of the statement of cash flows is to enable financial
statement users to assess the company’s inflows and outflows of
cash related to its operating, investing, and financial activities
for a period of time.
• The notes to a company’s financial statements are used to provide additional detail and context for items in the financial
statements. They enable the financial statements themselves to
remain uncluttered, while increasing their usefulness.
Key Terms
Accounting equation 1-19
Annual report 1-3
Assets 1-19
Auditor 1-26
Board of directors 1-6
Canada Revenue Agency (CRA) 1-8
Capital appreciation 1-11
Classified statement of financial
position 1-18
Common shares 1-9
Comparative information 1-14
Consolidated financial statement 1-14
Creditors 1-3
Current 1-18
Current assets 1-19
Current liabilities 1-19
Dividends 1-11
Earnings 1-14
Earnings management 1-17
Earnings per share 1-16
Equity 1-17
Expenses 1-14
Financial accounting 1-3
Financial statement users 1-3
Financial statements 1-3
Financing activities 1-10
Fiscal year 1-14
Gains 1-14
Gross profit 1-16
Income 1-14
Interest 1-7
International Financial Reporting Standards
(IFRS) 1-25
Investing activities 1-10
Investors 1-3
Liabilities 1-19
Liquidity 1-18
Losses 1-14
Management 1-3
Management discussion and analysis
(MD&A) 1-3
Managerial accounting 1-3
Market value 1-22
Net assets 1-21
Abbreviations Used
CRA
IFRS
MD&A
TSX
Canada Revenue Agency
International Financial Reporting Standards
Management discussion and analysis
Toronto Stock Exchange
Synonyms
Accounts payable | Trade payables
Depreciation | Amortization
Gross profit | Gross margin
Income | Revenues
Liabilities | Debt | Obligations
Net earnings | Net income | Profit
Property, plant, and equipment | Capital assets
Net earnings 1-14
Net income 1-14
Net loss 1-14
Non-current 1-18
Notes to the financial statements 1-25
Operating activities 1-10
Parent company 1-14
Principal 1-7
Private company 1-6
Profit 1-14
Public company 1-6
Retained earnings 1-11
Revenues 1-14
Share capital 1-17
Shareholders 1-6
Shareholders’ equity 1-11
Statement of cash flows 1-23
Statement of changes in equity 1-17
Statement of financial position 1-18
Statement of income 1-14
Subsidiary companies 1-14
Working capital 1-19
Chapter End Review Problem 1-2
1-29
Share capital | Common shares
Shareholders | Investors
Shareholders’ equity | Net assets
Statement of cash flows | Cash flow statement
Statement of changes in shareholders’ equity | Statement of shareholders’ equity | Statement of changes in equity | Statement of equity
Statement of income | Statement of operations | Statement of net earnings | Statement of earnings | Statement of profit or loss | Statement
of comprehensive income
Statement of financial position | Balance sheet
Deferred revenue | Unearned revenue | Deposits
The Chapter End Review Problems reinforce your understanding of major sections in the chapter. One or more questions have been created to illustrate the topics and demonstrate how you can use the information. Answers are provided so that you can check your knowledge. You can use these
questions as examples when working on other questions assigned by your instructor.
Chapter End Review Problem 1-1
Use the following abbreviations to answer this question:
O
I
F
Operating activities item
Investing activities item
Financing activities item
Required
Classify each of the following transactions according to whether they
are operating, financing, or investing activities:
a. Purchase of manufacturing equipment
g. Proceeds from new bank loan
h. Payment of employee bonuses
STRATEGIES FOR SUCCESS
• Remember that there are only four main financing
activities, two inflows (proceeds from issuing shares
and from taking out a loan) and two outflows (paying
dividends and repaying loan principal).
e. Payment of dividends
• Remember that there are only four main investing
activities, two inflows (proceeds from selling long-term
assets, like equipment, or the shares of other companies)
and two outflows (purchasing long-term assets, like
equipment, and the shares of other companies).
f. Payments of rent for leased store locations
• All other activities are operating activities.
b. Payments to suppliers
c. Collection of amounts owed by customers
d. Proceeds from issuing common shares
Chapter End Review Problem 1-2
Use the following abbreviations to answer this question:
CA
NCA
CL
NCL
SC
RE
SI
SCF
SCE
Current assets
Non-current assets
Current liabilities
Non-current liabilities
Share capital
Retained earnings
Statement of income item
Statement of cash flows item
Statement of changes in equity item
Required
Classify the following items according to where they would appear in
the financial statements:
a. Accounts receivable
b. Bank indebtedness
c. Declaration of dividends, which will be paid in the next period
d. Goodwill
e. Purchase of a forklift for use in the warehouse
f. Deferred revenue
g. Payment of loan interest
h. Dividends payable
i. Cost of goods sold
j. Income taxes payable
k. Loan payable (due in five years)
STRATEGIES FOR SUCCESS
• Remember that revenues and expenses are found
on the statement of income. Assets, liabilities, and
shareholders’ equity items are found on the statement
of financial position. The statement of changes in equity
includes changes in share capital and retained earnings,
while the statement of cash flows presents the inflows
and outflows of cash from operating, investing, and
financing activities.
1-30
C H A PTE R 1
Overview of Corporate Financial Reporting
Chapter End Review Problem 1-3
Common shares
Beginning
Ending
Determine the four missing amounts (A, B, C, and D) using financial
statement relationships.
Revenues
Expenses
Net income
A
668,000
194,000
Dividends declared during the year
Total assets
Beginning
Ending
Proceeds from issuing additional
common shares during the year
65,000
Retained earnings
Beginning
Ending
D
300,000
100,000
STRATEGIES FOR SUCCESS
• Remember the order in which the financial statements
are prepared (see Exhibit 1.23) and determine the
missing amounts by following that order. Note that this
may be different from the sequence of the letters.
686,000
815,000
• Remember that Revenues − Expenses = Net Income.
• Remember that Assets = Liabilities + Shareholders’
Equity
B
3,426,000
Total liabilities
Beginning
Ending
• Remember that Shareholders’ Equity = Common Shares
+ Retained Earnings
428,000
C
Chapter End Review Problem 1-4
The major financial statements of High Liner Foods
Incorporated from its 2020 annual report are included in
Exhibits 1.26A, 1.26B, and 1.26C. Nova Scotia–based High Liner
is a leading processor and marketer of frozen seafood. Note
EXHIBIT 1.26A High Liner
Foods Incorporated’s 2020
Consolidated Statement of
Income
that its fiscal year is a 52-week period ended January 2, 2021.
We will refer to these as the 2020 financial statements and use
them to answer a series of questions.
HIGH LINER FOODS INCORPORATED
Consolidated Statement of Income
(in thousands of United States dollars, except per share amounts)
Financial Statements
Notes
Sales
24
Fifty-three
weeks ended
January 2,
2021
Fifty-two
weeks ended
December 28,
2019
$
$
827,453
942,224
Cost of sales
649,529
756,364
Gross profit
177,924
185,860
Distribution expenses
45,076
45,759
Selling, general and administrative expenses
73,736
90,019
—
974
Impairment of property, plant and equipment
8
Business acquisition, integration and other expense
Results from operating activities
Finance costs
Income before income taxes
28
2,957
1,572
56,155
47,536
19,483
33,012
36,672
14,524
Chapter End Review Problem 1-4
1-31
Income taxes
Current
18
6,535
3,356
Deferred
18
1,335
879
18
7,870
4,235
Income tax expense
Net income
$
28,802
$
10,289
Earnings per common share
Basic
20
$
0.85
$
0.31
Diluted
20
$
0.83
$
0.30
Weighted average number of shares outstanding
Basic
20
33,853,881
33,801,217
Diluted
20
34,519,305
34,195,365
EXHIBIT 1.26B High Liner
Foods Incorporated’s 2020
Consolidated Statement of
Financial Position
HIGH LINER FOODS INCORPORATED
Consolidated Statement of Financial Position
(in thousands of United States dollars)
Notes
January 2,
2021
December 28,
2019
Assets
Current assets
Cash
Accounts receivable
$ 32,935
6
Income taxes receivable
Other financial assets
Inventories
$
3,144
60,927
85,089
2,609
3,494
25
211
236
7
250,861
294,913
Prepaid expenses
Total current assets
4,176
4,322
351,719
391,198
Non-current assets
Property, plant and equipment
8
107,221
108,986
Right-of-use assets
9
15,018
11,792
Deferred finance costs
11
287
—
Deferred income taxes
18
2,401
2,134
Other receivables and assets
25
47
34
Intangible assets
10
142,168
148,893
Goodwill
10
157,697
157,457
424,839
429,296
11, 14
$776,558
$820,494
$
—
$ 37,546
Total non-current assets
Total assets
Liabilities and shareholders’ equity
Current liabilities
Bank loans
11
Accounts payable and accrued liabilities
12
114,326
141,238
Contract liability
19
4,351
3,581
Provisions
13
3,327
329
(continued)
Financial Statements
1-32
C H A PTE R 1
Overview of Corporate Financial Reporting
EXHIBIT 1.26B High Liner
Foods Incorporated’s 2020
Consolidated Statement of
Financial Position (continued)
Notes
January 2,
2021
December
28, 2019
Other current financial liabilities
25
2,735
861
Other current liabilities
17
2,731
4,881
41
2,102
Current portion of long-term debt
14
20,185
14,511
Current portion of lease liabilities
9
4,866
4,582
152,562
209,631
268,048
289,020
Income taxes payable
Total current liabilities
Non-current liabilities
Long-term debt
14
Other long-term financial liabilities
25
329
292
Other long-term liabilities
17
6,510
3,031
Long-term lease liabilities
9
10,722
7,198
Deferred income taxes
18
31,071
30,182
Future employee benefits
15
16,314
12,970
Total non-current liabilities
332,994
342,693
Total liabilities
485,556
552,324
112,739
112,887
16,551
16,028
Retained earnings
183,649
162,773
Accumulated other comprehensive loss
(21,937)
(23,518)
Total shareholders’ equity
291,002
268,170
$776,558
$820,494
Shareholders’ equity
Common shares
16
Contributed surplus
Total liabilities and shareholders’ equity
EXHIBIT 1.26C High Liner Foods Incorporated’s 2020 Consolidated Statement of Cash Flows
Financial Statements
HIGH LINER FOODS INCORPORATED
Consolidated Statement of Cash Flows
(in thousands of United States dollars)
Notes
Fifty-three
weeks ended
January 2, 2021
Fifty-two weeks
ended December
28, 2019
$28,802
$10,289
Cash flows provided by (used in): Operating activities
Net income
Adjustments to net income not involving cash from operations:
Depreciation and amortization
28
23,228
22,455
Share-based compensation expense
17
5,861
7,124
Loss on asset disposals and impairment
8
135
1,292
Finance costs
28
19,483
33,012
Income tax expense
18
7,870
4,235
1,234
1,020
86,976
79,402
Future employee benefits contribution, net of expense
Unrealized foreign exchange loss
Cash flows provided by operations before changes in non-cash
working capital, interest and income taxes refunded (paid)
363
(25)
(continued)
Chapter End Review Problem 1-4
EXHIBIT 1.26C High Liner Foods Incorporated’s 2020 Consolidated Statement of Cash Flows (continued)
Changes in non-cash working capital balances:
Accounts receivable
24,325
212
Inventories
45,871
10,095
256
95
(30,970)
(18,388)
Prepaid expenses
Accounts payable and accrued liabilities
Provisions
Net change in non-cash working capital balances
Interest paid
Income taxes (paid) refunded
Net cash flows provided by operating activities
2,994
(1,158)
42,476
(9,144)
(19,271)
(20,173)
(7,184)
1,521
102,997
51,606
Financing activities
(Decrease) increase in bank loans
21
(37,745)
6,638
Repayment of lease liabilities
21
(5,568)
(5,649)
Repayment of long-term debt
14
(14,685)
(37,926)
Deferred finance costs
21
(54)
(6,344)
(5,518)
(7,424)
(289)
—
(63,859)
(50,705)
Purchase of property, plant and equipment, net of
investment tax credits, and intangible assets
(8,952)
(6,569)
Net cash flows used in investing activities
(8,952)
(6,569)
(395)
(756)
29,791
(6,424)
Common share dividends paid
Common shares repurchased for cancellation
Net cash flows used in financing activities
Investing activities
Foreign exchange decrease on cash
Net change in cash during the period
Cash, beginning of period
Cash, end of period
3,144
9,568
$32,935
$ 3,144
Required
a. Find the following amounts in the statements:
i. Total revenues for fiscal year 2020
ii. Total cost of sales for fiscal year 2020
iii. Total selling, general, and administrative expenses for fiscal year 2020
iv. Finance costs for fiscal year 2020
v. Income tax expense (current and deferred) for fiscal year 2020
vi. Net income for fiscal year 2020
vii. Inventories at the end of fiscal year 2020
viii. Accounts payable and accrued liabilities at the beginning of fiscal year 2020
ix. Shareholders’ equity at the end of fiscal year 2020
x. Retained earnings at the beginning of fiscal year 2020
xi. Cash provided from operating activities in fiscal year 2020
xii. Cash payments, net of investment tax credits, to acquire property, plant, and equipment and
intangible assets in fiscal year 2020
xiii. Cash used in the repayment of long-term debt in fiscal year 2020
xiv. Cash used in the payment of dividends in fiscal year 2020
xv. Cash provided from (used in) investing activities in fiscal year 2020
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b. Does High Liner Foods finance its business primarily with debt or with shareholders’ equity? Support your answer with appropriate data.
c. Does High Liner Foods use a classified statement of financial position? Explain.
STRATEGIES FOR SUCCESS
• Start by reviewing High Liner’s three financial statements. Refresh your understanding
of the kinds of information found in each statement.
• As you work through the list of items in question 1, try to remember which financial
statement to look at by linking in your mind the name of the item identified and the
financial statement on which it is included. As you work through more problems like
this, you will become more familiar with what is on each statement.
• To answer question 2, first reread the section in the statement of financial position
discussion in this chapter that explains shareholders’ equity. The discussion of
Dollarama’s use of liabilities and shareholders’ equity to finance its operations should be
helpful.
Solutions to Chapter End Review Problems
Suggested Solution to Chapter End Review Problem 1-1
Use the following abbreviations to answer this question:
O
I
F
Operating activities item
Investing activities item
Financing activities item
Required
Classify each of the following transactions according to whether they are operating, financing, or investing activities:
a. I – Investing activity
b. O – Operating activity
c. O – Operating activity
d. F – Financing activity
e. F – Financing activity
f. O – Operating activity
g. F – Financing activity
h. O – Operating activity
Suggested Solution to Chapter End Review Problem 1-2
Use the following abbreviations to answer this question:
CA
NCA
CL
NCL
SC
RE
SI
SCF
SCE
Current assets
Non-current assets
Current liabilities
Non-current liabilities
Share capital
Retained earnings
Statement of income item
Statement of cash flows item
Statement of changes in equity item
Required
Classify the following items according to where they would appear in the financial statements:
a. CA (as receivables from customers are normally collected within one year)
b. CL (as this represents amounts owing to the bank that will be repaid within one year)
Solutions to Chapter End Review Problems
c. SCE (as the dividends have not yet been paid, they will not appear on the statement of cash flows)
and CL (as these dividends will also be a current liability)
d. NCA (as goodwill embodies future economic benefits that will be realized over multiple future
periods)
e. SCF (as this will be an investing activity)
f. CL (as customers don’t normally prepay for goods or services more than one year in advance)
g. SCF (as this will be an operating activity)
h. CL (as the dividends will normally be paid to shareholders within one year)
i. SI (as this is an expense)
j. CL (as these will be payable to the government within one year)
k. NCL (as this won’t be paid within the next year)
Suggested Solution to Chapter End Review Problem 1-3
a. Solve first: $862,000 (Revenues = Expenses + Net Income; $194,000 + $668,000)
b. Solve third: $1,314,000 (Beginning Assets = Beginning Liabilities + Beginning Common Shares +
Beginning Retained Earnings; $428,000 + $200,000 + $686,000)
c. Solve fourth: $2,311,000 (Ending Liabilities = Ending Assets − Ending Common Shares − Ending
Retained Earnings)
d. Solve second: $200,000 (Beginning Common Shares = Ending Common Shares − Proceeds from
Issuing Additional Common Shares During the Year; $300,000 − $100,000)
Suggested Solution to Chapter End Review Problem 1-4
To find the answers to the above questions, you will need to examine closely the three financial statements that have been provided.
a. The following answers are found on the financial statements included in Exhibits 1.26A, 1.26B,
and 1.26C:
i. Total revenues in 2020: $827,453 thousand. Revenues are reported on the statement of income.
ii. Total cost of sales in 2020: $649,529 thousand. The cost of sales is a type of expense. Expenses
are reported on the statement of income.
iii. Total selling, general, and administrative expenses in 2020: $73,736 thousand. Expenses are
reported on the statement of income.
iv. Finance costs in 2020: $19,483 thousand. Expenses are reported on the statement of income.
v. Income tax expense (current and deferred) in 2020: $7,870 thousand ($6,535 + $1,335). Expenses
are reported on the statement of income.
vi. Net income in 2020: $28,802 thousand. Net income is reported on the statement of income.
vii. Inventories at the end of 2020: $250,861 thousand. Inventories are assets, which are reported on
the statement of financial position.
viii. Accounts payable and accrued liabilities at the beginning of 2020: $141,238 thousand (the end of 2019
is the same as the beginning of 2020). Liabilities are reported on the statement of financial position.
ix. Shareholders’ equity at the end of 2020: $291,002 thousand. Shareholders’ equity is reported on
the statement of financial position.
x. Retained earnings at the beginning of 2020: $162,773 thousand. (Again, you need to look to the
end of 2019 to find the beginning of 2020.) The retained earnings are a part of shareholders’
equity that is reported on the statement of financial position.
xi. Cash provided from operating activities in 2020: $102,997 thousand. The cash provided by various business activities is reported on the statement of cash flows. Operating activities are shown
in the first section of this statement.
xii. Cash payments, net of investment tax credits, to acquire property, plant, and equipment and
intangible assets in 2020: ($8,952 thousand). The net addition of capital assets is reported under
the investing section on the statement of cash flows. Putting the amount in parentheses indicates that it is a negative number. In other words, cash was used.
xiii. Cash used in the repayment of long-term debt in fiscal year 2020: ($14,685 thousand). The cash
used for various business activities is reported on the statement of cash flows. The repayment of
debt is a financing activity.
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xiv. Cash used in the payment of dividends in 2020: ($5,518 thousand). The cash used for various business activities is reported on the statement of cash flows. Paying dividends is a financing activity.
xv. Cash provided from (used for) investing activities in 2020: ($8,952 thousand). The cash provided
by various business activities is reported on the statement of cash flows. Investing activities are
one of the three main sections on this statement.
b. High Liner uses substantially more liabilities than shareholders’ equity to finance its business. You
can see this when you compare the total liabilities with the total liabilities plus shareholders’ equity
(on the statement of financial position as at January 2, 2021) as follows:
Total liabilities: $485,556 thousand
Total shareholders’ equity: $291,002 thousand
Total liabilities and shareholders’ equity: $776,558 thousand
Total liabilities are, therefore, 63% (($485,556 ÷ $776,558) × 100) of High Liner’s total sources of
financing. Because debt must be repaid, it is important for users to understand how much of the
company’s activities are being financed by debt. The greater the percentage of debt to total liabilities
and shareholders’ equity, the more risk there is that the company may not be able to repay its debt
when it comes due. At January 2, 2021, 63% of High Liner’s financing was debt financing.
c. High Liner does use a classified statement of financial position. It has labelled sections for current
assets and current liabilities and for non-current assets and non-current liabilities. It has included
the non-current assets and non-current liabilities in separate sections after the totals of the current
assets and current liabilities. It has also given you separate totals for the non-current assets and
non-current liabilities.
Assignment Material
Discussion Questions
DQ1-1 Describe the role that accounting plays in the management
of a business.
DQ1-11 Describe and illustrate the three major categories of items
that appear in a typical statement of financial position.
DQ1-2 Describe the owner’s legal liability and the taxation of
income in the following forms of business: corporation, proprietorship, and partnership.
DQ1-12 How do the activities that are considered to be operating
activities differ from those considered to be investing activities?
DQ1-3 Describe the circumstances in which it may make sense for
an entrepreneur to operate their business as a proprietorship rather
than as a corporation.
DQ1-4 Explain the difference between a public corporation and a
private corporation.
DQ1-13 How do the activities that are considered to be operating
activities differ from those considered to be financing activities?
DQ1-14 Explain whether the costs related to hiring and training a
company’s employees are considered to be an operating or investing
activity.
DQ1-5 Explain why public companies are required to publicly disclose their financial statements, while private companies are not.
DQ1-15 Would we normally expect a company to have an overall
inflow or an overall outflow of cash from its operating activities?
Explain why.
DQ1-6 Identify at least three major users of corporate financial
statements, and briefly state how these users might use the information from the statements.
DQ1-16 Would we normally expect a company to have an overall inflow or an overall outflow of cash from its investing activities?
Explain why.
DQ1-7 Explain how investors expect to receive a return on the
investment they make in a corporation.
DQ1-17 How is the statement of income related to the three major
types of business activities?
DQ1-8 What is capital appreciation and how can an investor realize
this type of return?
DQ1-18 Compare and contrast the purpose of the statement of
income and the statement of cash flows.
DQ1-9 Creditors are ultimately concerned with receiving two
streams of cash in relation to the loans they make. Explain each of
them.
DQ1-19 How does the statement of changes in equity relate to the
statement of income? Which of these statements would need to be
prepared first?
DQ1-10 Describe and illustrate the three major types of activities in
which all companies engage.
DQ1-20 Explain whether or not shareholders’ equity represents the
interests of owners after external claims have been satisfied.
Application Problems Set A
DQ1-21 Describe the purpose of the four main financial statements
that are contained in annual reports.
DQ1-23 What role does the management discussion and analysis
section of an annual report play in informing users about a company?
DQ1-22 Explain the purpose of the notes to the financial statements.
Application Problems Set A
AP1-1A
(Identifying financing, investing, and operating transactions)
Required
For a company like Canadian Tire Corporation, provide two examples of transactions that you would
classify as financing, investing, and operating activities.
AP1-2A
(Identifying financing, investing, and operating transactions)
Required
For a company like Bank of Nova Scotia, provide two examples of transactions that you would classify
as financing, investing, and operating activities.
AP1-3A (Classifying items on statement of cash flows) Use the following abbreviations to
answer this question:
O
I
F
Operating activities item
Investing activities item
Financing activities item
Required
Classify each of the following transactions according to whether they are operating, financing, or investing activities:
a. Purchase of manufacturing equipment
b. Issuance of long-term debt
c. Payment of property tax for office building
d. Sale of goods sold for cash
e. Interest paid on long-term debt
f. Proceeds from the sale of land
g. Payment of insurance premium
h. Purchase of shares of another company
AP1-4A
(Comparing statement of income and statement of financial position accounts)
Required
a. On what financial statement would you expect to find sales revenue, and what does it represent?
b. On what financial statement would you expect to find accounts receivable, and what does it
represent?
c. What is the connection between sales revenue and accounts receivable?
AP1-5A (Classifying items on financial statements) Use the following abbreviations to answer
this question:
CA
NCA
CL
NCL
SC
RE
SI
SCF
SCE
Current assets
Non-current assets
Current liabilities
Non-current liabilities
Share capital
Retained earnings
Statement of income item
Statement of cash flows item
Statement of changes in equity item
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Required
Classify the following items according to where they would appear in the financial statements:
a. Wages payable
b. Prepaid rent
c. Dividends payable
d. Inventory
e. Net increase in cash
f. Cost of goods sold
g. Dividends declared
h. Patents
i. Acquisition of bank loan with a five-year term
j. Deferred revenue
k. Common shares
AP1-6A (Classifying items on financial statements)
answer the following question.
Use the same abbreviations as in AP1-5A to
Required
Classify the following items according to where they would appear in the financial statements:
a. Intangible assets
b. Interest revenue
c. Cash collections from amounts owed by customers on account
d. Cost of developing a new advertising campaign
e. Earnings over the years that have not been paid to shareholders as dividends
f. Revenue from the provision of services to customers
g. Dividends paid
h. Increase in a bank loan (additional borrowings)
i. Supplies used this year
j. An investment in the shares of another corporation (the intent is not to sell the investment in the
near future)
k. Amounts paid to repurchase shares from shareholders
AP1-7A (Identifying items on statement of financial position and statement of income)
Required
Indicate whether each of the following items will be reported on the statement of financial position
(SFP), statement of income (SI), both the statement of financial position and statement of income (B), or
neither statement (N)—for example, it might appear only on the statement of cash flows.
a. Cash
b. Land acquired four years ago
c. Prepaid rent
d. Interest revenue
e. Sales of goods and services
f. Dividends paid to shareholders
g. Rent expense
h. Sales anticipated next period
i. Payment made to reduce the principal amount of a bank loan
j. Common shares issued when the company was organized five years ago
AP1-8A (Identifying items on statement of financial position and statement of income)
Required
Indicate whether each of the following items will be reported on the statement of financial position
(SFP), statement of income (SI), both the statement of financial position and statement of income (B), or
neither statement (N)—for example, it might appear only on the statement of cash flows.
Application Problems Set A
a. Temporary investments
b. Repurchase of shares issued 10 years ago
c. Goodwill
d. Rent revenue
e. Goods held for resale to customers
f. Retained earnings
g. Interest expense
h. Increase in accounts receivable
i. Depreciation expense
j. Gain on sale of equipment
AP1-9A
(Determining missing statement of financial position amounts)
Required
Calculate the missing statement of financial position amounts in each of the following independent
situations:
A
Current assets
$
Non-current assets
(1)
B
C
$ 600,000
$180,000
780,000
Total assets
(4)
Current liabilities
(2)
Non-current liabilities
(5)
345,000
(6)
Shareholders’ equity
135,000
330,000
638,000
(8)
Total liabilities and shareholders’ equity 1,350,000
(10)
$
990,000
390,000
1,335,000
375,000
D
(7)
(3)
1,650,000
390,000
225,000
330,000
(9)
(11)
(12)
AP1-10A (Determining missing statement of changes in equity amounts of retained
­earnings) The change in retained earnings from the beginning of the year to the end of the year is the
result of net earnings minus dividends for the year. These changes are part of the information presented
on the statement of changes in equity.
Required
Calculate the missing amounts in the reconciliation of retained earnings in each of the following independent situations:
Retained earnings, Dec. 31, 2023
A
B
$100,000
$420,000
Net earnings
40,000
Dividends declared and paid
10,000
Retained earnings, Dec. 31, 2024
AP1-11A
(4)
C
(2)
$
550,000
50,000
225,000
530,000
1,800,000
(Determining missing financial statement information)
Required
Determine the four missing amounts using financial statement relationships.
Revenues
Expenses
Net income
Dividends declared during the year
862,000
A
194,000
65,000
Retained earnings
Beginning
686,000
Ending
815,000
(continued)
D
(1)
$ 930,000
290,000
(3)
1,080,000
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Overview of Corporate Financial Reporting
(continued)
Total assets
Beginning
Ending
B
3,426,000
Total liabilities
Beginning
Ending
428,000
C
Common shares
Beginning
D
Ending
300,000
Proceeds from issuing additional
common shares during the year
100,000
AP1-12A (Preparing simple statement of income) Friedrich Burgel runs a ski school and excursion company called Easy Peasy Ltd. His busiest months are December through February, although, if the
weather holds, he extends his school and excursions into March. For the month of January, he recorded
the following items:
1. He spent $1,465 on the utilities for the office and $6,450 on gas and repairs for the vehicles.
2. He used supplies that cost $16,465.
3. Customers paid him $237,570 for excursions that took place in January and $65,500 in deposits for
trips scheduled in February.
4. He paid $35,791 for employee wages and he spent $10,000 to an influencer for advertising the
company.
Required
a. Prepare a statement of income to determine how much Easy Peasy Ltd. earned in January.
b. Are there any other costs that might have been incurred in January but were not listed?
AP1-13A (Preparing simple statement of income) Michelle Fontaine runs an outdoor adventure company called Call of the Wild Ltd. Her busiest months are June through September, although, if
the weather holds, she extends her excursions into October and November. For the month of July, she
recorded the following items:
1. She paid $49,860 for employee wages and spent $14,610 on advertising.
2. Customers paid her $171,430 for excursions that took place in July and $21,000 in deposits for trips
scheduled in August and September.
3. She used supplies in July that cost $25,629.
4. She spent $1,532 on the utilities for the office and $3,460 on gas and repairs on the vehicles.
Required
a. Prepare a statement of income to determine how much Call of the Wild Ltd. earned in July.
b. Are there any other costs that might have been incurred in July but were not listed?
AP1-14A (Preparing simple statement of financial position) AP1-12A introduced Friedrich
Burgel and his ski school and excursion company, Easy Peasy Ltd. At the end of January, the following
items were in his records:
Loan owed to the bank
$60,000
Common shares
41,000
Vehicles
65,000
Ski equipment
22,000
Amounts prepaid by customers for trips to be taken in February
95,000
Retained earnings
26,000
Amounts prepaid by Easy Peasy to secure accommodations in February
60,000
Cash in bank accounts
75,000
Application Problems Set B
Required
a. Identify each of the items in his records as an asset, liability, or shareholders’ equity item.
b. Prepare a statement of financial position for Easy Peasy Ltd. at the end of January.
c. Does Friedrich Burgel have any inventory? Explain.
d. Friedrich Burgel does not have accounts receivable in his records. Explain why it is unlikely that he
will record accounts receivable. Under what business circumstances would it be necessary for him
to record accounts receivable?
AP1-15A (Preparing statement of financial position) AP1-13A introduced Michelle Fontaine
and her outdoor adventure company, Call of the Wild Ltd. At the end of July, the following items were
in her records:
Loan owed to the bank
$24,000
Supplies on hand to be used in August
13,420
Cash in bank accounts
33,670
Common shares
20,000
Cost of tents and rafts
34,100
Retained earnings
56,450
Amounts prepaid by customers for trips to be taken in August
19,140
Vehicles
38,400
Required
a. Identify each of the items in her records as an asset, liability, or shareholders’ equity item.
b. Prepare a statement of financial position for Call of the Wild Ltd. at the end of July.
c. Does Michelle Fontaine have any inventory? Explain.
d. Michelle Fontaine does not have accounts receivable in her records. Explain why it is unlikely that
she will record accounts receivable. Under what business circumstances would it be necessary for
her to record accounts receivable?
Application Problems Set B
AP1-1B (Identifying financing, investing, and operating transactions)
Required
For a company like Aritzia Inc. provide two examples of transactions that you would classify as financing, investing, and operating activities.
AP1-2B (Identifying financing, investing, and operating transactions)
Required
For a company like Telus Corporation, provide two examples of transactions that you would classify as
financing, investing, and operating activities.
AP1-3B (Classifying items on statement of cash flows)
Required
Use the same abbreviations as in AP1-3A to classify each of the following transactions according to
whether they are operating, financing, or investing activities:
a. Proceeds from the sale of an investment in another company’s shares
b. Acquisition of a business
c. Cash paid to suppliers of inventory
d. Acquisition of a long-term bank loan
e. Payment of advertising costs
f. Purchase of a truck used for deliveries
g. Payment of dividends
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AP1-4B (Comparing statement of income and statement of financial position accounts)
Required
a. On what financial statement would you expect to find wages payable, and what does it
represent?
b. On what financial statement would you expect to find wages expense, and what does it
represent?
c. What is the connection between wages payable and wages expense?
AP1-5B (Classifying items on financial statements)
answer the following question.
Use the same abbreviations as in AP1-5A to
Required
Classify the following items according to where they would appear in the financial statements:
a. Rent payable
b. Amounts owed by customers of the company
c. Administrative expense
d. Proceeds received from taking out a long-term bank loan
e. Office supplies
f. Net earnings for the year
g. Cash proceeds from the sale of old equipment
h. Increase in the cash balance for the year
i. Income tax expense
j. Cost to the company of inventory sold to customers this year
k. Proceeds from issuing common shares during the year
AP1-6B (Classifying items on financial statements)
answer the following question.
Use the same abbreviations as in AP1-5A to
Required
Classify the following items according to where they would appear in the financial statements:
a. Goodwill arising from the acquisition of another company
b. Payment of a utility bill
c. Cash collections from loan receivable
d. Short-term investments
e. Dividends declared
f. Cost for renting equipment
g. Amounts owed to customers for advance payments
h. Insurance costs for the period
i. Inventory sold during the year
j. Dividends declared by the board of directors but not yet paid
k. Revenue from software licensing
AP1-7B (Identifying items on statement of financial position and statement of income)
Required
Indicate whether each of the following items will be reported on the statement of financial position
(SFP), statement of income (SI), both the statement of financial position and statement of income (B), or
neither statement (N)—for example, it might appear only on the statement of cash flows.
a. Notes receivable
b. Interest revenue from a short-term investment
c. Common shares
d. Accounts payable
e. Depreciation expense on a building
Application Problems Set B
f. Interest expense
g. Cash from the issuance of shares
h. Wages payable
i. Interest expense on a bank loan
j. Retained earnings
AP1-8B (Identifying items on statement of financial position and statement of income)
Required
Indicate whether each of the following items will be reported on the statement of financial position
(SFP), statement of income (SI), both the statement of financial position and statement of income (B), or
neither statement (N)—for example, it might appear only on the statement of cash flows.
a. Current portion of long-term debt
b. Gain on disposal of asset
c. Repayment of long-term debt
d. Deferred revenue
e. Amortization of an intangible asset
f. Rent paid in advance
g. Wages owed to employees
h. Dividend payable
i. Income tax expense
j. Retained earnings
AP1-9B (Determining missing statement of financial position amounts)
Required
Calculate the missing statement of financial position amounts in each of the following independent
situations:
A
Current assets
B
$ 650,000
Non-current assets
(2)
Total assets
$
(1)
750,000
Non-current liabilities
500,000
Shareholders’ equity
Total liabilities and shareholders’ equity
D
$320,000
380,000
1,800,000
Current liabilities
C
$150,000
(4)
170,000
(6)
(3)
760,000
360,000
50,000
(5)
410,000
120,000
(8)
425,000
(9)
(10)
800,000
(11)
(7)
400,000
(12)
AP1-10B (Determining missing statement of changes in equity amounts of retained
­earnings) The change in retained earnings from the beginning of the year to the end of the year is the
result of net earnings minus dividends for the year. These changes are part of the information presented
on the statement of changes in equity.
Required
Calculate the missing amounts in the reconciliation of retained earnings in each of the following independent situations:
A
Retained earnings, Dec. 31, 2023
Net earnings (loss)
Dividends declared and paid
Retained earnings, Dec. 31, 2024
$
(1)
30,000
5,000
95,000
B
C
$350,000
$2,400,000
400,000
(3)
600,000
D
(2)
200,000
$2,700,000
$540,000
190,000
340,000
(4)
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AP1-11B (Determining missing financial statement information)
Required
Determine the four missing amounts using financial statement relationships.
Revenues
A
Expenses
2,687,000
Net income
792,000
Dividends declared during the year
137,000
Retained earnings
Beginning
1,120,000
Ending
1,775,000
Total assets
Beginning
Ending
4,252,000
B
Total liabilities
Beginning
Ending
C
2,564,000
Common shares
Beginning
Ending
Proceeds from issuing additional common shares during the year
450,000
D
100,000
AP1-12B (Preparing simple statement of income) Lydia Cravette operates a florist shop called
Scents Unlimited Ltd. During the month of May, the following things occurred:
1. She spent $160 on the telephone system, $370 on utilities, and $1,500 on rent.
2. She took in $24,730 from selling flowers and plants. All of the shop’s sales were cash sales.
3. She spent $10,733 for the cost of the flowers sold, she paid $329 for gas and repairs to the delivery
vehicle, and she paid her employees $7,000 for wages earned during the month.
Required
a. Prepare a statement of income to determine how much Scents Unlimited Ltd. earned in May.
b. Are there any other costs that might have been incurred in May but are not listed?
AP1-13B (Preparing simple statement of income) Josephine D’eau operates a water park called
Slip and Slide Ltd. Her busiest months are April through September, although, if the weather holds, she
extends park access into October. For the month of July, she recorded the following items:
1. She paid $25,000 for employee wages and spent $5,430 on promotional material.
2. Customers paid her $200,650 to access the water park in July and $6,000 to park their cars. She
enticed customers to purchase advance tickets for the month of August and collected $35,000 for
these advance ticket sales in the month of July.
3. She used chemical supplies to purify the water in July that cost $15,469.
4. She spent $6,153 for the use of water and $8,756 on electricity as the water park extended operating
hours until midnight for the month of July.
User Perspective Problems
Required
a. Prepare a statement of income to determine how much Slip and Slide Ltd. earned in July.
b. Are there any other costs that might have been incurred in July but were not listed?
AP1-14B (Preparing simple statement of financial position) AP1-12B introduced Lydia Cravette
and her florist shop, Scents Unlimited Ltd. At the end of May, the following items were in her records:
Inventory
Wages owed to employees
Loan owed to the bank
Cash held in a chequing account
Cost of refrigerator used to store the flowers
Prepaid rent for June
Common shares
Retained earnings
$ 1,100
950
8,000
8,361
18,695
1,500
18,000
2,706
Required
a. Identify each of the items in her records as an asset, liability, or shareholders’ equity item.
b. Prepare a statement of financial position for Scents Unlimited Ltd. at the end of May.
c. Lydia Cravette does not have accounts receivable in her records. Explain why it is unlikely that she
will record accounts receivable. Under what business circumstances would it be necessary for her to
record accounts receivable?
AP1-15B (Preparing statement of financial position) AP1-13B introduced Josephine D’eau and
her water park company, Slip and Slide Ltd. At the end of July, the following items were in her records:
Cash in bank accounts
$15,000
Chemical supplies on hand
12,620
Loan owed to an investor
22,500
Retained earnings
20,120
Spare parts
15,000
Common shares
30,000
Amounts prepaid by customers to access the park in August
35,000
Cost of kayaks and pedal boats
65,000
Required
a. Identify each of the items in her records as an asset, liability, or shareholders’ equity item.
b. Prepare a statement of financial position for Slip and Slide Ltd. at the end of July.
c. Does Josephine D’eau have any inventory? Explain.
d. Josephine D’eau does not have accounts receivable in her records. Explain why it is unlikely that
she will record accounts receivable. Under what business circumstances would she need to record
accounts receivable?
User Perspective Problems
UP1-1 (Information for decision-making) Suppose that you started your own company that
assembles and sells laptop computers. You do not manufacture any of the parts yourself. The computers
are sold through orders received over the Internet and through mail orders.
Required
Make a list of the information that would be relevant to running this business. Then discuss the information you would need to gather if you were going to approach a bank for a small business loan.
1-45
1-46
C H A PTE R 1
Overview of Corporate Financial Reporting
UP1-2 (Information for decision-making) Suppose that you own and operate a company. You
need to raise money to expand your operation, so you approach a bank for a loan. The loan officer has
asked you for your company’s financial statements.
Required
a. What items on your financial statements would be of the most interest to the loan officer?
b. Develop four questions that you think the loan officer would be trying to answer by looking at your
financial statements.
UP1-3 (Form of business) Taylor Leblond just graduated from university and is planning to start a
software development company to develop and market a mapping program he has created. He is debating
whether to operate the business as a proprietorship or corporation.
Required
a. What advantages are there to operating as a proprietorship?
b. What advantages are there to operating as a corporation?
c. Which form of business organization would his customers likely prefer? Why?
d. Which form of business organization would his creditors likely prefer? Why?
e. Which form of business will be more advantageous to Taylor if he expects the business to grow
­rapidly? Why?
UP1-4 (Raising new capital) Suppose that your best friend wants to start a new company that provides website development services to customers. Your friend has some savings to start the company but
not enough to buy all the equipment that she thinks she needs. She has asked you for some advice about
how to raise additional funds.
Required
Give your friend at least two alternatives and provide the pros and cons for each one.
UP1-5 (Distribution of dividends to shareholders) The board of directors of a public company is
having its monthly meeting. One of the items on the agenda is the possible distribution of a cash dividend
to shareholders. If the board decides to issue a cash dividend, the decision obliges the company to issue
cash to shareholders based on the number of shares each shareholder owns.
Required
Before making its decision, what information about the company should the board consider? Think of
the items on the financial statements that you saw in this chapter.
Work in Progress
WIP1-1 (Dividends) You are part of a group of students analyzing a company’s financial statements
as part of a class project. At a team meeting, one of your group members makes the following statement:
“If we are trying to determine the dividends that the company has declared, then we should see it
reflected on the statement of income. If we want to determine if these dividends have been paid or
not, then we should review the statement of financial position. Normally, the amount of dividends
declared will be equal to a company’s earnings per share.”
Required
Evaluate your group member’s response. Identify the elements that are correct and incorrect. For any
elements that are incorrect, explain why.
WIP1-2 (Dividends) While preparing for an upcoming exam, you are studying with some classmates when one of them states the following:
“Dividends are extra cash flow to the company. Companies do not declare dividends unless they
have an overall positive cash flow. To determine the amount of dividends a company declared
during the year, you should look at the statement of income for the year.”
Required
Evaluate your classmate’s response. Identify the elements that are correct and incorrect. For any elements
that are incorrect, explain why.
Reading and Interpreting Published Financial Statements
1-47
WIP1-3 (Dividends) While studying with a classmate, you are discussing a question about which of
the financial statements you would look to in order to determine the amount of dividends that a company
declared during the year. Your classmate states:
“The amount of dividends that have been declared can be seen on the statement of income. This
statement tells users how much profit the company makes after expenses and dividends declared
have been deducted from the revenues earned during the period.”
Required
Evaluate your classmate’s response. Identify the elements that are correct and incorrect. For any elements
that are incorrect, explain why.
WIP1-4 (Shareholders’ equity)
She asks:
A friend from your accounting class asks you for some help.
“Am I correct in thinking that shareholders’ equity is equal to the amount shareholders paid for their
shares when they purchased them in the market? If not, can you please explain what it represents?”
Required
Evaluate your friend’s response. Identify the elements that are correct and incorrect. For any elements
that are incorrect, explain why.
WIP1-5 (Shareholders’ equity) You are part of a group of students analyzing the financial statements of a public company as part of a class project. At a team meeting, one of your group members
makes the following statement:
“Shareholders’ equity is really composed of two parts. The first part is the amounts contributed by
shareholders, and the second is the company’s subsequent earnings. If a company reports a profit for
the year, then shareholders’ equity increases by the same amount. On the other hand, ­shareholders’
equity is reduced by the amount of any dividends paid during the year.”
Required
Evaluate your friend’s response. Identify the elements that are correct and incorrect. For any elements
that are incorrect, explain why.
WIP1-6
(Statement of cash flows) A member of your study group stated the following:
“The costs related to hiring and training a company’s employees would be considered to be an investing activity because the company is investing in its employees, an important asset to the company.”
Required
Evaluate your friend’s response and explain any deficiencies.
Reading and Interpreting Published Financial Statements
RI1-1 (Financial statements of Leon’s Furniture Limited/Meubles Léon Ltée) Base your
answers to the following questions on the financial statements for Leon’s Furniture Limited/Meubles
Léon Ltée in Exhibits 1.27A to 1.27D.
EXHIBIT 1.27A Leon’s
Furniture Limited’s 2020
Consolidated Statements of
Financial Position
LEON’S FURNITURE LIMITED
Consolidated Statement of Financial Position
(C$ in thousands)
Notes
As at
December 31,
2020
As at
December 31,
2019
5
$ 368,635
$ 89,032
2,451
5,777
Assets
Current assets
Cash and cash equivalents
Restricted marketable securities
Debt securities
73,565
65,859
(continued)
1-48
C H A PTE R 1
Overview of Corporate Financial Reporting
EXHIBIT 1.27A Leon’s
Furniture Limited’s 2020
Consolidated Statements of
Financial Position (continued)
Notes
As at
December 31,
2020
As at
December 31,
2019
Equity securities
48,634
42,286
Trade receivables
130,582
140,535
4,266
3,578
Income taxes receivable
Inventories
6
332,072
334,443
Deferred acquisition costs
7
10,725
10,994
11,095
9,273
—
625
982,025
702,402
Prepaid expenses and other assets
Other assets
22
Total current assets
Non-current assets
Deferred acquisition costs
7
17,614
16,870
15
12,721
13,053
Property, plant and equipment
8
714,423
720,794
Investment properties
9
16,212
16,633
Intangible assets
10
270,481
271,810
Goodwill
10
390,120
390,120
Deferred income tax assets
20
Loan receivable
Total non-current assets
Total assets
14,993
14,779
1,436,564
1,444,059
$ 2,418,589
$ 2,146,461
Liabilities
Current liabilities
Trade and other payables
11
$ 304,844
$ 256,539
Provisions
12
25,608
23,274
Income taxes payable
20
15,479
6,505
Customers’ deposits
17
305,460
151,817
Lease liability
13
73,476
70,601
Dividends payable
16
36,163
10,822
Deferred warranty plan revenue
17
55,733
57,638
Loans and borrowings
14
—
25,000
Other liabilities
22
Total current liabilities
3,976
—
820,739
602,196
90,000
70,000
Non-current liabilities
Loans and borrowings
14
Convertible debentures
14
441
48,788
Lease liability
13
327,227
342,093
Deferred warranty plan revenue
17
88,604
85,305
Redeemable share liability
15
13
13
Deferred income tax liabilities
20
Total non-current liabilities
Total liabilities
75,562
82,302
581,847
628,501
1,402,586
1,230,697
Equity
Common shares
16
164,669
115,728
Equity component of convertible debentures
14
31
3,542
842,604
793,116
8,699
3,378
Retained earnings
Accumulated other comprehensive income
Total shareholders’ equity
Total liabilities and shareholders’ equity
1,016,003
915,764
$ 2,418,589
$ 2,146,461
Reading and Interpreting Published Financial Statements
EXHIBIT 1.27B Leon’s
Furniture Limited’s 2020
Consolidated Statements of
Income
LEON’S FURNITURE LIMITED
Consolidated Statement of Income
(C$ in thousands except share and share amounts)
For the
Year ended
Notes
Revenue
Cost of sales
1-49
December
31, 2020
December 31,
2019
17
$ 2,220,180
$ 2,283,411
6
1,236,258
1,284,826
983,922
998,585
750,951
830,495
232,971
168,090
(22,413)
(28,689)
4,526
3,505
Gross profit
Operating expenses
Selling, general and administration expenses
18
Operating profit
Finance costs
19
Finance income
19
Change in fair value of derivative instruments
(4,599)
Net income before income tax
Income tax expense
140
210,485
20
Net income for the year
143,046
47,235
$ 163,250
36,117
$
106,929
EXHIBIT 1.27C Leon’s
Furniture Limited’s 2020
Consolidated Statements of
Cash Flows
LEON’S FURNITURE LIMITED
Consolidated Statement of Cash Flows
(C$ in thousands except share and share amounts)
For the
Year ended
Notes
December 31, December 31,
2020
2019
Operating activities
Net income before income tax
$ 210,485
$ 143,046
108,970
118,775
2,319
3,920
(64,736)
(71,449)
Add (deduct) items not involving an outlay
of cash:
Depreciation of property, plant and
equipment and investment properties
Amortization of intangible assets
Amortization of deferred warranty plan
revenue
17
Amortization of premium
Net finance costs
Gain on sale of property, plant and
equipment and investment properties
Fair value gain on loan receivable
15
Gain (loss) on sale of debt and equity
instruments
Change in operating working capital
Cash received on warranty plan sales
26
222
144
18,050
25,472
(831)
(424)
(714)
(528)
(139)
5
273,626
218,961
217,674
(11,627)
66,130
66,086
Income taxes paid
(46,006)
(38,806)
Cash provided by operating activities
511,424
234,614
(continued)
1-50
C H A PTE R 1
Overview of Corporate Financial Reporting
EXHIBIT 1.27C Leon’s
Furniture Limited’s 2020
Consolidated Statements of
Cash Flows (continued)
For the
Year ended
Notes
December 31, December 31,
2020
2019
Investing activities
Purchase of property, plant and equipment
Purchase of intangible assets
8
(43,493)
(32,931)
10
(995)
(1,236)
Proceeds on sale of property, plant and equipment
1,298
1,004
Purchase of debt and equity instruments
(36,038)
(36,497)
Proceeds on sale of debt and equity instruments
30,586
22,097
Repayment of loan receivable
1,046
666
Interest received
4,526
3,505
(43,070)
(43,392)
Cash used in investing activities
Financing activities
Payment of lease liability
13
(71,076)
(66,149)
(44,636)
(43,313)
15
2,499
5,063
Repurchase of common shares
16
(48,202)
(10,158)
Repayment of term loan
14
(5,000)
(50,000)
Dividends paid
Decrease of employee loans—redeemable shares
(22,336)
(27,900)
Cash used in financing activities
Interest paid
(188,751)
(192,457)
Net increase (decrease) in cash and cash
equivalents during the year
279,603
Cash and cash equivalents, beginning of year
Cash and cash equivalents, end of year
(1,235)
89,032
90,267
$ 368,635
$ 89,032
EXHIBIT 1.27D Leon’s Furniture Limited’s 2020 Consolidated Statements of Changes in
Shareholders’ Equity
LEON’S FURNITURE LIMITED
Consolidated Statements of Changes in Shareholders’ Equity
(C$ in thousands)
Equity
component of
convertible
debentures
Common
shares
Accumulated
other
comprehensive
income
Retained
earnings
Total
As at December 31, 2019
Comprehensive income
Net income for the year
Other comprehensive income for the year
Total comprehensive income
Transactions with shareholders
Dividends declared
Management share purchase plan [note 15]
Convertible debentures [note 14]
Treasury shares [note 16]
Share repurchase commitment [note 16]
Repurchase of common shares [note 16]
Total transactions with shareholders
$ 3,542
$ 115,728
$ 3,378
$ 793,116
$ 915,764
—
—
—
—
—
—
—
5,321
5,321
163,250
—
163,250
163,250
5,321
168,571
—
2,499
51,859
(6)
(159)
(5,252)
48,941
—
—
—
—
—
—
—
(69,977)
—
—
(59)
(841)
(42,885)
(113,762)
(69,977)
2,499
48,348
(65)
(1,000)
(48,137)
(68,332)
As at December 31, 2020
$
$ 164,669
$ 8,699
—
—
(3,511)
—
—
—
(3,511)
31
$ 842,604
$1,016,003
(continued)
Reading and Interpreting Published Financial Statements
EXHIBIT 1.27D Leon’s Furniture Limited’s 2020 Consolidated Statements of Changes in
Shareholders’ Equity (continued)
Equity
component of
convertible
debentures
As at December 31, 2018
$ 3,546
Common
shares
$ 111,956
Accumulated
other
comprehensive
income (loss)
Retained
earnings
Total
$ (1,539)
$ 743,399
$ 857,362
106,929
Comprehensive income
Net income for the year
—
—
—
106,929
Other comprehensive income for the year
—
—
4,917
—
4,917
Total comprehensive income
—
—
4,917
106,929
111,846
—
—
—
(43,445)
(43,445)
Transactions with shareholders
Dividends declared
Management share purchase plan [note 15]
—
5,063
—
—
5,063
Convertible debentures [note 14]
(4)
100
—
—
96
Share repurchase commitment [note 16]
—
(443)
—
(4,557)
(5,000)
Repurchase of common shares [note 16]
—
(948)
—
(9,210)
(10,158)
Total transactions with shareholders
As at December 31, 2019
(4)
3,772
—
(57,212)
(53,444)
$ 3,542
$ 115,728
$ 3,378
$ 793,116
$ 915,764
In the questions below, the year 2020 refers to Leon’s fiscal year that ends December 31, 2020, and the
year 2019 refers to the prior fiscal year ended December 31, 2019.
Required
a. Determine the amount of dividends that Leon’s declared in 2020. On which financial statement(s)
did you find this information?
b. Find the following amounts in the statements:
i. Revenue in 2020
ii. Cost of sales in 2020
iii. Gross profit (as a dollar amount and as a percentage) in 2020
iv. Selling, general, and administrative expenses in 2020
v. Income tax expense in 2020
vi. Net income in 2019
vii. Trade receivables at the end of 2019
viii. Inventories at the end of 2020
ix. Trade and other payables at the beginning of the 2020 fiscal year
x. Retained earnings at the end of 2020
xi. Loans and borrowings at the beginning of 2020 (include the current portion)
xii. Cash flows provided by operating activities in 2020
xiii. Cash payments to purchase property, plant, and equipment in 2020
xiv. Cash payments for dividends in 2020
xv. Cash flows generated by (used in) financing activities in 2019
xvi. Cash payments to repurchase common shares in 2020
c. List the two largest sources of cash and the two largest uses of cash in 2020. (Consider operating
activities to be a single source or use of cash.)
d. Suggest two reasons why net income was $163,250 thousand in 2020, yet cash provided by operating
activities was $511,424 thousand.
e. During 2020, total revenue was approximately $63,231 thousand lower than in 2019. However, net
income in 2020 was $56,321 thousand higher than in 2019. Examine the consolidated statements
of income and explain how this was possible.
RI1-2 (Financial statements of Waterloo Brewing Ltd.) Base your answers to the following
questions on the 2021 financial statements for Waterloo Brewing Ltd. in Exhibits 1.28A to 1.28C.
1-51
1-52
C H A PTE R 1
Overview of Corporate Financial Reporting
EXHIBIT 1.28A Waterloo
Brewing Ltd.’s 2021 Statements
of Financial Position
WATERLOO BREWING LTD.
Statements of Financial Position
As at January 31, 2021 and January 31, 2020
Notes
January 31,
2021
Assets
January 31, 2020
[recast – note 3.6]
Current assets
Accounts receivable
6
$ 9,871,061
$ 4,976,226
Inventories
7
14,344,496
10,482,912
729,260
787,448
24,944,817
16,246,586
Prepaid expenses
Non-current assets
Property, plant and equipment
8
46,630,107
32,808,678
Right-of-use assets
9
26,936,861
27,840,996
10
15,002,826
15,184,333
1,949,074
1,050,425
90,518,868
76,884,432
$115,463,685
$93,131,018
$
$
Intangible assets
Construction deposits
Total Assets
Liabilities and Equity
Current liabilities
Bank indebtedness
11
3,366,489
783,077
Accounts payable and accrued liabilities
12
21,341,335
12,909,771
Current portion of lease liabilities
13
3,282,080
2,869,733
Non-revolving demand loans
14
25,896,379
13,748,967
Current portion of long-term debt
15
510,275
687,836
54,396,558
30,999,384
Non-current liabilities
Provisions
16
1,019,962
958,025
Lease liabilities
13
21,522,379
23,226,137
Long-term debt
15
1,367,930
1,852,023
Deferred income tax liability
17
3,462,495
2,208,947
27,372,766
28,245,132
81,769,324
59,244,516
Total Liabilities
Equity
Share capital
18
39,546,216
39,126,283
Share-based payments reserves
19
2,245,415
2,108,671
(8,097,270)
(7,348,452)
33,694,361
33,886,502
$115,463,685
$93,131,018
Deficit
Total Equity
Commitments
Total Liabilities and Equity
26
Reading and Interpreting Published Financial Statements
1-53
EXHIBIT 1.28B Waterloo
Brewing Ltd.’s 2021 Statements
of Comprehensive Income
WATERLOO BREWING LTD.
Statements of Comprehensive Income
Years ended January 31, 2021 and 2020
Notes
Revenue
Cost of sales
January 31,
2021
January 31,
2020
20
$86,699,345
$60,333,417
13, 21
66,000,997
42,483,862
Gross profit
Selling, marketing and administration expenses
Other expenses
Finance costs
Loss on misappropriated funds, net
20,698,348
17,849,555
13, 21
11,853,169
11,842,088
13, 21, 22
2,268,499
1,616,977
13, 23
2,107,363
1,500,682
12
—
1,869,595
Loss (gain) on disposal of property, plant and
equipment and right-of-use assets
215,756
Income before tax
Income tax expense
17
Net income and comprehensive income
for the year
(15,168)
4,253,561
1,035,381
1,253,548
537,779
$ 3,000,013
$
497,602
EXHIBIT 1.28C Waterloo Brewing Ltd.’s 2021 Statements of Cash Flows
WATERLOO BREWING LTD.
Statements of Cash Flow
Years ended January 31, 2021 and 2020
Notes
January 31,
2021
January 31,
2020
[recast – note 3.6]
Operating activities
Net income
$
3,000,013
$
497,602
Adjustments for:
Income tax expense
17
1,253,548
537,779
Finance costs
23
2,107,363
1,500,682
8, 9, 10, 21, 22
7,810,676
6,334,179
Depreciation and amortization of property, plant and equipment,
right-of-use assets and intangibles
Loss (gain) on disposal of property, plant and equipment and rightof-use assets
215,756
(15,168)
Share-based payments
19
792,327
892,360
Change in non-cash working capital
28
(442,761)
5,036,143
Less:
Interest paid
(1,859,817)
(1,373,019)
Cash provided by operating activities
12,877,105
13,410,558
Investing activities
Purchase of property and equipment
8
(18,407,338)
(11,013,763)
Construction deposit paid
8
(1,949,074)
(1,050,425)
Proceeds from sale of property, plant and equipment, net
Purchase of intangible assets
Cash used in investing activities
9,555
10
18,656
(25,659)
(134,624)
(20,372,516)
(12,180,156)
(continued)
1-54
C H A PTE R 1
Overview of Corporate Financial Reporting
EXHIBIT 1.28C Waterloo Brewing Ltd.’s 2021 Statements of Cash Flows (continued)
January 31,
2021
January 31,
2020
11
2,583,412
(1,104,176)
Notes
Financing activities
Increase (decrease) in bank indebtedness
Issuance of non-revolving demand loans
14
14,505,315
7,961,780
Repayment of non-revolving demand loans
14
(2,357,903)
(1,292,639)
Repayment of long-term debt
15
(671,169)
(672,193)
Repayment of lease liabilities
13
(2,579,763)
(1,563,059)
Dividends paid
18
(3,748,831)
(3,576,462)
Issuance of shares, net of fees
19
29,368
Shares repurchased and cancelled, including fees
18
(377,058)
Stock option costs
19
—
(17,169)
Proceeds from stock option exercise
19
112,040
62,278
Cash generated from (used in) financing activities
96,722
(1,125,484)
7,495,411
(1,230,402)
Net increase/(decrease) in cash
—
—
Cash, beginning of year
—
—
Cash, end of year
$
—
$
—
Non-cash investing activities:
Acquisition of assets under lease
9, 13
$ 1,311,281
$13,822,240
In the questions below, the year 2021 refers to Waterloo Brewing’s fiscal year ended January 31, 2021, and
the year 2020 refers to the prior year ended January 31, 2020.
Required
a. Waterloo Brewing’s financial statements do not include the word “consolidated” in their title. What
does this tell you about the company’s structure?
b. Waterloo Brewing prepared a classified statement of financial position. Calculate the difference
between current assets and current liabilities at the end of 2021, and at the end of 2020. This amount
is referred to as working capital. Did the company’s working capital improve in 2021? Explain.
c. Find the following amounts in Waterloo Brewing’s statements:
i. Revenues in 2021
ii. Cost of sales in 2021
iii. Gross profit (as a dollar amount and as a percentage) in 2021
iv. Selling, marketing, and administration expenses in 2020
v. Income tax expense in 2020
vi. Net income in 2021
vii. Intangible assets at the end of 2021
viii. Accounts receivable at the beginning of 2021
ix. Share capital at the end of 2021
x. Property, plant, and equipment at the end of 2021
xi. Cash flows from operating activities in 2021
xii. Cash payments to purchase property, plant, and equipment in 2021
xiii. Cash used for the payment of dividends in 2021
d. Did Waterloo Brewing finance the company’s assets mainly from creditors (total liabilities) or from
shareholders (shareholders’ equity) in 2021? Support your answer with appropriate calculations.
Reading and Interpreting Published Financial Statements
e. List the two largest sources of cash and the two largest uses of cash in 2021. (Consider cash generated from operating activities to be a single source or use of cash.)
f. Suggest some reasons why Waterloo Brewing’s net income was $3,000,013 in 2021, yet cash provided
by operating activities was $12,877,105.
RI1-3 (Financial statements of Roots Corporation) The major financial statements of Roots
Corporation for the year ended January 30, 2021, are included in Exhibits 1.29A to 1.29C.
EXHIBIT 1.29A Roots
Corporation’s 2021
Consolidated Statement of
Financial Position
ROOTS CORPORATION
Consolidated Statement of Financial Position
As at January 30, 2021 and February 1, 2020
(in thousands of Canadian dollars)
Note
January 30, February 1,
2021
2020
Assets
Current assets
Cash
19
$
9,166
$
949
Accounts receivable
4, 14
7,165
7,158
Inventories
5, 19
42,401
40,152
3,137
5,418
61,869
53,677
608
585
Prepaid expenses
Total current assets
Non-current assets
Loan receivable
14, 18
Lease receivable
9, 14
1,187
1,511
Fixed assets
6, 19
47,981
55,694
Right-of-use assets
9, 19
79,995
128,322
Intangible assets
7
190,777
193,079
Goodwill
7
7,906
7,906
328,454
387,097
$390,323
$440,774
$
$
Total non-current assets
Total assets
Liabilities and shareholders’ equity
Current liabilities
Bank indebtedness
Accounts payable and accrued liabilities
14, 19
—
7,226
25,850
20,252
5,759
6,011
15
5,955
2,008
Current portion of lease liabilities
9, 14, 19
22,197
26,569
Current portion of long-term debt
10, 14
4,984
4,984
8, 14
418
158
65,163
67,208
15
15,891
13,942
9, 14, 19
78,989
124,590
10, 14
66,100
84,528
Total non-current liabilities
160,980
223,060
Total liabilities
226,143
290,268
Deferred revenue
Income taxes payable
Derivative obligations
Total current liabilities
Non-current liabilities
Deferred tax liabilities
Long-term portion of lease liabilities
Long-term debt
(continued)
1-55
1-56
C H A PTE R 1
Overview of Corporate Financial Reporting
EXHIBIT 1.29A Roots
Corporation’s 2021
Consolidated Statement of
Financial Position (continued)
Note
January 30, February 1,
2021
2020
Shareholders’ equity:
Share capital
11
197,333
196,903
Contributed surplus
13
3,682
3,407
Accumulated other comprehensive income (loss)
(227)
(116)
Retained earnings (deficit)
(36,608)
(49,688)
Total shareholders’ equity
164,180
150,506
$390,323
$440,774
Total liabilities and shareholders’ equity
EXHIBIT 1.29B Roots
Corporation’s 2021
Consolidated Statement of Net
Income (Loss)
ROOTS CORPORATION
Consolidated Statement of Net Income (Loss)
For the 52-week periods ending January 30, 2021 and February 1, 2020
(in thousands of Canadian dollars, except per share amounts)
Note
Sales
Cost of goods sold
5
Gross profit
Selling, general and administrative expenses
Goodwill impairment
Gain from deconsolidation of RTS USA Corp.
$ 329,865
100,767
153,676
176,189
114,807
188,308
7
—
44,799
19
4,774
—
29,706
(56,918)
11,741
15,567
17,965
(72,485)
4,885
(10,456)
$ 13,080
$ (62,029)
10
15
Net income (loss)
EXHIBIT 1.29C Roots
Corporation’s 2021
Consolidated Statement of
Cash Flows
$240,506
139,739
Income (loss) before income taxes
Income taxes expense (recovery)
February 1,
2020
20
Income (loss) before interest expense and
income taxes expense (recovery)
Interest expense
January 30,
2021
ROOTS CORPORATION
Consolidated Statement of Cash Flows
For the 52-week periods ended January 30, 2021 and February 1, 2020
(in thousands of Canadian dollars)
Note
January 30, February 1,
2021
2020
Cash provided by (used in):
Operating activities:
Net income (loss)
$ 13,080
$(62,029)
6, 7, 9
33,325
39,606
Share-based compensation expense (recovery)
13
705
(518)
Impairment of fixed assets and right-of-use assets
6, 9
2,048
22,398
7
—
Items not involving cash:
Depreciation and amortization
Impairment of goodwill
44,799
(continued)
Reading and Interpreting Published Financial Statements
Gain from deconsolidation of RTS USA Corp.
19
(4,774)
105
—
Unrealized losses on forward contracts
8
Gain on lease modification
9
(310)
(520)
Rent concessions related to practical expedient
9
(3,525)
—
Interest expense
10
11,741
15,567
Income taxes expense (recovery)
15
Interest paid
Payment of interest on lease liabilities
9
Taxes refunded (paid)
—
4,885
(10,456)
(4,337)
(5,904)
(6,724)
(9,048)
1,056
(2,200)
Change in non-cash operating working capital:
Accounts receivable
4
(7)
(531)
Inventories
5
(4,540)
9,381
Prepaid expenses
2,281
1,025
Accounts payable and accrued liabilities
6,165
(2,039)
Deferred revenue
(252)
513
50,922
40,044
(14,000)
9,000
Financing activities
Issuance (repayment) of long-term debt
10
Long-term debt financing costs
10
(148)
(163)
Repayment of Term Credit Facility
10
(4,984)
(4,984)
9
(12,383)
(17,436)
(31,515)
(13,583)
6
(3,423)
(22,320)
19
(541)
—
(3,964)
(22,320)
Payment of principal on lease liabilities, net
of tenant allowance
Investing activities:
Additions to fixed assets
Deconsolidation of RTS USA Corp.
Increase in cash
15,443
4,141
Cash and bank indebtedness, beginning of period
(6,277)
(10,418)
9,166
$ (6,277)
Cash and bank indebtedness, end of period
$
Required
a. Find the following amounts in the statements:
i. Total sales for fiscal year 2021
ii. Total cost of goods sold for fiscal year 2021
iii. Selling, general, and administrative expenses for fiscal year 2020
iv. Interest expense for fiscal year 2020
v. Income tax expense for fiscal year 2021
vi. Net income for fiscal year 2021
vii. Inventories at the end of fiscal year 2021
viii. Accounts payable and accrued liabilities at the beginning of fiscal year 2021
ix. Shareholders’ equity at the end of fiscal year 2021
x. Retained earnings (deficit) at the end of fiscal year 2021
xi. Cash provided from operating activities in fiscal year 2021
xii. Cash payments to acquire fixed assets in fiscal year 2021
xiii. Cash used to repay long-term debt in fiscal year 2021
xiv. Cash used to pay dividends in fiscal year 2021
EXHIBIT 1.29C Roots
Corporation’s 2021
Consolidated Statement of
Cash Flows (continued)
1-57
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C H A PTE R 1
Overview of Corporate Financial Reporting
b. Does Roots finance its business primarily with debt or with shareholders’ equity? Support your
answer with appropriate data.
c. Did Roots have a net inflow or a net outflow of cash from financing activities in 2021? What about
from its investing activities?
d. Does Roots use a classified statement of financial position? Explain.
RI1-4 (Financial statements of Gildan Activewear Inc.) Excerpts from the 2020 financial statements of Gildan Activewear Inc. are in Exhibits 1.30A to 1.30C.
EXHIBIT 1.30A Gildan
Activewear Inc.’s 2020
Consolidated Statements of
Earnings and Comprehensive
Income
GILDAN ACTIVEWEAR INC.
Consolidated Statements of Earnings and Comprehensive Income
Fiscal years ended January 3, 2021 and December 29, 2019
(in thousands of U.S. dollars)
2020
2019
$1,981,276
$2,823,901
1,732,217
2,119,440
Gross profit
249,059
704,461
Selling, general and administrative expenses (note 16(a))
272,306
340,487
Impairment of trade accounts receivable (note 6)
15,453
27,652
Restructuring and acquisition-related costs (note 17)
48,154
47,329
Impairment of goodwill and intangible assets
93,989
—
Net sales (note 25)
Cost of sales (note 16(c))
Operating income (loss)
(180,843)
288,993
Financial expenses, net (note 14(c))
48,530
39,168
Earnings (loss) before income taxes
(229,373)
249,825
(4,091)
(9,984)
(225,282)
259,809
(8,503)
(3,917)
12,142
(1,296)
3,639
(5,213)
Income tax recovery (note 18)
Net earnings (loss)
Other comprehensive income (loss), net of related
income taxes:
Cash flow hedges (note 14(d))
Actuarial gain (loss) on employee benefit obligations
(note 12(a))
Comprehensive income (loss)
EXHIBIT 1.30B Gildan
Activewear Inc.’s 2020
Consolidated Statements of
Financial Position
$ (221,643)
$ 254,596
GILDAN ACTIVEWEAR INC.
Consolidated Statements of Financial Position
(in thousands of U.S. dollars)
January 3,
2021
December
29, 2019
Cash and cash equivalents (note 5)
$ 505,264
$
Trade accounts receivable (note 6)
196,480
320,931
4,632
—
727,992
1,052,052
Current assets:
Income taxes receivable
Inventories (note 7)
Prepaid expenses deposits and other current assets
Total current assets
64,126
110,105
77,064
1,544,473
1,514,173
(continued)
Reading and Interpreting Published Financial Statements
Non-current assets
Property, plant and equipment (note 8)
Right-of-use assets (note 9(a))
896,800
994,980
59,445
73,539
Intangible assets (note 10)
289,901
383,864
Goodwill (note 10)
206,636
227,865
17,689
9,917
6,004
6,732
1,476,475
1,696,897
$3,020,948
$3,211,070
$ 343,722
$ 406,631
Deferred income taxes (note 18)
Other non-current assets
Total non-current assets
Total assets
1-59
EXHIBIT 1.30B Gildan
Activewear Inc.’s 2020
Consolidated Statements of
Financial Position (continued)
Current liabilities:
Accounts payable and accrued liabilities
Income taxes payable
Current portion of lease obligations (note 9(b))
Total current liabilities
—
1,255
15,884
14,518
359,606
422,404
Non-current liabilities
Long-term debt (note 11)
1,000,000
845,000
Lease obligations (note 9(b))
66,580
66,982
Other non-current liabilities (note 12)
35,865
42,190
Total non-current liabilities
1,102,445
954,172
Total liabilities
1,462,051
1,376,576
183,938
174,218
24,936
32,769
1,359,061
1,628,042
Commitments, guarantees and contingent liabilities (note 23)
Equity (note 13)
Share capital
Contributed surplus
Retained earnings
Accumulated other comprehensive income
Total equity attributable to shareholders of the Company
Total liabilities and equity
(9,038)
(535)
1,558,897
1,834,494
$3,020,948
$3,211,070
EXHIBIT 1.30C Gildan
Activewear Inc.’s 2020
Consolidated Statements of
Cash Flows
GILDAN ACTIVEWEAR INC.
Consolidated Statements of Cash Flows
Fiscal years ended January 3, 2021 and December 29, 2019
(in thousands of U.S. dollars)
2020
2019
Cash flows from (used in) operating activities:
Net earnings (loss)
Adjustments to reconcile net earnings to cash flows
from operating activities (note 21(a))
$(225,282)
$ 259,809
297,802
175,548
72,520
435,357
Changes in non-cash working capital balances:
Trade accounts receivable
Income taxes
Inventories
125,150
(5,747)
320,384
(3,515)
2,969
(115,082)
(continued)
1-60
C H A PTE R 1
Overview of Corporate Financial Reporting
EXHIBIT 1.30C Gildan
Activewear Inc.’s 2020
Consolidated Statements of
Cash Flows (continued)
2020
2019
Prepaid expenses, deposits and other current assets
(34,801)
(8,320)
Accounts payable and accrued liabilities
(62,476)
49,621
Cash flows from operating activities
415,030
361,030
(50,670)
(128,676)
(7,670)
(11,558)
Cash flows from (used in) investing activities:
Purchase of property, plant and equipment
Purchase of intangible assets
Business acquisitions
—
Proceeds on disposal of property, plant and equipment
Cash flows used in investing activities
(1,300)
830
5,783
(57,510)
(135,751)
(245,000)
176,000
Cash flows from (used in) financing activities:
(Decrease) increase in amounts drawn under revolving
long-term bank credit facility
Proceeds from term loan
400,000
Payment of lease obligations
(15,418)
(13,534)
Dividends paid
(30,553)
(110,346)
2,854
10,318
(23,216)
(257,233)
(2,558)
(7,008)
Withholding taxes paid pursuant to the settlement of
non-Treasury RSUs
(2,571)
(6,001)
Cash flows (used in) from financing activities
83,538
(207,804)
80
(6)
Proceeds from issuance of shares
Repurchase and cancellation of shares (note 13(d))
Share repurchases for settlement of non-Treasury RSUs
Effect of exchange rate changes on cash and cash
equivalents denominated in foreign currencies
Net increase in cash and cash equivalents during the
fiscal year
Cash and cash equivalents, beginning of fiscal year
Cash and cash equivalents, end of fiscal year
—
441,138
17,469
64,126
46,657
$ 505,264
$
64,126
In the questions below, the year 2020 refers to Gildan’s fiscal year ended January 3, 2021, and the year
2019 refers to the prior year ended December 29, 2019.
Required
a. Find the following amounts in the statements:
i. Net sales in 2020
ii. Gross profit in 2020
iii. Total selling, general, and administrative expenses in 2019
iv. Net earnings (loss) in 2020
v. Inventories at the beginning of 2020
vi. Trade accounts receivable at the end of 2020
vii. Retained earnings at the end of 2020
viii. Long-term debt at the end of 2019
ix. Cash flows from operating activities in 2020
x. Cash payments to acquire property, plant, and equipment in 2020
xi. Dividends paid in 2020
xii. Cash produced or used for investing activities in 2019
b. Did Gildan Activewear finance its business primarily from creditors (total liabilities) or from shareholders (shareholders’ equity) in 2020? Support your answer with appropriate calculations.
c. List the two largest sources of cash and the two largest uses of cash in 2020. (Consider operating
activities to be a single source or use of cash.)
Cases
d. Did Gildan Activewear prepare a classified statement of financial position? How can you tell?
e. Calculate the difference between the current assets and current liabilities at the end of 2020, and at
the end of 2019. This amount is referred to as working capital. Did the company’s working capital
improve in 2020? Explain.
RI1-5 (Using sources other than the textbook to find company information) The SEDAR website (www.sedar.com) contains most securities-related information required by the Canadian securities
regulatory authorities. It is probably your best source for financial statements of Canadian companies on
the Internet. In addition, most companies that have a website have a section on investor information. In
this section, they often include their most recent financial reports and news releases.
Required
Choose a Canadian publicly traded company. Collect several articles about the company that cover the
most recent two-year period. Try to find at least three longer articles. If the company has a website (most
companies do), it will probably have useful news releases there. Finally, go to the SEDAR website and
find the company’s most recent financial statements filed there.
Answer the following questions:
a. What are the products (or product lines) and/or services that it sells? Be as specific as possible.
b. Who are the company’s customers?
c. In what markets, domestic and global, does the company sell its products and/or services?
d. Who are the company’s major competitors?
e. What are the major inputs that the company needs in order to produce its product? Who are the
suppliers of these inputs?
f. Are any of the items listed in the questions above changing substantially? Use a two-year time span
to answer this question.
RI1-6 (Using sources other than the textbook to find company information)
Required
Go to a publicly traded company’s website and find the company’s most recent annual report. Answer
the following questions:
a. What are the major sections of the annual report?
b. What are the three most important points in the letter to the shareholders?
c. What are the titles of the major financial statements in the report?
d. What are the company’s total assets, total liabilities, and total shareholders’ equity? What percentage of the company’s total assets is financed through liabilities?
e. Is the statement of financial position classified or unclassified? If it is classified, what are the major
categories?
f. What are the net sales in the most recent year? Are they up or down from the previous year? (Answer
in both dollar and percentage amounts.)
g. What is the net income and earnings per share in the most recent year? Are these amounts up or
down from the previous year? (Answer in both dollar and percentage amounts.)
h. What is the net cash provided (used) by operating, financing, and investing activities for the most
recent year?
i. What is the last day of the company’s fiscal year?
Cases
C1-1 Enticing Fashions Ltd.
Enticing Fashions Ltd. designs and manufactures upscale women’s clothing. The company’s early customers were small boutiques in Toronto, Montreal, and Vancouver. Customers liked the colours and fabrics used and enjoyed the unique styling of the garments. Demand for the company’s clothing rose to the
point where it is looking at opening a number of its own stores in various retail locations across Canada.
The company has approached its bank seeking additional financing so that it can proceed with its plan
to develop retail locations and hire more people to assist with various aspects of the business. The bank
wants to see the company’s financial statements.
1-61
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C H A PTE R 1
Overview of Corporate Financial Reporting
You are an accountant employed by a local accounting firm, and Enticing Fashions Ltd. has been your
client for several years. In previous years, you have prepared the company’s financial statements and
corporate tax returns. Enticing Fashions’ CEO has approached you because he wants to have an understanding about how the bank may use the company’s financial statements in determining whether or not
to grant the loan.
Required
Prepare a memo to Enticing Fashions’ CEO addressing his question regarding how banks use financial
statements to determine whether or not to grant loans to companies.
Endnotes
1
Dollarama, 2021 Annual Report; Dollarama corporate website, https://www.dollarama.com.
Wildflower Brands Inc., “Wildflower Brands Cease Trade Order,” Press release, February 23, 2021;
“Cease Trade Orders: Wildflower Brands Inc.” British Columbia Securities Commission, February 3,
2021,
https://www.bcsc.bc.ca/enforcement/early-intervention/cease-trade-orders/2021/wildflowerbrands-cease-trade-order; Wildflower Brands Inc., Financial Statements for the Year Ended June 30, 2019.
3
“Canadian Business Counts, with employees,” Statistics Canada, June 2020, https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3310026701; “Business Startup Statistics Canada (2021 Update),”
Fundsquire Limited, accessed April 10, 2021, https://fundsquire.ca/startup-statistics-canada/; TSX, Interlisted Companies, accessed January 15, 2021, https://www.tsx.com/trading/market-data-and-statistics/
market-statistics-and-reports/interlisted-companies.
4
Sam Bourgi, “5 Canadian Companies That Have Paid a Dividend for Over 100 Years,” Dividend Investing
Ideas Center, https://dividend.com/how-to-invest/over-100-years-of-dividends-for-5-canadian-companies/.
5
Canada Goose Holdings, 2020 Annual Report.
6
“CPA Canada Study of Climate-Related Disclosures by Canadian Public Companies,” CPA Canada,
accessed 2017, https://cpacanada.ca/en/business-and-accounting-resources/financial-and-non-financial-reporting/sustainability-environmental-and-social-reporting/publications/climate-related-disclosure-study; IFRS Foundation, Effects of Climate-Related Matters on Financial Statements, November
2020, https://ifrs.org/content/dam/ifrs/supporting-implementation/documents/effects-of-climate-related-matters-on-financial-statements.pdf; Sebastien Betermier, “Are University Pension Plans
the Next Battleground in the Climate Debate?” The Globe and Mail, December, 20, 2019, https://
theglobeandmail.com/business/commentary/article-are-university-pension-plans-the-next-battleground-in-the-climate/; ICAEW Insights, “Beyond Financial Reporting to Sustainability Reporting,”
ICAEW, March 16, 2021, https://www.icaew.com/insights/viewpoints-on-the-news/2021/mar-2021/
beyond-financial-reporting-to-sustainability-reporting.
7
“CPAs and the New Social Contract: The Rise of the Warrior Accountant,” Chartered Professional
Accountants of Ontario, January 2021, https://cpaontario.ca/insights/esg-thought-leadership; Sustainability Accounting Standards Board, Hotels & Lodging Sustainability Accounting Standard 2018-10,
­Restaurants Sustainability Accounting Standard 2018-10, Agricultural Products Sustainability Accounting
Standard 2018-10, Food Retailers & Distributors Sustainability Accounting Standard 2018-10; Maple Leaf
Foods Inc., 2019 Sustainability Report; The Toronto-Dominion Bank, 2020 Environmental, Social and
Governance Report.
2
iamporpla/Shutterstock.com
CHAPTER 2
Analyzing Transactions and Their
Effects on Financial Statements
iamporpla/Shutterstock
A Growing Appetite for Financial
Transparency
Whether you grow your own food or buy it in a supermarket,
you benefit from fertilizers that increase crop yield. As the
amount of farmland per person shrinks around the globe, the
race is on to develop even more efficient fertilizers that cause
less environmental harm and can ensure an economical and
steady food supply. Would you want to invest in a fertilizer
company?
Before you did, you would want to read its financial statements to get a sense of market conditions and how well the
company had been performing and what its prospects were.
A growing number of publicly traded companies in Canada
and around the world are making their financial statements
more transparent to potential investors, customers, suppliers, and a public concerned with environmental issues and
corporate practices. One such company is Saskatoon-based
Nutrien, the world’s largest provider of crop inputs—fertilizers such as potash, nitrogen, and phosphate—and services.
Potash and phosphate are mined, while nitrogen is converted
from a gas. Sales for the company, which was formed in 2018
by the merger of two Canadian competitors, Agrium Inc. and
the Potash Corporation of Saskatchewan Inc., were U.S. $20.9
billion in 2020.
Nutrien’s annual financial statements include the elements required by accounting standards, such as the statement of financial position (or balance sheet), which shows
assets, liabilities, and shareholders’ equity. But the Nutrien
statements present additional information to help readers
better understand them. For example, a one-page summary
at the beginning of the financial statements uses illustrations
to present key amounts over the past two years, including net
earnings, total assets, total liabilities and shareholders’ equity,
and cash provided by operating activities. Several of the notes
to the financial statements also use illustrations to provide
additional context for the financial information being presented. For example, the company provides doughnut charts
illustrating the length of time its accounts receivable have
been outstanding for each of its major business segments. It
uses similar charts to provide financial statement users with
information on the nature of its inventories and its property,
plant, and equipment. Nutrien also uses colours throughout
its financial statements to make it easy for users to distinguish
between the current and prior year balances.
Nutrien’s annual report also has a one-page analysis of
its balance sheet. It includes bar charts showing the most
significant contributors to changes in assets and in liabilities
and shareholders’ equity. The analysis also summarizes the
major changes in plainer language for readers who may not
have a financial background—for example, on the liabilities
side in 2020, the following statement was included: “Shortterm debt increased . . . as we continue to manage our working
capital needs.” Regarding shareholders’ equity, the analysis
said, “Retained earnings decreased due to dividends declared
exceeding net earnings.”
Even though some financial statements are getting easier
to understand, nothing can replace the rock-solid foundation
that this accounting course will provide you with in order to
analyze financial statements and make informed investing,
business, and career decisions.1
2-1
2-2
CH A PT E R 2
Analyzing Transactions and Their Effects on Financial Statements
CORE QUESTIONS
If you are able to answer the following questions, then you
have achieved the related learning objectives.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Accounting Standards
• What are accounting standards?
• Do all Canadian companies use the same accounting
standards?
1. Identify the accounting standards used by Canadian
companies.
• Who sets the accounting standards used in Canada?
Qualitative Characteristics of Financial Information
• How do the standard setters determine what
constitutes useful financial information?
2. Identify and explain the qualitative characteristics
of useful financial information and how the cost
constraint affects these.
Accrual Versus Cash Basis of Accounting
• What is the difference between the cash basis of
accounting and the accrual basis of accounting?
3. Explain the difference between the cash basis of
accounting and the accrual basis of accounting.
The Accounting Equation Template Approach
• What is the accounting equation template approach to
recording transactions?
4. Explain the accounting equation template approach
to recording transactions.
Using the Accounting Equation Template Approach to
Analyze and Record Transactions
• How is the accounting equation used to analyze and
record transactions?
5. Analyze basic transactions and record their effects on
the accounting equation.
• What are the limitations of the accounting equation
template approach?
Financial Statements
• How do we know if the company was profitable during
the accounting period?
• How can we tell if the equity position of shareholders
changed during the accounting period?
6. Summarize the effects of transactions on the
accounting equation, and prepare and interpret a
simple set of financial statements.
• How do we determine the company’s financial
position at the end of the accounting period?
• How can we tell if the company’s cash position
changed during the accounting period?
Using Ratios to Analyze Financial Statements
• How do we determine the company’s profit margin?
• How do we determine how effective the company has
been at generating a return on shareholders’ equity?
• How do we determine how effective the company has
been at generating profits using its assets?
7. Calculate and interpret three ratios used to assess the
profitability of a company.
Accounting Standards
Introduction
Nutrien in our feature story uses illustrations and summaries to help communicate its financial story to its shareholders and other users. Many organizations present simplified financial statements or summarized financial statement information in their annual reports, but
all also present detailed financial statements that are prepared in accordance with financial
accounting standards. This chapter will begin to show you how accounting information is
obtained to create these financial statements and how to start to interpret these statements.
2.1
Accounting Standards
LEARNING OBJECTIVE 1
Identify the accounting standards used by Canadian companies.
What Are Accounting Standards?
When a company begins the task of measuring, collecting, recording, and reporting financial
information for users, it needs some guidelines to follow so that the information is presented
in a relatively standardized way. Accounting standards have been developed to provide companies with a broad set of rules to be followed when preparing their financial statements.
These standards enhance the usefulness of financial information because they help to ensure
that users can understand the information presented. They also enable users to evaluate the
statements and compare them with those of other companies in order to make knowledgeable decisions. If there were no guidelines, each company would develop its own information
reporting system, making financial statements difficult for users to understand and significantly affecting their ability to compare them.
Do All Canadian Companies Use the Same
Accounting Standards?
No. All Canadian public companies (which are companies whose shares trade on a Canadian public stock exchange) are required to prepare their financial statements using Inter­
national Financial Reporting Standards (IFRS). Private companies generally follow
Accounting Standards for Private Enterprises (ASPE) but have the option of using
IFRS if they wish. As the name implies, IFRS are international standards. They are being
used in more than 120 countries around the world, though not in the United States. Most
public companies operate internationally, and a significant number of them are also inter­
listed or cross-listed, meaning that they are listed on stock exchanges both inside and
outside of Canada. This common set of financial reporting standards was developed to
minimize the differences in financial reporting across countries and to reduce the need for
companies to generate different sets of financial information in each country in which they
operate or raise funds. ASPE, on the other hand, represents a set of simplified standards
that Canadian standard setters have established to reduce the financial reporting burden for
private companies.
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CH A PT E R 2
Analyzing Transactions and Their Effects on Financial Statements
For Example
As of February 2021, there were 1,640 companies listed on the
Toronto Stock Exchange (TSX). Of these, 219 were also listed
on another public stock exchange outside of Canada. As a
result, these companies are interlisted, or cross-listed. Just
over 40% of these interlisted companies were listed on the New
York Stock Exchange (NYSE). Other interlisted companies are
traded on stock exchanges around the world, including the
Matteo
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Colombo/GettyImages
Images
London Stock Exchange, the Australian Securities Exchange,
the Nasdaq Nordic, the Lima Stock Exchange, and the Johannesburg Stock Exchange.2 These interlisted companies benefit from the use of IFRS, because
financial statements prepared using these accounting standards are accepted on all of these stock
exchanges. This saves these companies from having to prepare different financial statements for
each exchange.
The U.S. Securities and Exchange Commission (SEC), which regulates U.S. stock exchanges,
allows listed companies to submit financial statements prepared using IFRS rather than the U.S.
accounting standards determined by the Financial Accounting Standards Board (FASB). These
FASB standards are also referred to as “U.S. GAAP,” or U.S. generally accepted accounting principles. Just as the SEC allows IFRS-based financial statements, the Ontario Securities Commission
(OSC), which regulates the TSX, allows Canadian public companies with U.S. listings to submit financial statements prepared using FASB standards. Some Canadian public companies, like
Canadian National Railway Company and Canadian Pacific Railway Limited, have chosen
this option and prepare their financial statements using FASB standards rather than IFRS.
As a financial statement user, you need to be aware of the standards a company is using to
prepare its financial statements. This information is disclosed in the notes to the financial statements, which include a note outlining the significant accounting policies used in preparing the
financial statements.
The objective of both IFRS and ASPE is to produce financial reporting that is useful to
the financial statement users. Both IFRS and ASPE focus on the needs of shareholders (current and potential) and creditors in determining the financial information that would be useful. Specifically, the standards’ aim is to provide financial information that assists these two
user groups in making decisions about providing resources to the reporting company, such
as whether they should buy or sell the reporting company’s shares and whether they should
extend credit to the reporting company. The needs of these two user groups often correspond
with the needs of other users, such as employees, unions, and governments, but they may not
completely overlap.
Throughout this text, we will be concentrating on the reporting practices under IFRS,
because we will be focused on analyzing the financial statements of public companies. Because
these companies are required to use IFRS, it is essential that we understand the requirements
of these standards. In many cases, the financial reporting treatments under IFRS and ASPE
are similar.
Who Sets the Accounting Standards Used in
Canada?
The Canadian Accounting Standards Board (AcSB) is the body responsible for developing and
establishing the accounting standards used by Canadian companies. The AcSB is responsible
for the accounting standards for both public and private companies. It was the AcSB that
made the decision that required Canadian public companies to adopt IFRS effective January
1, 2011. The responsibility for the ongoing development of IFRS belongs to the International
Accounting Standards Board (IASB), but the AcSB retains ultimate responsibility for determining whether Canadian public companies continue to follow IFRS. In terms of ASPE, the
AcSB is also the body responsible for the development and establishment of these standards
for private companies.
Qualitative Characteristics of Financial Information
2.2
Qualitative Characteristics of Financial Information
LEARNING OBJECTIVE 2
Identify and explain the qualitative characteristics of useful financial information
and how the cost constraint affects these.
How Do the Standard Setters Determine What
Constitutes Useful Financial Information?
The objective of both IFRS and ASPE is to produce financial information that is useful to
financial statement users. In order to help users determine what is “useful,” the IASB and the
AcSB have developed conceptual frameworks of financial reporting. A conceptual framework is an underlying set of objectives and concepts that guide accounting standard-setting
bodies in justifying new standards and revising old ones.
The IASB’s and the AcSB’s conceptual frameworks were developed with a number of
objectives in mind:
• to assist the organizations as they develop new financial reporting standards
• to assist accountants in determining how to account for items for which no specific
accounting standards have been developed
• to assist users in their interpretation of the information contained in the financial
statements
The two conceptual frameworks have much in common, though they differ somewhat
in both terminology and structure. Our discussion will focus on the IASB’s conceptual framework, because it serves as the basis for IFRS. According to this framework, useful financial
information must be both relevant and representationally faithful. In other words, to be
useful, the information must matter to users’ decision-making, and it must also represent
events and transactions as they actually took place or are at present. Relevance and representational faithfulness are both considered to be fundamental qualitative characteristics.
That means that they are essential if financial information is to be considered useful, and
without them the information is useless.
In addition to relevance and being representationally faithful, the IASB identified four
other qualitative characteristics that increase the usefulness of financial information: com­
parability, verifiability, timeliness, and understandability. These are considered to be
enhancing qualitative characteristics. In other words, on their own they cannot make
useless information useful, but they can enhance the usefulness of useful information.
For Example
To help understand the conceptual framework of financial reporting, ask yourself this: Did you
drive to the university or college today? If you did, how did you know how fast to drive?
We can draw a parallel between the conceptual framework of financial reporting and the
framework used by governments to establish speed limits. Accounting standard setters developed
the conceptual framework for financial reporting to help them determine the accounting treatment that should apply for specific types of transactions and the approach that should be taken in
the absence of specific guidance.
This is similar to the process followed by governments when they establish speed limits for
our roads and highways. Typically, their overriding concern is public safety, but rather than just
post road signs that say “Drive Safely” and allow users to apply their own judgement about what
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Analyzing Transactions and Their Effects on Financial Statements
this means, they post signs with maximum speeds that vary according to circumstance. The government uses characteristics to help it assess what it means to drive safely, factoring in things such
as geography (steep hills, curvy roads, schools nearby), the type of road (divided, gravel), the volume of traffic, accident histories, and so on. Even when we are aware of what the maximum “safe”
driving speed is, many of us will drive slower (or perhaps faster) than this based on our judgement
about whether or not it is safe to do so. Our judgement is informed by the framework that has been
established by government. For example, in British Columbia, the speed limit in school zones is 30
km/h and generally 50 km/h in other urban areas. However, many drivers will consider it unsafe
to drive faster than 30 km/h if small children are present on and around the road, even if they are
outside of a school zone and the posted speed limit is higher.
This is the same way that the conceptual framework of accounting is used. It provides us with
a framework for understanding why standard setters consider certain types of financial ­information
to be useful and for determining what this means in the absence of specific standards.3
For Example
Timeliness is an enhancing qualitative characteristic. This
means that financial information is more useful if it is available to users on a timely basis. The Ontario Securities Commission (OSC), which regulates the TSX, requires Canadian
public companies listed on the TSX to submit annual financial statements within 90 days after the company’s fiscal year
end. Also, rather than financial statement users having to
wait until the end of the year to receive financial information, the OSC requires companies listed on the TSX to prepare quarterly financial statements and submit them within
45 days of the end of each quarter. Both of these requirements
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pictore/Getty
mean that timely financial information is available for users.
Verifiability is another enhancing qualitative characteristic. This means that financial statement
information is more useful if it can be verified—in other words, that knowledgeable and independent
observers would conclude that the financial information is faithfully represented. The OSC requires
that the annual financial statements submitted by public companies be audited by an independent
public accountant (clearly a knowledgeable and independent observer). This external auditor provides
an opinion on whether the financial statements are fairly presented in all material respects. The audit
opinion, which is referred to as the auditor’s report, is included in each company’s annual report, preceding the financial statements. The auditor’s report is discussed in more detail in Chapter 12.
Let’s explore the qualitative characteristics in a bit more depth.
To be relevant, financial information must matter to users. In assessing this, standard setters consider whether the information has predictive value or confirmatory value. Predictive information is information that users can use as the basis for developing expectations about
the company’s future. For example, based on the changes in sales this year, what might next
year’s sales be? Information has a confirmatory value if it provides feedback to users on their
previous assessments of the company. For example, analysts may have projected that a company would achieve a certain revenue target, and the actual revenues for that period allow them
to assess this. Some financial information may reflect both predictive and confirmatory value.
The concept of materiality must also be considered in determining whether or not
financial information is relevant. Information is considered to be material if it, or its absence,
would impact the decisions of a financial statement user. Information that is critical to user
decision-making is considered to be material, and therefore relevant, while information that
would not affect the user’s decisions is considered to be immaterial. The concept of materiality is company specific. In other words, something may be material to the users of one
company that is immaterial to the users of another company. Materiality is also assessed from
a quantitative perspective (it can be measured in dollars) and a qualitative perspective (it can
be assessed in context). Normally, the greater the dollar value of an item, the more material it
is considered to be, although some small dollar items may also be qualitatively material, such
as payments to senior management.
Qualitative Characteristics of Financial Information
Standard setters have also determined that useful financial information must be representationally faithful. In other words, it must present the company’s transactions in a manner
that reflects what actually happened. To be representationally faithful information, it must be
complete, neutral, and free from error.
Completeness is related to providing users with all of the information needed to understand what is being presented in the financial statements, including any necessary explanations. Neutral financial information is unbiased; it is neither optimistic nor overly conservative.
Prudence is to be exercised when determining neutral financial information when it involves
making judgements involving uncertainty. Exercising prudence means that assets, liabilities,
income, and expenses should be neither overstated nor understated. Information is free from
error if it has been determined based on the best information available, using the correct process, and with an adequate explanation provided.
Enhancing qualitative characteristics can increase the usefulness of financial information. In situations where there are alternative methods of accounting for a transaction that are
considered to be relevant and representationally faithful, the enhancing qualitative characteristics can be used to determine which treatment should be used. Comparability refers to the
need for users to be able to compare the financial information of two companies, especially
if they are in the same industry, or the need to be able to compare financial information for
the same company across multiple periods. In either case, the goal is that the users are able
to compare “apples to apples” rather than “apples to bananas.” Verifiability is achieved if a
third party, with sufficient understanding, would arrive at a similar result to that used by the
company. Information must be timely if it is to be useful. Generally, the older the financial
information is, the less useful it is considered to be. Finally, to be useful, financial information
must be understandable to users. This is achieved when the information is presented in as
clear and concise a manner as is possible given its complexity.
In addition to the qualitative characteristics, there is an overriding constraint that must be kept
in mind. This is the cost constraint, which is applied to all financial information. It recognizes that
capturing and reporting financial information is costly for companies. According to this constraint,
the benefits of reporting financial information must exceed the costs of doing so. If they do not,
then the financial information should not be captured and reported in the financial statements.
Exhibit 2.1 summarizes our discussion of the characteristics and constraints of the IFRS
conceptual framework.
Fundamental Qualitative Characteristics
Enhancing Qualitative Characteristics
Relevance
Comparability
Predictive value
Verifiability
Confirmatory value
Timeliness
Materiality
Understandability
Faithful representation
Completeness
Constraints
Cost constraint
Neutrality
Freedom from error
The conceptual framework’s qualitative characteristics create a flow of useful financial
information. We can picture this like a series of rivers, as shown in Exhibit 2.2. Every major
river has tributaries, such as smaller rivers, streams, and creeks, that flow into it to increase its
volume. Think of useful financial information as a major river, established when its two main
tributaries (relevance and faithful representation) flow together. At this confluence, a major
river begins: useful financial information is created.
Each of these major tributaries has three minor tributaries, but they all contribute to the
downstream flow; that is, they all add to usefulness. Without the two major tributaries, there
would be no significant river, or no useful financial information.
There are also four minor tributaries that flow into the river below the confluence. While
these add to the flow of the river (to usefulness), they would not, on their own, have created
a major river.
EXHIBIT 2.1 Characteristics
and Constraints of Accounting
Information According to the
IFRS Conceptual Framework
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Analyzing Transactions and Their Effects on Financial Statements
EXHIBIT 2.2 How the
Qualitative Characteristics
Create a Flow of Useful
Financial Information
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Predictive
Value
Completeness
Confirmatory
Value
Neutrality
Freedom
from Error
Materiality
FAITHFUL
REPRESENTATION
RELEVANCE
COMPARABILITY
TIMELINESS
UNDERSTANDABILITY
VERIFIABILITY
USEFUL FINANCIAL
INFORMATION
The Conceptual Framework
Throughout the text, we will refer back to the conceptual framework and consider its impact on the accounting treatment used
for different items. Text boxes such as this will be used to highlight
these references for you. By the end of the text, you will have seen
that the framework’s qualitative characteristics permeate financial statements.
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 2-1
• Demonstration Problem 2-1 in Wiley’s course resources
When a company’s financial statements are prepared, they are normally prepared on a
going concern basis, which assumes that the company will continue operating for the foreseeable future. This means that there is normally an expectation that the company will continue operating for at least the next 12 months and, if it is a public company, that its shares will
continue to trade on a stock exchange during that period. This is known as the going concern
assumption and is essential if a company is to be able to realize its assets and discharge its
liabilities through the normal course of its operations. If this assumption were not valid, then
the company would need to report its assets and liabilities at the amounts expected to result
from the liquidation process. Management is responsible for assessing the company’s ability to
continue as a going concern. The appropriateness of management’s going concern assessment
is evaluated by the company’s auditors as part of their work.
Accrual Versus Cash Basis of Accounting
When management identifies that there are significant doubts about the company’s ability to
continue as a going concern but they consider it appropriate to continue to use the going concern
assumption, these uncertainties must be disclosed in the notes to the company’s financial statements. If management determines that use of the going concern basis is inappropriate, then the
financial statements should be prepared using an alternative basis, such as the liquidation basis.
For Example
The economic impacts of the COVID-19 pandemic significantly increased the uncertainty related
to the ability of many companies to continue as going concerns. As a result, an increased number
of companies reported going concern uncertainties in the notes to their financial statements. The
operations of Cineplex Inc., which operates theatres and entertainment venues across Canada,
were severely impacted by the pandemic, including closure of all of the company’s locations for
several months. In its financial statements for the year ended December 31, 2020, the company
provided four pages of note disclosure related to the pandemic and the company’s ability to continue as a going concern. This included an overview of the various measures the company had
taken, including amending borrowing agreements, issuing new debt, laying off employees, reducing wages, applying for government assistance programs, suspending or deferring capital projects,
and selling the company’s head office building. As a result of these steps, Cineplex’s management
concluded that use of the going concern assumption was appropriate but that material uncertainties remained that required note disclosure.
2.3
Accrual Versus Cash Basis of Accounting
LEARNING OBJECTIVE 3
Explain the difference between the cash basis of accounting and the accrual basis of
accounting.
What Is the Difference between the Cash Basis of
Accounting and the Accrual Basis of Accounting?
Before transactions can be analyzed and recorded, it is important for you to understand the difference between the cash basis of accounting and the accrual basis of accounting. Accounting
standard setters have concluded that the financial information that results from accrual accounting
is more useful to users than the information that results from the cash basis. Under the accrual basis
of accounting, transactions are recorded in the period in which they occur, regardless of when the
cash related to these transactions flowed into or out of the company. Under the cash basis of accounting, transactions are recorded only when the cash is actually received or paid by the company.
To help you understand the distinction between the cash and accrual bases of accounting, let’s
look at a couple of simple examples. Most universities and colleges require students to pay their
tuition before the semester starts or within the first few weeks of the semester. Is this tuition revenue
to the university at the time of payment, or is the revenue earned over the course of the semester?
Alternatively, the university has faculty and staff who work to provide you with instruction and
related services. These people are all employees of the university and are typically paid after they
have provided their services. They are normally paid every two weeks for the services they provided
in the preceding two-week period. When should the university record the wage expense: at the time
of payment to the employees or over the period in which the services have been provided? The
answers to both of these questions are different depending on the basis of accounting being used.
Under the cash basis of accounting, transactions are recorded only when cash flows into
or out of the company. In other words, revenues would be recorded only when the customer
or client pays for the goods or services. Expenses, on the other hand, are recorded only when
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Analyzing Transactions and Their Effects on Financial Statements
KEY POINTS
Under the cash basis of
accounting:
• Revenues are recorded
when the cash is
received.
• Expenses are recorded
when the cash is paid.
KEY POINTS
Under the accrual basis
of accounting:
• Revenues are recorded
when they are earned.
• Expenses are recorded
when they are incurred.
they are paid for by the company. (See the Key Points for a summary.) Under the cash basis
of accounting, the university would recognize all of your tuition payment as revenue in the
month it was received. In other words, if you paid all of your tuition for the fall semester
in September, the university would record all of the revenue for the semester in September.
There would be no revenue recorded in October, November, or December. Employee wages
would be recorded only when they were paid. Therefore, any wages outstanding to employees
at the end of a month or semester would not be recorded until the next month or semester,
when they were paid. From this simple example, you can see that the university’s financial
statements would look great for the month of September, because there would be lots of revenue and few expenses, but would look bad for the remaining months of the semester, because
no revenue would be recorded for these periods.
Under the accrual basis of accounting, the recognition of revenues and expenses is not a
function of when the related cash was received or paid. Instead, revenues are recorded when
they have been earned, regardless of whether the related cash was received by the company.
Expenses are recorded in the period in which they are incurred, regardless of whether the
related payment was made by the company. (See the Key Points for a summary.) Organizations using the accrual basis of accounting use a five-step process for revenue recognition
to determine when revenue should be recorded, or recognized. We will discuss this in depth
in Chapter 4. For now, focus on the fact that companies should recognize revenues when they
have been earned (that is, when the company has satisfied its performance obligations in the
contract by providing the goods or services to its customers). Expenses are incurred when
there has been a decrease in economic resources, such as a decrease in assets or an increase in
liabilities, for the purpose of generating revenues.
Under the accrual basis of accounting, the university would recognize a portion of your
tuition payment as revenue in each month of the semester in which it is delivering your
courses to you. In other words, if you paid all of your tuition for a 15-week fall semester in
September, the university would record 4/15 of the revenue in September (because it would
have provided 4 of the 15 weeks of instruction), 4/15 in October, and so on. Employee wages
would be recorded in the period in which the faculty and staff provided their services (because
the university has a liability to those employees once they have worked), rather than when the
wages were paid. As such, even if wages were outstanding to employees at the end of a month
or semester, they would be recorded in the month the work was provided. From this simple
example, you can see that the university’s financial statements would be much more reflective
of actual events, because the revenues and related expenses would be shown in the periods in
which they were earned or incurred.
Ethics in Accounting
If financial information is prepared on the cash basis of accounting, it is much easier for management to manipulate the revenues and expenses being reported in a given accounting period.
Why?
Under the cash basis of accounting, revenues and expenses
are recognized only when cash flows into or out of a company
rather than when they are actually earned or incurred. Management would just have to get customers to make deposits before the
end of an accounting period (which could then be recognized as
revenue), or it could delay paying suppliers or employees until the
next accounting period (which would delay the recording of these
as expenses until that time).
The Conceptual Framework
The Accrual Basis
Accounting standard setters have concluded that financial
information prepared on the accrual basis provides users with
information that is more relevant and representationally faithful than the information that results from the cash basis of
accounting. The IFRS conceptual framework states that information prepared under accrual accounting “provides a better
basis for assessing the entity’s past and future performance than
information solely about cash receipts and payments during
that period.”4
The Accounting Equation Template Approach
2-11
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 2-2
Take5 Video
• Demonstration Problem 2-2 in Wiley’s course resources
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2.4
The Accounting Equation Template Approach
LEARNING OBJECTIVE 4
Explain the accounting equation template approach to recording transactions.
What Is the Accounting Equation Template
Approach to Recording Transactions?
If financial information is to be useful, it must be understandable. Understanding financial information is significantly enhanced if the user has basic knowledge of the accounting process: how to analyze transactions, how they are measured and recorded (or not
recorded), and how financial statements are generated from the recorded data. Without that
basic knowledge, users will have difficulty understanding the importance and relevance of
accounting reports and may not be able to use them effectively to support their decisions.
Chapter 1 provided an overview of the types of information presented in each of the financial statements. The next part of this chapter and a significant portion of the next chapter
explain how accountants collect and classify the information used to build the financial
statements.
Initially, we will use the accounting equation as the framework for our transaction analysis and recording. This approach is known as the template approach or synoptic approach
and is the most basic of accounting systems. It is an approach that some very small businesses
use as their accounting system, but most quickly outgrow it when they require financial information that is not readily available from the template.
Even though the template approach has limitations, for now let’s focus on learning how
it works. If you can develop a solid understanding of the mechanics of the template approach,
making the next step to the double-entry accounting system used by most companies is
much easier.
In Chapter 1, we learned about the accounting equation, which is shown in Exhibit 2.3.
Accounting Equation
Assets = Liabilities + Shareholders’ Equity
We then went on to learn about what an asset is and discussed some common assets. We
did the same thing for liabilities and shareholders’ equity. As part of our discussion of shareholders’ equity, we discussed how retained earnings is determined. It is useful to review this
quickly, because it will affect the way we record certain transactions within the accounting
equation. Retained earnings represents the company’s profits (revenues less expenses) that
have been reinvested in the business rather than being distributed to the shareholders as dividends. It is determined as shown in Exhibit 2.4.
EXHIBIT 2.3 The Accounting
Equation
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EXHIBIT 2.4 How to
Calculate Retained Earnings
Retained Earnings =
+ Revenues
Opening Retained Earnings
− Expenses
+ Net Income
Net Income
− Dividends Declared
Ending Retained Earnings
The transactions involving assets, liabilities, and shareholders’ equity are recorded in a
company’s books in various accounts. Each account groups transactions of a similar nature
and is given a title, such as Cash, Equipment, or Retained Earnings. We will show account
titles beginning in capital letters. We will learn more about accounts in the next chapter. In
this chapter, we will focus on how these accounts fit within an expanded accounting equation.
This expanded equation will provide the framework within which we will analyze and record
transactions. Each of the various asset, liability, and shareholders’ equity accounts will have
its own column in the template. We will call these accounts, as in “Cash is an asset account.”
We also have a column in which to record the transaction date and another in which we will
record the effect, if any, that the transaction has on retained earnings. The template will be set
up as shown in Exhibit 2.5.
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EXHIBIT 2.5 Template Approach
=
Assets
Date
Cash
A/R
KEY POINTS
When using the
accounting equation
to analyze and record
transactions:
• Every transaction
must affect at least two
accounts.
Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
The template uses the following abbreviations:
• “A/R” for accounts receivable
• “Inv.” for inventory
• “Prepaid Ins.” for prepaid insurance
• “Equip.” for equipment
• “A/P” for accounts payable
• “S/H Equity” for shareholders’ equity
• Each line must balance
(the effects on the
asset side must be
equal to the effects
on the liabilities and
shareholders’ equity
side).
The abbreviations in the final column are explained below.
When recording transactions within the template, we will follow a few basic rules, also
summarized in the Key Points:
• Each entry in the
retained earnings
column must be
accompanied by an
entry in the final
column indicating
whether it results from
a revenue, an expense,
or the declaration of a
dividend.
3. Nothing can be recorded in the Retained Earnings account without an explanation of the
nature of that transaction being recorded in the final column, stating whether it is due to
a revenue, an expense, or a dividend declared.
1. Every transaction must affect at least two accounts.
2. The accounting equation must remain in balance with each transaction; that is, assets
must constantly equal the sum of liabilities and shareholders’ equity.
The third rule is to help you understand the links between the financial statements,
because we will see that the information in the Retained Earnings account is a “bridge”
between the financial statements. We will use the following abbreviations in the final column:
• “R” for revenues (which will increase retained earnings)
• “E” for expenses (which will decrease retained earnings)
• “DD” for dividends declared (which also decrease retained earnings)
Using the Accounting Equation Template Approach to Analyze and Record Transactions
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Using the Accounting Equation Template Approach to
Analyze and Record Transactions
2.5
LEARNING OBJECTIVE 5
Analyze basic transactions and record their effects on the accounting equation.
How Is the Accounting Equation Used to Analyze
and Record Transactions?
The basic accounting equation will now be used to illustrate the fundamentals of the accounting
system and the preparation of financial statements. We will use typical transactions for a retail sales
company to demonstrate the analysis of transactions and how they affect the financial statements.
Assume that a business, called Sample Company Ltd. (SCL), is formed as a corporation on
January 1, 2024. During the month of January, it engages in the following basic transactions
(as shown in Exhibit 2.6):
Trans. #
Date
Description
1
Jan. 1
SCL issued 10,000 common shares in exchange for $250,000 cash.
2
Jan. 1
To raise additional financing, SCL borrowed $100,000 from its bank. The
loan principal is due in three years, while the interest rate on the loan is 6%
per year. The interest is payable every three months.
3
Jan. 1
The company rented a retail location, paying $1,100 in rent for the month
of January.
4
Jan. 1
The company paid $65,000 to purchase equipment.
5
Jan. 1
SCL paid $1,800 cash for a one-year insurance policy covering the new
equipment for the period January 1 to December 31.
6
Jan. 6
SCL purchased some land for $180,000, on which it plans to build a
warehouse in the future.
7
Jan. 10
The company bought $23,000 of inventory from suppliers on account. This
means that SCL will pay for these goods at a later date.
8
Jan. 12
SCL sold products to customers for $34,000, of which $21,000 was received in
cash and the balance was on account. SCL’s customers will pay the balance
owing at a later date. The products that were sold cost SCL $17,000.
9
Jan. 20
SCL received $11,000 from its customers as payments on their accounts
that originated from sales on January 12.
10
Jan. 22
The company made payments of $13,500 to its suppliers, settling part of the
account that originated from the purchase on January 10.
11
Jan. 25
SCL paid monthly utility costs of $1,900.
12
Jan. 26
SCL paid advertising costs for the month of $2,200.
13
Jan. 28
SCL paid $2,900 in wages to its employees for the month of January.
14
Jan. 31
SCL’s board of directors declared and paid $400 of dividends to
shareholders.
15
Jan. 31
SCL’s accountant determined that the depreciation expense on the
company’s equipment was $850 per month.
16
Jan. 31
SCL’s insurance expense was recorded for January.
17
Jan. 31
SCL recorded the interest expense on the bank loan for the month. Although
the principal of the loan does not have to be repaid for three years, the company
is incurring interest expense each month that the loan is outstanding.
EXHIBIT 2.6 Sample
Company Ltd. Transactions in
January 2024
2-14
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
KEY POINT
When analyzing
transactions, it is often
helpful to think first
about the effect, if any,
the transaction had on
the Cash account.
Let’s analyze each of these transactions in detail and show its effects on the basic accounting
equation. See also the Key Point for a tip on how to analyze transactions.
Transaction 1: Issuance of Shares for Cash
SCL issued 10,000 common shares in exchange for $250,000 cash.
Analysis SCL’s shareholders invested $250,000 in the company, in exchange for ownership
rights represented by share certificates that indicate ownership of 10,000 common shares.
The issuance of shares is the first transaction for a new company, because it is part of the process of establishing the company, which is known as incorporation. Companies also issue
shares subsequent to incorporation as a means of raising capital. This is a common financing
transaction.
All companies issue common shares. Most companies also have other classes and types
of shares, which we will discuss further in Chapter 11. For now, we will assume that the company has a single class of common shares and that each share entitles its owner to a single vote
when electing the company’s board of directors. The number of shares issued does not affect
the accounting entry but will matter when it comes to votes or the payment of dividends. We
will also see information on the number of issued shares in the statement of changes in equity.
The cash received by SCL is recorded as an asset (cash) and represents an increase in shareholders’ equity (common shares).
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) increased by $250,000
Shareholders’ Equity (specifically, Common Shares) increased by $250,000
Note: These entries keep the two sides of the basic accounting equation in balance; that
is, Assets = Liabilities + Shareholders’ Equity.
Earnings Effect It is important to note that the issuance of shares is not considered reve-
nue to a company. This is not what the company is in the business of doing. In other words, it
is not related to the sale of goods or services to customers. As such, this transaction will have
no effect on the company’s earnings.
=
Assets
Date
Cash
A/R Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
Jan. 1 250,000
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
250,000
Transaction 2: Taking Out a Bank Loan
To raise additional financing, SCL borrowed $100,000 from its bank. The loan principal is due
in three years, while the interest rate on the loan is 6% per year. The interest is payable every
three months.
Analysis SCL borrowed $100,000 by taking out a bank loan. This is also a very common
financing transaction. At the time the loan is taken out, we account only for the principal and
not the interest. This is because the interest expense on the loan will be incurred with the
passage of time. At the date the loan is taken out, no interest has been incurred, but with each
day that passes, interest expense is being incurred. Interest costs are normally recorded at the
Using the Accounting Equation Template Approach to Analyze and Record Transactions
end of each month. SCL does this at the end of January in transaction 17, which we will get to
later. For now, we need to record only the initial receipt of the loan principal.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) increased by $100,000
Liabilities (specifically, Bank Loan Payable) increased by $100,000
Earnings Effect It is important to note that taking out a loan is not considered revenue to
a company. Just like with issuing shares, taking out a loan is not what the company is in the
business of doing; it is not related to the sale of goods or services to customers. As such, this
transaction will have no effect on the company’s earnings.
=
Assets
Date
Cash
Prepaid
Ins.
A/R Inv.
Equip.
Land
Liabilities
A/P
Interest
Payable
Jan. 1 100,000
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
100,000
Transaction 3: Paying Rent for the Month
The company rented a retail location, paying $1,100 in rent for the month of January.
Analysis SCL paid rent of $1,100 to its landlord (the owner of the building where its retail
operation is located). Rent is a common expense for many companies. In this case, the rent
is only for the month of January, so all of it will be an expense for the month. Sometimes,
companies prepay their rent or are required to pay a deposit to the landlord. In these cases,
the advance payments are not an expense. We will see examples of these in subsequent chapters. The current month’s rent is an expense to SCL. As we have discussed, expenses reduce
retained earnings.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $1,100
Shareholders’ Equity (specifically, Retained Earnings) decreased by $1,100
Earnings Effect Note that we record an “E” in the final column of the template so that
users can clearly see the reason that Retained Earnings decreased: the company incurred an
expense. Each time we enter an amount into the Retained Earnings account, we will indicate
the rationale for the change in the final column.
=
Assets
Date
Cash
Jan. 1
(1,100)
A/R Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
(1,100)
E
2-15
2-16
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Transaction 4: Purchasing Equipment
The company paid $65,000 to purchase equipment.
Analysis SCL paid $65,000 to purchase equipment. The company will use this equipment
in its operations to generate revenues. Equipment is part of a group of assets known as property, plant, and equipment (PP&E). These assets are purchased to use in the business and not
with the intent of being resold. If they were being purchased for resale, they would be part of
the company’s inventory. This does not mean that they can’t be sold when the company has
finished using them in the business. The purchase of PP&E is a common investing activity of
all companies. Companies “invest” in these assets to help them generate revenues.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $65,000
Assets (specifically, Equipment) increased by $65,000
Earnings Effect
The equipment is an asset at the time of acquisition. In a subsequent
transaction, we will learn that the cost of the equipment will be allocated and expensed in
each period in which it contributes to the generation of revenues, but at this point there are no
effects on the company’s earnings.
Note that both of these entries are being made on the left side of the accounting equation. Since they offset each other (one increased assets, while the other decreased assets), the
accounting equation remains in balance.
Assets
Date
Cash
Jan. 1 (65,000)
A/R Inv.
Prepaid
Ins.
=
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
65,000
Transaction 5: Purchasing Insurance Coverage
SCL paid $1,800 cash for a one-year insurance policy covering the new equipment for the
period January 1 to December 31.
Analysis SCL paid $1,800 for a one-year insurance policy covering the new equipment.
The company benefits from this insurance coverage in each month of the policy. For example,
if the equipment was stolen or damaged in a fire, the insurance company would replace or
cover the costs of repairing it. We will see in a subsequent transaction that, as each month of
the policy passes, the company will expense 1⁄12 of the policy costs. These transactions are normally recorded at the end of the month, after the company has benefited from the coverage.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $1,800
Assets (specifically, Prepaid Insurance) increased by $1,800
Using the Accounting Equation Template Approach to Analyze and Record Transactions
Earnings Effect The insurance is an asset at the time of acquisition. In a subsequent
transaction, we will expense the insurance cost in each period as the company benefits from
the insurance coverage, but at this point there are no effects on the company’s earnings.
=
Assets
Date
Cash
Jan. 1
(1,800)
Prepaid
Ins.
A/R Inv.
Equip.
Liabilities
A/P
Land
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
1,800
Transaction 6: Purchasing Land
SCL purchased some land for $180,000, on which it plans to build a warehouse in the future.
Analysis SCL paid $180,000 to purchase a piece of land, on which the company hopes to
construct a warehouse in the future. The land is an asset for the company, because it hopes to
use it to generate revenues in the future, and it could sell it if needed. The purchase of land
is a common investing activity of all companies. Companies “invest” in PP&E to help them
generate revenues.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $180,000
Assets (specifically, Land) increased by $180,000
Earnings Effect The land is an asset at the time of acquisition. Land is not expensed,
because the economic benefits it embodies are not being used up. Therefore, there are no
effects on the company’s earnings as a result of this transaction.
=
Assets
Date
Cash
A/R Inv.
Jan. 6 (180,000)
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
180,000
Transaction 7: Purchasing Inventory
The company bought $23,000 of inventory from suppliers on account. This means that SCL
will pay for these goods at a later date.
Analysis SCL purchased goods to resell to its customers. The goods cost $23,000, but SCL’s
supplier agreed that the company could pay for them at a later date. This is known as pur­
chasing on account (also known as a credit purchase) and results in a liability being created on SCL’s records, because it owes the supplier for those goods.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Inventory) increased by $23,000
Liabilities (specifically, Accounts Payable) increased by $23,000
Retained
Earnings
R/E/
DD
2-17
2-18
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Earnings Effect These goods, which will be sold to customers in the future, are an
asset at the time of acquisition. Until they are sold, there are no effects on the company’s
earnings.
=
Assets
Date
Cash A/R
Jan. 10
Inv.
23,000
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
23,000
Transaction 8: Selling Products
SCL sold products to customers for $34,000, of which $21,000 was received in cash and the
balance was on account. SCL’s customers will pay the balance owing at a later date. The products that were sold cost SCL $17,000.
KEY POINTS
When analyzing
transactions involving
the sale of goods, think
“two parts”:
• Part 1 accounts for
the sales revenue
and cash/accounts
receivable.
• Part 2 accounts for
the inventory that has
become cost of goods
sold.
Analysis When a company sells products to a customer, the transaction should be separated into two parts. Part 1 is to account for the sales revenue and the cash or accounts
receivable that flow into the company as a result. Part 2 is to account for the inventory that
has been provided to the customer and has become an expense (known as cost of goods
sold) to the company. The Key Points summarize these two parts of the transaction.
Part 1 of the sales transactions will always be known, because companies always
know the price at which goods are being sold. Part 2 of the sales transaction will not
always be known at the time of sale, because it requires that the company know how
much the goods being sold cost when they were acquired. Some inventory systems constantly provide this information, while with other systems this information will be known
only when inventory has been counted, at the end of a month, quarter, or year. We will
discuss inventory systems in Chapter 7. For now, it is important that you understand that
the information needed to record the second part of a sales transaction may not always be
available at the time of sale. If this information is not available, then the company would
not record part 2 of the sales transaction until the information becomes available at the
end of the month, quarter, or year.
With part 1 of the sales transaction, it is often easiest to think first about the cash effects,
if any. Often sales are made on account or partially on account, meaning that the customer is
not required to pay the entire purchase price at the time of sale. Regardless of whether or not
the customer has paid the full amount, if the company has provided the customer with the
goods, it has earned sales revenue. As we discussed earlier in the chapter, revenues increase
net income, which ultimately increases Retained Earnings. Accordingly, we will record an
increase in Retained Earnings and indicate the reason for that change by noting an “R” for
revenue in the adjacent column.
In part 2 of the sales transaction, we need to recognize that goods have been provided to
the customer and are no longer in the company’s inventory. The goods, which were recorded
in inventory at the amount they cost the company when they were initially purchased, must
be removed from inventory. The cost of these goods becomes an expense to the company,
which is called cost of goods sold. As discussed earlier in the chapter, expenses decrease net
income, which means they ultimately also decrease Retained Earnings. Accordingly, we will
record a decrease in Retained Earnings and indicate the reason for that change by noting
an “E” for expense in the adjacent column. The difference between the selling price of the
goods in part 1 and the cost of goods sold in part 2 represents the company’s gross profit on
the sale. As discussed previously, this amount will be seen on the company’s statement of
income.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Using the Accounting Equation Template Approach to Analyze and Record Transactions
Analysis of Transaction
Part 1
Assets (specifically, Cash and Accounts Receivable) increased by $34,000
Shareholders’ Equity (specifically, Retained Earnings) increased by $34,000
Part 2
Assets (specifically, Inventory) decreased by $17,000
Shareholders’ Equity (specifically, Retained Earnings) decreased by $17,000
Earnings Effect
Part 1: The sale of goods to a customer results in revenue to the company and increases the
company’s earnings.
Part 2: The cost of goods sold to the customer results in an expense to the company, decreasing the company’s earnings.
=
Assets
Date
Cash
A/R
Prepaid
Ins.
Inv.
Equip. Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Jan. 12: 1 21,000 13,000
Jan. 12: 2
(17,000)
Retained
Earnings
R/E/
DD
34,000
R
(17,000)
E
Transaction 9: Receiving Payments from Customers
SCL received $11,000 from its customers as payments on their accounts that originated from
the sale on January 12.
Analysis In this transaction, SCL is receiving payments from customers who owe the company
money as a result of a previous transaction. SCL sold them goods, and the customers agreed to pay
for them at a later date. In this transaction, the customers are following through on this agreement.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) increased by $11,000
Assets (specifically, Accounts Receivable) decreased by $11,000
Earnings Effect The transaction involves the company collecting from its customers for
sales made previously. This does not involve a new sale being made; therefore, there are no
effects on the company’s earnings as a result of this transaction.
=
Assets
Date
Cash
A/R
Jan. 20
11,000
(11,000)
Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
Transaction 10: Making Payments to Suppliers
The company made payments of $13,500 to its suppliers, settling part of the account that ori­
ginated from the purchase on January 10.
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
2-19
2-20
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Analysis
When SCL purchased goods from one of its suppliers, the supplier agreed to
let SCL pay it at a later date. In this transaction, SCL is making part of that payment. The
company is not receiving additional goods in this transaction; it is simply paying for goods
it received previously. The company is settling, or extinguishing, part of its liability to its
supplier.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $13,500
Liabilities (specifically, Accounts Payable) decreased by $13,500
Earnings Effect No new goods are received in this transaction. SCL is settling part of its
liability to its supplier (an account payable) by paying the supplier. There are no effects on the
company’s earnings as a result of this transaction.
=
Assets
Date
Cash
Jan. 22
(13,500)
A/R Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
(13,500)
Transaction 11: Paying Utility Costs
SCL paid monthly utility costs of $1,900.
Analysis In this transaction, SCL is paying for the costs of utilities (such as electricity,
natural gas, and water) it used during the month. These costs are expenses to SCL. As noted
previously, expenses reduce Retained Earnings, and we will record an “E” in the final column
to indicate that Retained Earnings has been reduced as a result of an expense.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $1,900
Shareholders’ Equity (specifically, Retained Earnings) decreased by $1,900
Earnings Effect The utility costs have been incurred by SCL. The company has used the
electricity, natural gas, and so on provided by the utility companies. These costs are an expense
incurred by SCL to be able to generate revenue. Expenses decrease net income (reduce
earnings).
Assets
Date
Cash
Jan. 25
(1,900)
A/R Inv.
Prepaid
Ins.
Liabilities
Equip.
Land
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
(1,900)
E
Using the Accounting Equation Template Approach to Analyze and Record Transactions
Transaction 12: Paying Advertising Costs
SCL paid advertising costs for the month of $2,200.
Analysis In this transaction, SCL is paying the costs of its monthly advertising. These costs
are an expense to SCL. As noted previously, expenses reduce Retained Earnings, and we will
record an “E” in the final column to indicate that Retained Earnings has been reduced as a
result of an expense.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $2,200
Shareholders’ Equity (specifically, Retained Earnings) decreased by $2,200
Earnings Effect These advertising costs have been incurred by SCL to generate revenue,
because the purpose of the advertising was to increase sales. Expenses decrease net income
(reduce earnings).
=
Assets
Date
Cash
Jan. 26
(2,200)
Prepaid
Ins.
A/R Inv.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
(2,200)
E
Transaction 13: Paying Wages
SCL paid $2,900 in wages to its employees for the month of January.
Analysis SCL hires employees to help the company generate revenue, either directly or indi-
rectly. In this transaction, the employees have worked (provided their services) and SCL is paying
them. As noted previously, expenses reduce Retained Earnings, and we will record an “E” in the
final column to indicate that Retained Earnings has been reduced as a result of an expense.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $2,900
Shareholders’ Equity (specifically, Retained Earnings) decreased by $2,900
Earnings Effect
The wage costs have been incurred by SCL, because the employees
have worked. Wage costs are an expense to SCL. Expenses decrease net income (reduce
earnings).
=
Assets
Date
Cash
Jan. 28
(2,900)
A/R Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
(2,900)
E
2-21
2-22
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Transaction 14: Declaring and Paying Dividends
SCL’s board of directors declared and paid $400 of dividends to shareholders.
Analysis Dividends are a distribution of a company’s profits to its shareholders. They are
declared by the company’s board of directors. In this case, SCL’s board declared and paid
dividends of $400. As noted previously, the declaration of dividends reduces Retained Earnings, because the dividends are actually a distribution of retained earnings. We will record a
“DD” in the final column to indicate that Retained Earnings has been reduced as a result of
dividends being declared. When dividends are declared by a company’s board, they become
a liability. In this case, the dividends that were declared by the board of directors were paid
immediately, so we reduce Cash rather than record a liability. We will see situations later in
this text where dividends are declared but paid at a later date.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Cash) decreased by $400
Shareholders’ Equity (specifically, Retained Earnings) decreased by $400
Earnings Effect Dividends are a distribution of a company’s profits (or earnings) to its
shareholders. They have no effect on a company’s earnings, because they are not an expense
incurred to generate revenues. Therefore, there is no effect on the company’s earnings as a
result of this transaction.
=
Assets
Date
Cash
Jan. 31
(400)
A/R Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
(400)
DD
Transaction 15: Recording Depreciation Expense on Equipment
KEY POINTS
To depreciate property,
plant, and equipment, we
need to know four things:
1. the pattern in which
the asset’s economic
benefits will be
consumed
2. the asset’s cost
3. the asset’s estimated
residual value
4. the asset’s estimated
useful life
SCL’s accountant determined that the depreciation expense on the company’s equipment was
$850 per month. The Key Points show what you need to know to depreciate property, plant,
and equipment.
Analysis In transaction 4, SCL purchased equipment costing $65,000. The company purchased this equipment to help it generate revenue for a number of years. Since the equipment
was expected to generate these future economic benefits, it was recorded as an asset at the
time of purchase. These future economic benefits will be realized over a fixed period of time
(the useful life of the equipment). Therefore, the cost of the equipment (less any amount the
company estimates it may be able to recover from the disposal of the asset when it has finished using it) must be allocated to those periods. The process of cost allocation is known as
depreciation. The amount the company estimates it may be able to recover from the disposal
of the asset when the company is finished using it is known as the estimated residual value.
It is equal to the estimate of the amount that the company would receive today if it disposed
of the asset in the age and condition it is expected to be in at the time of disposal. The period
of time a company estimates an asset will be used to help generate revenue is its estimated
useful life.
There are a number of different ways that the cost of property, plant, and equipment can
be allocated or depreciated. These are based on the manner in which the economic benefits
expected to be provided by the property, plant, and equipment are expected to be consumed.
Using the Accounting Equation Template Approach to Analyze and Record Transactions
This generally corresponds with the manner in which the property, plant, and equipment is
expected to generate revenues for the company. We will discuss a number of these in depth
in Chapter 8. For now, we will assume that the equipment is expected to generate revenues
evenly over the course of its useful life. As such, we will allocate a consistent portion of the
asset’s cost to each of these periods. This approach is known as straight-line depreciation,
because the amount of depreciation expense is constant each year and would form a straight
line if shown graphically.
The straight-line method of depreciation determines the portion of an asset’s cost that
should be expensed each year as follows:
Straight-Line Depreciation Expense =
Original Cost − Estimated Residual Value
Estimated Useful Life
This formula is used to determine the annual depreciation expense. This must be prorated for periods of less than 12 months. That is, the monthly depreciation expense can be
determined by dividing the annual amount by 12. It is also important to note that the formula
includes two estimated amounts. These amounts are estimated by the company’s management. In the case of SCL, let’s assume that management has estimated that the equipment
will have a useful life of six years and a residual value of $3,800. Based on these estimates, the
company’s accountant would have determined the monthly depreciation expense as follows:
=
65,000 − 3,800
6 years
= 10,200 per year
The monthly depreciation expense would be:
= 10,200/12 = 850 per month
We will record a reduction in the Equipment account to reflect that a portion of the asset’s
cost has been expensed. We will also reduce Retained Earnings, because expenses have this
effect. We will record an “E” in the final column to indicate that Retained Earnings has been
reduced as a result of an expense. Note that we will record depreciation as a reduction directly
to the Equipment account only when we are using the template method. In the next chapter,
we will learn that companies follow a slightly different approach in practice. The net effect of
both approaches is the same, but being aware that the approach to recording the transaction
will change in future chapters will help you when we get there.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Equipment) decreased by $850
Shareholders’ Equity (specifically, Retained Earnings) decreased by $850
Earnings Effect The depreciation expense will decrease net income (reduce earnings).
=
Assets
Date
Jan. 31
Cash
A/R Inv.
Prepaid
Ins.
Equip.
(850)
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/
DD
(850)
E
2-23
2-24
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Transaction 16: Recording Insurance Expense
SCL’s insurance expense was recorded for January.
Analysis In transaction 5, SCL paid $1,800 for a one-year insurance policy covering the
company’s new equipment. The term of the policy was from January 1 to December 31. On
January 1, when the policy was taken out, SCL accounted for it as an asset, Prepaid Insurance.
We also noted that SCL would expense 1⁄12 of the cost of the policy each month as the company
benefits from that month’s coverage. The monthly insurance cost is an expense, which reduces
Retained Earnings. We will record an “E” in the final column to indicate that Retained Earnings has been reduced as a result of an expense. The asset, Prepaid Insurance, will also be
reduced by the amount that has been expensed for the month.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Assets (specifically, Prepaid Insurance) decreased by $150
Shareholders’ Equity (specifically, Retained Earnings) decreased by $150
Earnings Effect The monthly insurance cost of $150 ($1,800 × 1⁄12) is an expense, which
decreases net income (reduces earnings).
=
Assets
Date
Jan. 31
Cash
A/R Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
+
Bank Loan
Payable
S/H Equity
Common
Shares
(150)
Retained
Earnings
R/E/
DD
(150)
E
Transaction 17: Recording Interest Expense
SCL recorded the interest expense on the bank loan for the month. Although the principal of
the loan does not have to be repaid for three years, the company is incurring interest expense
each month that the loan is outstanding.
Analysis In transaction 2, SCL borrowed $100,000 from the bank. The loan, which bears
interest at 6% per year, is to be repaid in three years, and the interest on the loan must be paid
to the bank every three months. The loan interest is an expense to SCL and is a function of the
amount of time that SCL has borrowed the money. As such, the company’s interest expense
grows each day that the borrowed funds are outstanding. Note that interest rates are stated as
annual rates, so the 6% interest rate on the loan must be pro-rated to a monthly rate. SCL will
quantify its monthly interest expense as follows:
Loan Principal Outstanding × Interest Rate × 1⁄12
= $100,000 × 6% × 1⁄12
= $500 per month
Any unpaid interest on the loan is a liability to SCL, because it will involve an outflow of
economic benefits. That is, it will be paid in cash every three months.
The analysis of this transaction and its effects on the basic accounting equation are summarized in the following box:
Analysis of Transaction
Liabilities (specifically, Interest Payable) increased by $500
Shareholders’ Equity (specifically, Retained Earnings) decreased by $500
Using the Accounting Equation Template Approach to Analyze and Record Transactions
Earnings Effect The monthly interest cost is an expense, which decreases net income
(reduces earnings).
=
Assets
Date
Cash
A/R Inv.
Prepaid
Ins.
Equip.
Land
Liabilities
A/P
Interest
Payable
Jan. 31
+
S/H Equity
Bank Loan
Payable
Common
Shares
500
Retained
Earnings
R/E/
DD
(500)
E
Exhibit 2.7 is a summary of all of the individual transactions we have analyzed. It provides enough information for the owners of a small business to prepare a set of financial statements for SCL, but it does have some limitations, which we’ll see in the next section.
EXHIBIT 2.7 Accounting Equation Template
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=
Assets
Date
Cash
Jan. 1
250,000
Jan. 1
100,000
Jan. 1
(1,100)
Jan. 1
(65,000)
Jan. 1
(1,800)
Jan. 6
(180,000)
A/R
Prepaid
Ins.
Equip.
Land
A/P
Bank Loan
Payable
S/H Equity
Common
Shares
Retained R/E/DD
Earnings
100,000
(1,100)
E
34,000
R
(17,000)
E
65,000
1,800
180,000
23,000
23,000
21,000
Interest
Payable
+
250,000
Jan. 10
Jan. 12: 1
Inv.
Liabilities
13,000
Jan. 12: 2
(17,000)
Jan. 20
11,000
(11,000)
Jan. 22
(13,500)
Jan. 25
(1,900)
(1,900)
E
Jan. 26
(2,200)
(2,200)
E
Jan. 28
(2,900)
(2,900)
E
Jan. 31
(400)
(13,500)
Jan. 31
(850)
Jan. 31
(150)
500
Jan. 31
113,200
2,000
6,000
1,650
64,150
180,000
9,500
367,000
500
100,000
250,000
367,000
What Are the Limitations of the Accounting
Equation Template Approach?
The template method is an acceptable method for recording financial information and is simple and easy to understand. However, it is normally used only by very small businesses due to
a number of limitations. Before we discuss a few of these limitations, note that having a solid
understanding of how transactions are analyzed and recorded within the template method
is important. This understanding will make it much easier for you to move to the system of
transaction analysis and recording that is used by the vast majority of companies and that we
will learn about in the next chapter.
One of the main limitations of the template method is the number of columns that can be
included within the template. Having many columns is not a problem when the user is working on
(400)
DD
(850)
E
(150)
E
(500)
E
7,000
2-25
2-26
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
a computer where there are no limitations to the width of the spreadsheet, but it is a real challenge
when printing out reports. You will see from the templates used throughout the chapter that the
number of accounts is limited and may not provide sufficient detail for management or users. For
example, a company may have many different types of inventory or property, plant, and equipment
that it would like to account for separately, but it would be unable to do so within this method.
Another significant limitation of the template method is the lack of specific revenue,
expense, and dividends declared accounts. Instead, these transactions are recorded directly to
Retained Earnings. While this accounting treatment is ultimately correct, it makes it difficult
and time-consuming for business owners to quantify revenue and expense information. If
they were wondering about their sales for a given period, they would have to go through the
retained earnings column and pull out all of the transactions with an “R” indicated in the
adjacent column. If they were wondering about wage expense for a period, they would need
to identify all of the transactions in the retained earnings column with an “E” in the adjacent
column and then determine which of those were related to wages rather than other expenses.
This may not be a significant limitation for companies with only a few transactions each
period, but it certainly is for those with significant transaction volumes.
Now that we are aware of a few of the limitations of this method, let’s have a look at the
financial statements that can be developed for SCL using the information recorded in the template.
Assess Your Understanding
Attempt the following problem and review the solution provided:
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2.6
• Demonstration Problem 2-3 in Wiley’s course resources.
Financial Statements
LEARNING OBJECTIVE 6
Summarize the effects of transactions on the accounting equation, and prepare and
interpret a simple set of financial statements.
How Do We Know if the Company Was Profitable
during the Accounting Period?
In Chapter 1, we learned that the statement of income is the first financial statement that
should be prepared for a company, because the net income figure provided by this statement is
needed for all of the other financial statements. We also learned that the statement of income
included information about the revenues and expenses of a company. Refer back to Chapter 1
if you need to review the contents of this statement.
The statement of income can be constructed from the information recorded in the
retained earnings column in Exhibit 2.7. Because we labelled each of the amounts that affected
retained earnings with an “R” to indicate revenues, an “E” to indicate expenses, or a “DD” to
indicate dividends declared, this will be an easy task. Each of the revenue and expense items
in the retained earnings column of Exhibit 2.7 has to be reported on the statement of income.
In its simplest form, the statement of income would be presented as shown in Exhibit
2.8. While it would normally be prepared on a comparative basis, because this is SCL’s first
month of operations, there are no figures from previous periods for comparison. In terms
of the order in which expenses are presented, it is worth noting that cost of goods sold is
normally presented first, as it is the expense most directly linked to the sale of goods and is
also often the most significant expense. This also allows us to determine gross profit. Interest expense is also reported separately on the statement of income, because it is a financing
expense as opposed to an operating expense.
Financial Statements
2-27
EXHIBIT 2.8 Statement of
Sample Company Limited
Income
Statement of Income
For the month ended January 31, 2024
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Sales revenue
$34,000
Cost of goods sold
17,000
Gross profit
17,000
Wage expense
2,900
Utilities expense
1,900
Rent expense
1,100
Advertising expense
2,200
Insurance expense
150
Depreciation expense
850
Interest expense
500
$ 7,400
Net income
We can see from the statement of income that SCL was profitable during the month of
January. The company’s net income for the month was $7,400, because the revenues earned
during the month exceeded the expenses incurred. We can also see that SCL’s gross profit
percentage was 50% ($17,000 ÷ $34,000), meaning that for every $1 in sales, the company
had profits after cost of goods sold of $0.50. It is important to remember that the dividends
declared do not appear on the statement of income. Because they are a distribution of earnings, they will appear on the statement of changes in equity instead.
How Can We Tell if the Equity Position of
Shareholders Changed during the Accounting
Period?
In Chapter 1, we learned about two components of shareholders’ equity: share capital and
retained earnings. The statement of changes in equity reflects all of the information recorded
in the common shares and retained earnings columns of the template. From the template,
we know that the balance in SCL’s Common Shares account was $250,000 at the end of the
month, while the company’s Retained Earnings balance was $7,000. In Exhibit 2.9, we can
see how we arrive at these numbers using a statement of changes in equity.
EXHIBIT 2.9 Statement of
Changes in Equity
Sample Company Limited
Statement of Changes in Equity
For the month ended January 31, 2024
Number of
­Common Shares
Share Capital—
Common Shares
$
—
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Retained
Earnings
$
—
Total
Balance, Jan. 1
—
Net income
—
—
Declaration of
dividends
—
—
Issuance of
common shares
10,000
250,000
—
250,000
Balance, Jan. 31
10,000
$250,000
$7,000
$257,000
7,400
(400)
$
—
7,400
(400)
2-28
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
From the statement of changes in equity, we can see that SCL started the month with
no equity (because it was a new company) and ended the month with total shareholders’
equity of $257,000. We can see that, from the company’s earnings of $7,400, dividends
totalling $400 were distributed to shareholders. Finally, we can also see that the company
had 10,000 common shares outstanding at the end of the month. From this we can determine that a dividend of $0.04 ($400 ÷ 10,000 common shares) was paid to the owner of
each of SCL’s common shares.
How Do We Determine the Company’s Financial
Position at the End of the Accounting Period?
The last two rows of Exhibit 2.7 present the net results of SCL’s January transactions.
Because both the template and the statement of financial position are based on the accounting equation, the totals for each of the accounts on the template are the figures that appear
on the company’s statement of financial position at the end of the month. We can also see
from the final row of Exhibit 2.7 that the accounting equation was in balance at the end of
the month. In other words, SCL’s total assets ($367,000) equalled the sum of the company’s
liabilities and shareholders’ equity ($367,000); therefore, the statement of financial position
was balanced!
We can use the totals from each account determined using the template to prepare
the company’s statement of financial position, as shown in Exhibit 2.10. We will group
certain accounts and build in subtotals to enhance the usefulness of the information
presented on the statement. The groupings will be based on the concept of liquidity
that we learned about in Chapter 1. The company’s current assets will be grouped separately from the non-current assets, and the current liabilities will be grouped separately from the non-current liabilities. This enables users to determine the company’s
working capital and assess its ability to meet those obligations coming due within the
next 12 months. This presentation is known as a classified statement of financial
position.
From SCL’s statement of financial position, we can see that the company had working
capital of $112,850 (current assets of $122,850 − current liabilities of $10,000) and has a strong
liquidity position. The company will have no difficulty meeting its current liabilities, because
it has more than enough current assets. We can also see that 70% of the company’s assets have
been financed by shareholders’ equity ($257,000 ÷ $367,000), while 30% have been financed
by creditors ($110,000 ÷ $367,000).
We can also see that SCL’s equipment is presented on the statement of financial position
at $64,150. We know this equipment cost SCL $65,000 and that the company recorded $850
in depreciation expense related to it for the month. This left the carrying amount of $64,150
that we see on the statement of financial position. This carrying amount is also known as
the net book value of the equipment. It represents the portion of the equipment’s cost that
has yet to be expensed.
How Can We Tell if the Company’s Cash Position
Changed during the Accounting Period?
In Chapter 1, we learned that there are three categories of business activities: operating,
financing, and investing. Operating activities include all inflows of cash related to the sale of
goods and services to customers and the outflows related to the payment of expenses. Investing activities generally involve the purchase and sale of long-term assets such as property,
plant, and equipment, and investments in other companies. Finally, financing activities are
transactions that resulted either from new funds being received from investors or creditors or
from the return of funds to these two groups.
Financial Statements
EXHIBIT 2.10 Statement of
Financial Position
Sample Company Limited
Statement of Financial Position
As at January 31, 2024
ASSETS
Current assets
Cash
Accounts receivable
Inventory
Prepaid insurance
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$113,200
2,000
6,000
1,650
$122,850
Non-current assets
Equipment
Land
Total assets
LIABILITIES
Current liabilities
Accounts payable
Interest payable
64,150
180,000
244,150
$367,000
$ 9,500
500
$ 10,000
Non-current liabilities
Bank loan payable
Total liabilities
SHAREHOLDERS’ EQUITY
Common shares
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders’ equity
2-29
100,000
110,000
250,000
7,000
257,000
$367,000
In order to understand how the company’s cash position changed during the month, let’s
review how each transaction recorded during the month affected the Cash account, as shown
in Exhibit 2.11.
While any of the three categories of business activities could have a net cash inflow or
outflow depending upon the company’s transactions, we would normally expect the following
pattern:
• Operating activities are normally expected to result in a net inflow of cash (and therefore have a positive effect on cash), because companies are expected to collect more cash
from customers than they spend to generate these sales. This may not be the case for new
businesses.
• Investing activities are normally expected to result in a net outflow of cash (and therefore
have a negative effect on cash), because companies are expected to spend more purchasing new property, plant, and equipment than they would receive from selling the property, plant, and equipment that they have finished using.
• Financing activities are normally expected to result in a net inflow of cash (and
therefore have a positive effect on cash) for new companies, because they are generally borrowing and issuing shares to finance their growth. Mature companies may
not fit this pattern, because they are often able to finance new assets through operating activities, while returning some profits to shareholders as dividends or repaying
debt.
2-30
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
EXHIBIT 2.11 Analysis of
SCL’s Cash Account
Date
Jan. 1
$250,000
Jan. 1
100,000
Jan. 1
Jan. 1
Jan. 1
KEY POINTS
• Cash flows from
operating activities
normally generate a
net inflow of cash (a
positive effect on cash).
• Cash flows from
investing activities
normally generate a
net outflow of cash
(a negative effect on
cash).
EXHIBIT 2.12 Statement of
Cash Flows
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Cash
Jan. 6
Jan. 10
Jan. 12: 1
Jan. 12: 2
Jan. 20
Jan. 22
Jan. 25
Jan. 26
Jan. 28
Jan. 31
Jan. 31
Jan. 31
Jan. 31
Description
Operating
Activities
Investing
Activities
Issued common shares
$250,000
Took out bank loan
(1,100) Paid rent
Financing
Activities
100,000
$ (1,100)
(65,000) Purchased equipment
(1,800) Purchased insurance
policy
(1,800)
(180,000) Purchased land
No cash effect
21,000 Made sales to customers
21,000
No cash effect
11,000 Collected from customers 11,000
(13,500) Paid suppliers
(13,500)
(1,900) Paid utility costs
(1,900)
(2,200) Paid advertising costs
(2,200)
(2,900) Paid wages
(2,900)
(400) Paid dividends
No cash effect
No cash effect
No cash effect
$113,200
$ 8,600
$ (65,000)
(180,000)
(400)
$(245,000)
$349,600
We will discuss cash flow patterns further in Chapter 5, and they are summarized in the
Key Points. For now, we can see that SCL fits this normal + / − / + (Operating / Investing /
Financing) cash flow pattern. The company’s statement of cash flows would be as shown in
Exhibit 2.12.
Sample Company Limited
Statement of Cash Flows
For the month ended January 31, 2024
Cash flows from operating activities
Cash received from customers
Cash paid for rent
Cash paid for insurance
Cash paid for inventory
Cash paid for utilities
Cash paid for advertising
Cash paid for wages
Total cash flows from operating activities
Cash flows from investing activities
Cash paid to purchase equipment
Cash paid to purchase land
Total cash flows from investing activities
Cash flows from financing activities
Cash received from issuance of shares
Cash received from bank loan
Cash paid for dividends
Total cash flows from financing activities
Net change in cash during the period
Cash balance on January 1, 2024
Cash balance on January 31, 2024
$ 32,000
(1,100)
(1,800)
(13,500)
(1,900)
(2,200)
(2,900)
8,600
A
(65,000)
(180,000)
(245,000)
B
250,000
100,000
(400)
349,600
113,200
0
$ 113,200
C
=A+B+C
Financial Statements
2-31
Analytics in Action
Data visualizations can be powerful tools for companies when
communicating with users of their financial information. Compelling visualizations can be a very effective way of telling a
company’s story. Financial accounting is about providing information that is useful for users and visualizations help with this.
Let’s look at the case of HUB Cycling, a charitable not-for-profit
organization in Vancouver, BC. The organization’s mission “is to
get more people cycling more often.” It has almost 3,000 members
and more than 40,000 direct supporters, many of whom will have
non-financial backgrounds. When communicating its revenues
and expenses for the year to these members and supporters in the
organization’s annual report, HUB Cycling’s board has chosen to
do so using a visualization that is understandable and meaningful to them: a bicycle. While they also present the numbers in a
traditional manner, there’s no doubt that many members and supporters are drawn to the visual first, rather than to the columns of
figures. They are then able to use the other information provided
in the annual report for further analysis.5
To help you begin to develop skills in understanding and
interpreting data visualizations, there are a number of Analytics
in Action cases featured in this edition of the text.
Assets
Revenue
2020
Current Assets
Cash & Short-Term Investments
Accounts Receivable
Prepaid Expenses & Deposits
Capital Assets
Total
2019
$ 303,782
$ 59,735
$ 2,600
$ 12,609
$378,726
$ 368,328
$ 52,700
$ 4,830
$ 8,660
$434,518
2020
2019
Liabilities and Net Assets
Current Liabilities
Accounts Payable &
Accrued Liabilities
$ 5,454
Deferred Revenue
Total Liabilities
Net Assets
Total
$
5,433
Government Revenue
Private Funding & Donations
Regional Government
Courses & Fees for Service
Membership Fees
Interest & Expenses Recovered
Merchandise Sales
Total
2019
$ 410,921
$ 446,137
$ 248,000
$
33,461
$
75,177
$
2,530
$
2,256
$1,218,482
Expenses
2020
Programming
2019
$ 215,152 $ 204,263
Staffing
$ 957,546 $ 834,857
Organizational & Overhead
$ 109,477 $ 87,074
$ 119,209
$ 160,285
$165,718
$182,662
Total
$ 254,063
$ 258,800
(Deficiency) Excess of
Revenue Over Expenses
for the Year
$ 378,726 $434,518
2020
$ 533,067
$ 434,118
$ 182,000
$ 37,564
$
52,490
$
27,275
$ 924
$1,267,438
$1,282,175 $1,126,194
($ 14,737)
$
92,288
Merchandise Sales 0.07%
Interest 2.2%
Membership
Fees 4.1%
Courses & Fees
for Service 3.0%
Organizational
& Overhead
8.5%
Regional
Government
14.4%
Government
Revenue
42.1%
Staffing
74.7%
Programming
16.8%
Private Funding
& Donations
34.3%
Revenue Dollars in Percent
Expenses Dollars in Percent
2-32
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Assess Your Understanding
Attempt the following problems and review the solutions provided:
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• Chapter End Review Problem 2-3
• Demonstration Problem 2-4 in Wiley’s course resources
2.7
Using Ratios to Analyze Financial Statements
LEARNING OBJECTIVE 7
Calculate and interpret three ratios used to assess the profitability of a company.
One of the things financial statement users do with the statements is calculate ratios. Ratios
allow users to compare companies of different sizes or the same company’s situation at various times. Ratio analysis can be used to assess things such as profitability, the effectiveness of
management, and the company’s ability to meet debt obligations. In Chapter 1, we discussed
how the ratio of a company’s total liabilities to its total liabilities plus shareholders’ equity
could be used to indicate how much a company relies on debt financing. As we introduce new
topics, we will present and discuss additional ratios that can help users understand and evaluate a set of financial statements. In addition to this, Chapter 12 presents a complete discussion
of these ratios.
We will now use SCL’s financial statements to examine profitability ratios. Profitability ratios are usually constructed by comparing some measure of the company’s profit (net
income or earnings) with the amount invested, or by comparing the profit with the company’s
revenues. We will calculate three such measures.
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How Do We Determine the Company’s Profit
Margin?
The profit margin ratio is calculated by dividing the company’s profit (or net income) by the
revenues that produced the profit. For SCL, this ratio is calculated by dividing its net income
of $7,400 by its sales revenue of $34,000, giving a result of 0.218. This means that SCL’s profit
was 21.8% of sales revenue. In other words, for every $1 in sales, SCL has profits after all
expenses of $0.218.
Profit Margin = Net Income/Sales Revenue
= 7,400/34,000
= 0.218 or 21.8%
A higher profit margin is considered to be better than a lower one. These profits can be
retained and reinvested in the company, distributed to shareholders as dividends, or a combination of the two.
Using Ratios to Analyze Financial Statements
For Example
The profit margins for Aritzia Inc. in 2021 and 2020 were as follows (amounts in thousands of
Canadian dollars):
2021
2020
Profit Margin = 19,227/857,323
= 90,594/980,589
= 0.022 or 2.2%
= 0.092 or 9.2%
From this analysis, we can see that Aritzia’s profitability decreased in 2021, meaning there were
less profits that could be retained and reinvested in the company and/or distributed as dividends.
For every $1 of sales revenue, the company had profits of $0.022.
How Do We Determine How Effective the
Company Has Been at Generating a Return on
Shareholders’ Equity?
The return on equity ratio compares the profit (or net income) earned relative to the amount
invested by the shareholders (represented by the total shareholders’ equity). Again, we would
normally calculate the average shareholders’ equity. However, an average amount would not
be very meaningful for the month of January, because it was the company’s first period of
operations, and the beginning balances were zero. Therefore, we will simply use the amount
for total shareholders’ equity at the end of January.
For SCL, this ratio is calculated by dividing its net income of $7,400 by shareholders’
equity of $257,000, giving a result of 0.0288, or 2.88%. This measure shows that, in the month
of January, SCL’s shareholders earned a 2.88% return on their investment in the company. It
also means that during its first month of operations, the company earned profit at the rate of
$0.0288 for each $1 that was invested by the owners.
Return on Equity = Net Income/Average Total Shareholders’ Equity
= 7,400/257,000*
= 0.0288 or 2.88%
*In this case, SCL’s shareholders’ equity was not averaged, because there was no opening balance.
Again, a higher return on equity is considered to be better than a lower one. Shareholders
can compare this return with other investment alternatives to help them assess whether they
should invest, stay invested, or move their resources to other alternatives.
For Example
Aritzia Inc.’s return on shareholders’ equity ratios for 2021 and 2020 were as follows:
2021
2020
Return on Equity = 19,227/((332,065 + 360,263)/2)
= 90,594/((374,309 + 332,065)/2)
= 0.056 or 5.6%
= 0.256 or 25.6%
From this analysis, we can see that the return that Aritzia’s shareholders realized on their equity
investment decreased in 2021. This means that the company earned profit at a rate of $0.056 for
every $1 invested by shareholders.
2-33
2-34
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
How Do We Determine How Effective the
Company Has Been at Generating Profits Using Its
Assets?
The return on assets is another measure of profitability. It is calculated by dividing the company’s profit (or net income) by its average total assets.
Like all the amounts on the statement of financial position, the amount for total assets
is determined at a particular point in time. For SCL, the relevant points in time are January 1
and January 31, 2024 (that is, the beginning and end of the current accounting period). To get
a measure of the total assets during the period between these two dates, we would normally
calculate the average. However, since SCL had no beginning balances for January, the average
amount would not be very meaningful in this situation. Therefore, we will simply use the
amount for total assets at the end of the period.
In January 2024, SCL’s return on assets was its net income of $7,400 divided by its total
assets of $367,000, giving a result of 0.020 or 2.0%. Remember that a company acquires
assets to use them to generate profits. SCL’s return on assets of 2.0% means that during its
first month of operations, it earned profit at the rate of $0.02 for each $1 that was invested
in its assets.
Return on Assets = Net Income/Average Total Assets
=7,400/367,000*
=0.020 or 2.0 %
*In this case, SCL’s total assets were not averaged because there was no opening balance.
Again, a higher return on assets is considered to be better than a lower one. It shows that
the company is using its assets effectively to generate profits.
For Example
Aritzia Inc.’s return on asset ratios for 2021 and 2020 were as follows:
2021
2020
Return on Assets = 19,227/((1,036,715 + 1,140,737)/2)
= 90,594/((629,374 + 1,036,715)/2)
= 0.018 or 1.8%
= 0.109 or 10.9%
From this analysis, we can see that Aritzia was able to generate fewer profits from using its assets
in 2021. The company’s return on assets ratio decreased from 10.9% to 1.8%, indicating that it was
able to generate less profit from use of its assets in 2021 than in 2020.
Now that you know how users can analyze financial statements, in the next chapter, we’ll
look in more detail at transactions and how they are recorded and used to create financial
statements.
Summary
2-35
Review and Practice
Summary
Identify the accounting standards used by Canadian
companies.
1
• Canadian public companies (those whose shares trade on a
public stock exchange) are required to prepare their financial
statements using International Financial Reporting Standards
(IFRS).
• Private companies in Canada generally follow Accounting Standards for Private Enterprises (ASPE) but have the option of following IFRS.
Identify and explain the qualitative characteristics of
useful financial information and how the cost constraint
affects these.
2
• Standard setters have developed conceptual frameworks (one for
IFRS and another for ASPE) to assist them in determining what
“useful information” is.
• Useful information has two fundamental qualitative characteristics. It must be relevant (it must matter to users’ decision-making), and it must be representationally faithful (it must represent
transactions and balances as they took place or are at present).
• To be relevant, the information must be material and have a predictive value or a confirmatory value.
• To be representationally faithful, the information must be complete, neutral, and free from error.
• Revenues are earned when the company has satisfied its performance obligations in the contract by providing the goods or
services to its customers.
• Accounting standard setters have determined that financial
information prepared using the accrual basis of accounting
is more useful than that resulting from the use of the cash
basis.
4 Explain the accounting equation template approach
to recording transactions.
• Every transaction must affect at least two accounts when it is
recorded.
• The accounting equation must remain in balance as transactions
are recorded; total assets must equal the sum of total liabilities
plus shareholders’ equity.
• One of the main limitations of the accounting equation template
method is that the number of columns that can be used is limited, which means that the number of accounts is also limited.
The information resulting from this system may lack the level of
detail required by management and other users.
• The other main limitation of the accounting equation template method is the lack of specific accounts for recording
revenues, expenses, and dividends declared. Instead, these are
recorded in the Retained Earnings account. This makes it difficult and time-consuming for management to quantify revenue
and expense information, which is critical for managing any
business.
• Four other enhancing qualitative characteristics have been identified that can increase the usefulness of financial information.
These are comparability, verifiability, timeliness, and understandability. These characteristics increase usefulness, but they
cannot make useless information useful.
5
• Financial statements are prepared using the going concern
assumption. This assumes that the company will continue
to operate for at least the next 12 months, and, if it is a public
company, that its shares will continue to trade on an exchange
during that period.
• Transactions affecting the Retained Earnings account (revenues,
expenses, and the declaration of dividends) should be referenced
to indicate the nature of the transaction.
3 Explain the difference between the cash basis of
accounting and the accrual basis of accounting.
• Under the cash basis of accounting, revenues are recorded when
cash is received, and expenses are recorded when cash is paid
out.
• Under the accrual basis of accounting, revenues are recorded
when they are earned, and expenses are recorded when they are
incurred.
Analyze basic transactions and record their effects on
the accounting equation.
• Revenues increase Retained Earnings, while expenses and the
declaration of dividends decrease Retained Earnings.
Summarize the effects of transactions on the
accounting equation, and prepare and interpret a simple
set of financial statements.
6
• The statement of income is normally the first financial statement prepared. This statement, which includes all revenues and
expenses, provides the net income figure that is required for all
of the other financial statements.
2-36
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
• The statement of changes in equity is the next financial statement prepared. It illustrates any changes in the number of
shares, changes in the dollar value of share capital, and changes
to the Retained Earnings account (due to net income or loss or
the declaration of dividends).
• The statement of financial position is a vertical presentation of
the accounting equation. It includes all assets, liabilities, and
shareholders’ equity accounts. It is often prepared on a classified
basis, meaning that asset and liability accounts are presented in
order of liquidity. Current assets are presented separately from
non-current assets, while current liabilities are presented separately from non-current liabilities.
• All assets expected to be received, realized, or consumed within
the next 12 months are considered to be current assets. All liabilities expected to be settled or paid within the next 12 months are
considered to be current liabilities.
• The final financial statement to be prepared is the statement of
cash flows. This statement categorizes all transactions of a business that affect cash into three categories: operating activities,
investing activities, and financing activities.
Calculate and interpret three ratios used to assess the
profitability of a company.
7
• The profit margin ratio is calculated by dividing net income by
sales revenue. It indicates the percentage of sales revenue that
remains after all expenses, including income taxes, have been
recorded.
• The return on equity ratio is calculated by dividing net income
by average shareholders’ equity. It compares profit relative to
the amount invested by shareholders. It provides shareholders
with a sense of the returns being generated on their equity in
the company.
• The return on assets ratio is calculated by dividing net income
by average total assets. It provides an indication of how effective
management has been at generating a return given the assets at
their disposal.
Key Terms
Accounting Standards for Private Enterprises
(ASPE) 2-3
Accounts 2-12
Accrual basis of accounting 2-9
Carrying amount 2-28
Cash basis of accounting 2-9
Classified statement of financial position 2-28
Comparability 2-5
Complete 2-7
Conceptual frameworks 2-5
Confirmatory value 2-6
Cost constraint 2-7
Cost of goods sold 2-18
Credit purchase 2-17
Depreciation 2-22
Double-entry accounting system 2-11
Earned 2-10
Enhancing qualitative characteristics 2-5
Estimated residual value 2-22
Estimated useful life 2-22
Five-step process for revenue recognition 2-10
Free from error 2-7
Fundamental qualitative characteristics 2-5
Going concern assumption 2-8
Going concern basis 2-8
Immaterial 2-6
Incorporation 2-14
Incurred 2-10
Interlisted 2-3
International Financial Reporting Standards
(IFRS) 2-3
Material 2-6
Materiality 2-6
Net book value 2-28
Abbreviations Used
AcSB
ASPE
A/P
A/R
CRA
FASB
GAAP
IASB
IFRS
Accounting Standards Board
Accounting Standards for Private Enterprises
accounts payable
accounts receivable
Canada Revenue Agency
Financial Accounting Standards Board
generally accepted accounting principles
International Accounting Standards Board
International Financial Reporting Standards
Neutral 2-7
Predictive value 2-6
Profit margin ratio 2-32
Prudence 2-7
Purchasing on account 2-17
Relevant 2-5
Representationally faithful 2-5
Return on assets 2-34
Return on equity 2-33
Straight-line depreciation 2-23
Synoptic approach 2-11
Template approach 2-11
Timeliness 2-5
Understandability 2-5
Useful life 2-22
Verifiability 2-5
Chapter End Review Problem 2-2
NYSE
OSC
PP&E
R/E
SEC
S/H
TSX
2-37
New York Stock Exchange
Ontario Securities Commission
property, plant, and equipment
retained earnings
Securities and Exchange Commission
shareholders’
Toronto Stock Exchange
Synonyms
Carrying amount | Net book value
Interlisted | Cross-listed | Dual-listed
Purchase on account | Credit purchase
Template approach | Synoptic approach
Chapter End Review Problem 2-1
Required
i. Timeliness
Identify whether the following characteristics are fundamental or
enhancing qualitative characteristics. If neither, state that.
k. Reliability
a. Verifiability
b. Conservatism
c. Responsive
d. Relevance
e. Understandability
f. Comparability
j. Substance over form
STRATEGIES FOR SUCCESS
• A starting point for remembering the qualitative
characteristics is to distinguish the fundamental
qualitative characteristics from the enhancing
qualitative characteristics.
g. Quantifiable
• Each of the two fundamental qualitative characteristics
has three subcharacteristics.
h. Faithful representation
• There are four enhancing qualitative characteristics.
Chapter End Review Problem 2-2
Required
Indicate whether and how each of the following transactions would
affect net income (increase, decrease, or no effect) if the Little
­Furniture Company (LFC) followed: (a) the cash basis of accounting
and (b) the accrual basis of accounting.
1. November 2: A customer places an order with LFC for a piece of
custom furniture.
2. November 3: The customer pays LFC a $1,500 deposit for the custom order.
3. November 5: LFC purchases on account the materials needed to
construct the piece of custom furniture.
4. November 15: LFC pays for the material purchased on November 5.
5. November 22: LFC completes the work to make the piece of custom furniture.
6. November 24: LFC delivers the custom furniture to the customer’s home and invoices the customer.
7. November 28: The customer pays LFC the amount invoiced on
November 24.
STRATEGIES FOR SUCCESS
• Under the cash basis of accounting, revenues are
recorded when cash is received, and expenses are
recorded when cash is paid. As such, focus on whether
cash was received or paid when trying to determine
how each transaction might affect net income under
the cash basis of accounting.
• Under the accrual basis of accounting, revenues are
recorded when they are earned, and expenses are recorded
when they are incurred. Normally, goods or services
must be provided to a customer before revenue is earned.
Expenses are incurred when there has been a decrease in
economic resources for the purpose of generating revenues.
2-38
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Chapter End Review Problem 2-3
Doing this problem will reinforce and extend what you have learned in this chapter. You should carefully
work through the following problem and then check your work against the suggested solution.
Exhibit 2.13 shows the statement of financial position of Alahai Ltd. at December 31, 2023. Note
that the company has a December 31 year end and that these balances will be opening balances for the
company’s accounts at January 1, 2024.
EXHIBIT 2.13 Alahai Ltd.’s
Statement of Financial
Position
ALAHAI LIMITED
Statement of Financial Position
As at December 31, 2023
ASSETS
Current assets
Cash
$4,500
Accounts receivable
2,500
Inventory
7,500
Prepaid rent
1,000
$15,500
Non-current assets
Equipment
9,500
TOTAL ASSETS
$25,000
LIABILITIES
Current liabilities
Accounts payable
$3,100
Wages payable
1,300
$ 4,400
Non-current liabilities
Bank loan payable
3,500
TOTAL LIABILITIES
7,900
SHAREHOLDERS’ EQUITY
Common shares
10,600
Retained earnings
6,500
TOTAL SHAREHOLDERS’ EQUITY
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
The following transactions occurred during 2024:
1. Additional inventory was purchased for $39,700 on account.
2. Goods with selling prices totalling $80,000 were sold, all on
account. These goods cost Alahai Ltd. $38,200.
3. The company received $78,400 from customers as payments on
accounts receivable.
4. The company paid $37,300 to suppliers on its accounts payable.
5. The company issued 10,000 common shares to investors for
$20,000 cash. This brought the total number of issued common
shares to 20,600.
6. New equipment was purchased for $15,000 cash during the year.
7. Dividends of $1,500 were declared and paid during the year.
17,100
$25,000
8. Employees earned wages for the year totalling $20,500. (Hint:
The next transaction deals with the payment of wages. Therefore, at this point the wages should be recorded as payable.)
9. Cash payments for wages during the year totalled $20,800.
10. The rent for each month was prepaid on the last day of the previous month. Accordingly, a payment of $1,000 was made on
December 31, 2023, for the rent for the month of January 2024.
The rent payments during 2024 were $1,000 per month from
January 31 through November 30, and $1,200 on December 31
(because the rent was increased for 2025). (Hint: Record the payments as prepaid rent initially; then, as a separate transaction,
transfer the cost for the year 2024 to rent expense.)
Solutions to Chapter End Review Problems
2-39
11. Interest on the bank loan, at 8%, was paid on December 31, 2024.
At the same time, $400 of the loan principal was repaid.
each of those items is increasing or decreasing, and enter
the effects in the table.
12. Depreciation expense on the company’s equipment totalled
$2,000 for the year.
• As you enter the effects of each transaction, ensure that
the basic accounting equation remains balanced (that is,
Assets = Liabilities + Shareholders’ Equity).
Required
a. Analyze and record the effects of each transaction on the company’s accounts using the template approach (as illustrated in this
chapter).
b. Use your answer for part (a) of this problem to prepare a statement of income, a statement of changes in equity, a statement of
financial position, and a statement of cash flows.
c. Calculate the following ratios for the year 2024:
i. Profit margin ratio
ii. Return on assets
iii. Return on equity
STRATEGIES FOR SUCCESS
• Start by setting up a table, such as the one in Exhibit
2.7 of this chapter. Use the account titles from Alahai’s
statement of financial position (in Exhibit 2.13) as the
column headings. Enter the beginning balances as the
first line of data in the table.
• Begin your analysis of each transaction by thinking
about what items are affected by it, bearing in mind that
there must be at least two. Then determine whether
• Watch for keywords such as collected, received, or paid,
indicating that cash has increased or decreased. On
the other hand, on account means that the collection,
receipt, or payment will occur later; in the meantime, an
account receivable or account payable will exist.
• Remember that revenues have to be earned by selling
goods or services. Issuing shares in the company does
not generate revenue, because the money that comes
in has not been earned by operating the business; it
has simply been invested by the owners. Similarly,
collecting accounts receivable from customers does not
generate revenue. The revenue is earned and recorded
when the goods are sold, not when the accounts are
collected.
• Be careful to distinguish between expenses and assets.
Expenses are costs that have been used up or consumed
in the process of operating the business and generating
revenues. Assets are costs that have not yet been
consumed and can be used to operate the business and
generate revenues in the future.
Chapter End Review Problem 2-4
Canada Goose Holdings Inc. reported the following amounts:
Canada Goose Holdings Inc. (amounts in millions)
2020
Total assets
2019
$1,112.7 $725.4
2018
$548.4
Total shareholders’ equity
520.2
399.1
243.6
Sales revenue
958.1
830.5
591.2
Net income
151.7
143.6
96.1
Required
a. Calculate the following ratios for the years 2020 and 2019, and
explain what they tell you:
i. Profit margin ratio
ii. Return on assets
Solutions to Chapter End Review Problems
Suggested Solution to Chapter End Review Problem 2-1
a. Verifiability: Enhancing
b. Conservatism: Neither
iii. Return on equity
b. Explain whether each of these ratios has improved or worsened
from 2019 to 2020.
STRATEGIES FOR SUCCESS
• Remember to calculate average shareholders’ equity for
the return on equity ratio and average total assets for
the return on assets ratio. These average numbers are
calculated by adding the opening shareholder’s equity
(or total assets) to the ending shareholders’ equity (or
total assets) and dividing this balance by two.
• Remember that for each of these ratios, a higher
number is better than a lower number, as it indicates
that the company has been able to generate more
profits as a percentage of sales or more profits relative
to either its total assets or shareholders’ equity.
2-40
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
c. Responsive: Neither
d. Relevance: Fundamental
e. Understandability: Enhancing
f. Comparability: Enhancing
g. Quantifiable: Neither
h. Faithful representation: Fundamental
i. Timeliness: Enhancing
j. Substance over form: Neither
k. Reliability: Neither
Suggested Solution to Chapter End Review Problem 2-2
Transaction
Cash Basis
Accrual Basis
1. November 2: A
customer places an
order with LFC for
a piece of custom
furniture.
No effect on net income,
because no cash is changing
hands.
No effect on net income, because no
revenue has been earned yet (because
no work has been completed).
2. November 3: The
customer pays LFC a
$1,500 deposit for the
custom order.
Increases net income,
because revenue would be
recorded as cash was received.
No effect on net income, because no
revenue has been earned yet (because
no work has been completed). This
would be recorded as deferred revenue
(a liability).
3. November 5: LFC
purchases on account
the materials needed to
construct the piece of
custom furniture.
No effect on net income,
because no cash is changing
hands.
No effect on net income, because
no expenses have been incurred yet
(because the materials would be
considered inventory until the work has
been completed).
4. November 15: LFC
pays for the material
purchased on
November 5.
Decreases net income,
because an expense would be
recorded as cash was paid out.
No effect on net income, because
no expenses have been incurred yet.
This would be recorded as payment of
accounts payable.
5. November 22: LFC
completes the work
to make the piece of
custom furniture.
No effect on net income,
because no cash is changing
hands.
No effect on net income, because no
revenue has been earned yet (because
the furniture has not been delivered to
the customer). It remains part of the
company’s inventory.
6. November 24: LFC
delivers the custom
furniture to the
customer’s home and
invoices the customer.
No effect on net income,
because no cash is changing
hands.
Increases net income, because
revenue would be recorded at this
point (because it has been earned).
The company would also record an
expense for the cost of the furniture,
which would decrease net income.
Because the company would have sold
the furniture for more than it cost
to produce, there would be a net
increase in net income, because the
revenue would exceed the expense.
7. November 28: The
customer pays LFC the
amount invoiced on
November 24.
Increases net income,
because revenue would be
recorded as cash was received.
No effect on net income, because the
revenue has already been recorded. This
would be recorded as the collection of
an account receivable.
Suggested Solution to Chapter End Review Problem 2-3
The template analysis (part (a) of the problem) is shown in Exhibit 2.14. The entries are numbered to
match the transaction numbers in the problem. The financial statements (required for part (b)) are shown
in Exhibits 2.15, 2.16, 2.17, 2.18, and 2.19. Following these, the ratios (required for part (c)) are presented.
Solutions to Chapter End Review Problems
EXHIBIT 2.14 Analysis of Transactions: Alahai Ltd.
Assets
Trans. #
Cash
A/R
Inv.
Opening
Balances
4,500
2,500
7,500
1
Liabilities
Prepaid
Rent
Equip.
A/P
Wages
Payable
1,000
9,500
3,100
1,300
3,500
Common
Shares
Retained
Earnings
10,600
6,500
80,000
2: 2
(38,200)
3
78,400
4
(37,300)
5
20,000
6
(15,000)
7
(1,500)
=
(20,800)
10: 1
(12,200)
(38,200)
E
(1,500)
DD
(20,500)
E
(12,000)
E
(280)
E
(2,000)
E
15,000
(20,800)
12,200
(12,000)
(400)
(680)
12
(2,000)
4,100
9,000
1,200
22,500
5,500
1,000
3,100
52,220
30,600
52,220
Explanations follow for selected transactions.
Part (a)
Transactions 8 and 9: Wages
The company’s wage expense for the period should be the amount of wages earned by employees during that
period. This may be different from the amounts actually paid to employees for wages during the same period.
The two amounts may differ due to payments being made for wages owing at the beginning of the year (the
opening balance in Wages Payable) or because some of the wages earned by the employees during the period
remain unpaid at the end of it. (These would be the amount of wages payable at the end of the period.)
Transaction 10: Rent
There were 12 rent payments during 2024:
• 11 × $1,000 = $11,000 (these were related to the rent for February to December 2024)
• 1 × $1,200 =
R
20,000
10: 2
15,420
80,000
(37,300)
20,500
9
R/E/
DD
(78,400)
8
11
Bank Loan
Payable
S/H Equity
39,700
39,700
2: 1
+
$ 1,200
(this was related to the rent for January 2025)
$12,200
However, the rent expense for 2024 is equal to:
• 1 × $1,000 = $ 1,000 (the rent for January 2024 was prepaid in December 2023)
$11,000
• 11 × $1,000 =
(the rent for February to December 2024)
$12,000
The final payment of $1,200 on December 31, 2024, is the rent for January 2025. It is an asset at the end
of 2024 and is recorded as prepaid rent.
Transaction 11: Loan Interest and Principal Repayment
During 2024, Alahai Ltd. incurred and paid interest of $280 on its bank loan, which was determined as
follows:
= Loan Principal × Annual Interest Rate × (number of months outstanding/12)
​ ​12
​​
= $3,500 × 8% × __
12
= $280
12,020
2-41
2-42
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
This interest is an expense to the company. Alahai Ltd. also repaid $400 in loan principal at the end of
the year. Repaying the principal of a loan does not create an expense; it simply reduces the loan liability.
Part (b)
EXHIBIT 2.15 Statement of
ALAHAI LIMITED
Statement of Income
For the year ended December 31, 2024
Income
Sales revenue
$80,000
Cost of goods sold
38,200
Gross profit
41,800
Wage expense
20,500
Rent expense
12,000
Depreciation expense
2,000
Interest expense
280
Net income
EXHIBIT 2.16 Statement of
Changes in Equity
$ 7,020
ALAHAI LIMITED
Statement of Changes in Equity
For the year ended December 31, 2024
Balance, Jan. 1
Number of
Common Shares
Share Capital—
Common Shares
10,600
$10,600
Retained
Earnings
$ 6,500
Total
$17,100
Net income
—
—
7,020
7,020
Declaration of dividends
—
—
(1,500)
(1,500)
Issuance of common
shares
10,000
20,000
—
20,000
Balance, Dec. 31
20,600
$30,600
$12,020
$42,620
EXHIBIT 2.17 Statement of
Financial Position
ALAHAI LIMITED
Statement of Financial Position
As at December 31, 2024
ASSETS
Current assets
Cash
$15,420
Accounts receivable
4,100
Inventory
9,000
Prepaid rent
1,200
$29,720
Non-current assets
Equipment
22,500
TOTAL ASSETS
$52,220
LIABILITIES
Current liabilities
Accounts payable
Wages payable
$ 5,500
1,000
$ 6,500
Solutions to Chapter End Review Problems
2-43
EXHIBIT 2.17 Statement of
Financial Position (continued)
ALAHAI LIMITED
Statement of Financial Position
As at December 31, 2024
Non-current liabilities
Bank loan payable
3,100
TOTAL LIABILITIES
9,600
SHAREHOLDERS’ EQUITY
Common shares
30,600
Retained earnings
12,020
TOTAL SHAREHOLDERS’ EQUITY
42,620
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
Date
Cash
Description
1
No cash effect
2: 1
No cash effect
2: 2
$52,220
Operating
Activity
78,400
4
(37,300)
Collected from customers
Paid suppliers
5
20,000
Issued common shares
6
(15,000)
Purchased equipment
7
(1,500)
8
EXHIBIT 2.18 Analysis of
Alahai Ltd.’s Cash Account
78,400
(37,300)
20,000
(15,000)
Paid dividends
(1,500)
No cash effect
9
(20,800)
Paid wages
(20,800)
10: 1
(12,200)
Paid rent
(12,200)
10: 2
No cash effect
(680)
12
Total
Financing
Activity
No cash effect
3
11
Investing
Activity
Paid loan principal and
interest
(280)
(400)
No cash effect
10,920
7,820
(15,000)
18,100
EXHIBIT 2.19 Statement of
ALAHAI LIMITED
Statement of Cash Flows
For the year ended December 31, 2024
Cash Flows
Cash flows from operating activities
Cash received from customers
$ 78,400
Cash paid for inventory
(37,300)
Cash paid for wages
(20,800)
Cash paid for rent
(12,200)
Cash paid for interest
Total cash flows from operating activities
(280)
7,820
A
Cash flows from investing activities
Cash paid to purchase equipment
Total cash flows from investing activities
(15,000)
(15,000)
B
2-44
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
EXHIBIT 2.19 Statement of
Cash Flows (continued)
ALAHAI LIMITED
Statement of Cash Flows
For the year ended December 31, 2024
Cash flows from financing activities
Cash received from issuance of shares
20,000
Cash payments of dividends
(1,500)
Cash repayments of bank loan principal
(400)
Total cash flows from financing activities
18,100
C
Net change in cash during the period
10,920
=A+B+C
Cash balance on January 1, 2024
4,500
$ 15,420
Cash balance on December 31, 2024
Part (c)
Profit Margin = Net Income/Sales Revenue
= 7,020/80,000
= 0.0878 or 8.78%
Return on Equity = Net Income/Average Total Shareholders’ Equity
= 7,020/((17,100 + 42,620)/2)
= 7,020/29,860
= 0.235 or 23.5%
Return on Assets = Net Income/Average Total Assets
= 7,020/((25,000 + 52,200)/2)
= 7,020/38,610
= 0.182 or 18.2%
Suggested Solution to Chapter End Review Problem 2-4
Part (a)
i. Profit margin ratio
2020
2019
Profit margin = 151.7/958.1
= 0.158 or 15.8%
= 143.6/830.5
= 0.173 or 17.3%
Canada Goose was able to generate $0.158 in profits from every $1 in sales in 2020.
ii. Return on assets
2020
Return on assets = 151.7/((725.4 + 1,112.7)/2)
= 151.7/919.05
= 0.165 or 16.5%
2019
= 143.6/((548.4 + 725.4)/2)
= 143.6/636.9
= 0.225 or 22.5%
Canada Goose earned profit at a rate of $0.165 for every $1 invested in assets in 2020.
Discussion Questions 2-45
iii. Return on equity
2020
Return on equity = 151.7/((399.1 + 520.2)/2)
= 151.7/459.65
= 0.330 or 33.0 %
2019
= 143.6/((243.6 + 399.1)/2)
= 143.6/321.35
= 0.447 or 44.7%
Canada Goose earned profit at a rate of $0.330 for every $1 invested by shareholders in 2020.
(b) Explain whether each of these ratios has improved or worsened from 2019 to 2020.
i. Profit margin ratio: Worsened in 2020, as the ratio was lower.
ii. Return on equity: Worsened in 2020, as the ratio was lower.
iii. Return on assets: Worsened in 2020, as the ratio was lower.
Assignment Material
Discussion Questions
DQ2-1 Identify and explain the advantages of using IFRS for interlisted public companies.
semester that is paid for at the beginning of the semester? How would
this change under the cash basis of accounting?
DQ2-2 Explain the difference between a fundamental qualitative
characteristic and an enhancing qualitative characteristic.
DQ2-12 Explain how a prepaid expense (such as rent) is handled
under accrual basis accounting.
DQ2-3 Explain how the fundamental qualitative characteristics of
relevance and representational faithfulness may be in conflict when
deciding the amount at which land is carried on a company’s statement of financial position.
DQ2-13 Explain how an accrued expense (such as interest) is handled under accrual basis accounting.
DQ2-4 Explain how the conceptual framework is useful in situations where there is no specific accounting standard for a particular
transaction.
DQ2-5 In your own words, define materiality, and identify the fundamental qualitative characteristic that it is related to.
DQ2-6 Explain how the cost constraint is applied by companies
when determining what financial information should be reported.
DQ2-7 Explain, in your own words, the going concern assumption
and what the implications are in terms of a company’s financial statements if the assumption is not valid.
DQ2-8 Explain, in your own words, the difference between the cash
basis of accounting and the accrual basis of accounting.
DQ2-9 What are the advantages and disadvantages of using the
accrual basis of accounting rather than the cash basis?
DQ2-10 Explain two ways that management could manipulate net
income if a company used the cash basis of accounting. Also explain
how these are prevented under the accrual basis of accounting.
DQ2-11 Under the accrual basis of accounting, when would your
university or college bookstore recognize revenue from the sale
of textbooks? What about from the sale of a parking pass for the
DQ2-14 Describe how the basic accounting equation (or statement
of financial position equation) is used to analyze how transactions are
recorded in the template system.
DQ2-15 Discuss why dividends do not appear on the statement of
income but do appear on the statement of cash flows.
DQ2-16 Explain why revenues are recorded as increases to retained
earnings in the template system.
DQ2-17 Explain why no interest expense is recorded at the time a
company takes out a new loan. Also explain when interest expense
should be recorded.
DQ2-18 Explain why prepaid insurance is considered to be an asset.
What happens to this asset over time?
DQ2-19 Explain what depreciation is and how it is calculated using
the straight-line method.
DQ2-20 Explain why companies depreciate their buildings and
equipment.
DQ2-21 Explain what is meant by estimated residual value. Why is it
subtracted from the asset’s cost when calculating depreciation under
the straight-line method?
DQ2-22 Briefly explain why it is necessary to prepare the statement
of income before preparing the statement of changes in shareholders’
equity.
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C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
DQ2-23 Identify the three major sections in the statement of cash flows,
and briefly describe the nature of the items that appear in each section.
b. In the cash basis of accounting, there is no such thing as a prepaid
rent account.
DQ2-24 In the first two chapters, we have discussed financing,
investing, and operating activities in the business cycle (or statement
of cash flows). Identify one example of a financing activity that would
result in an outflow of cash and one example of an investing activity
that would result in an inflow of cash.
c. In the accrual basis of accounting, paying an account payable creates an expense.
DQ2-25 In the first two chapters, we have discussed financing,
investing, and operating activities in the business cycle (or statement
of cash flows). Identify one example of a financing activity that would
result in an inflow of cash and one example of an investing activity
that would result in an outflow of cash.
DQ2-26 Indicate whether each of the following statements is true or
false:
a. The cash basis of accounting recognizes revenues when they are
received.
d. In the accrual basis of accounting, interest should be recognized
only when it is paid.
e. Cash receipts from customers increase accounts receivable.
f. Expenses decrease shareholders’ equity.
g. Dividends are an expense of doing business and should appear on
the statement of income.
h. Interest paid on bank loans is reported in the operating activities
section of the statement of cash flows.
DQ2-27 Explain, in your own words, why the normal cash flow pattern is generally + / – / + (operating / investing / financing).
Application Problems Series A
AP2-1A
(Qualitative characteristics of the conceptual framework)
Required
Identify the following qualitative characteristics as F (fundamental) or E (enhancing):
a. Understandability
b. Faithful representation
c. Timeliness
d. Comparability
e. Verifiability
f. Relevance
AP2-2A
(Cash basis versus accrual basis)
Required
Based on the following transactions, calculate the revenues, expenses, net income that would be reported
(a) on the cash basis and (b) on the accrual basis:
i. Purchased inventory with a cost of $23,000 on account.
ii. Sales on account to customers totalled $56,000.
iii. Payments made to employees for wages totalled $18,000.
iv. Cash collections from customers settling their accounts totalled $41,000.
v. Invoice received from the utility company for $3,800 is due in 30 days.
vi. Payments totalling $19,000 were made to suppliers to settle part of the balance owing to them.
vii. Received a deposit of $2,200 from a customer for goods to be delivered next month.
AP2-3A
(Transaction analysis and the basic accounting equation)
Required
For each of the following transactions, indicate the effect on the basic accounting equation (Assets =
Liabilities + Shareholders’ Equity):
a. Issuance of shares for cash.
b. Purchase of land for cash.
c. Sale of services to a customer on credit.
d. Receipt of cash from customers as payments on their accounts.
e. Payment of cash to shareholders as a distribution of earnings.
f. Receipt of a loan from a bank.
g. Payment of interest on the bank loan.
Application Problems Series A
h. Purchase of inventory on credit.
i. Payment of an account payable.
j. Payment to a courier company for delivering goods to a customer.
k. Payment of an insurance premium to cover the following year.
l. Depreciation of equipment.
AP2-4A (Transaction analysis)
Required
For each of the transactions below, indicate which accounts are affected and whether they are increased
or decreased:
a. Sold shares for cash.
b. Borrowed money from a bank.
c. Bought equipment from a supplier on credit.
d. Bought inventory from a supplier, partly for cash and partly on account.
e. Sold inventory to a customer on account. (Hint: Your answer should deal with both the revenue and
the related expense.)
f. Made a payment on an account owing to a supplier.
g. Received a payment from a customer on account.
h. Bought supplies for cash.
i. Declared and paid a dividend.
j. Accrued the interest on the money that was borrowed in transaction (b) (that is, recognized the
interest but did not pay it).
k. Paid for the equipment that was purchased on credit in transaction (c).
l. Used some of the supplies that were purchased in transaction (h).
AP2-5A (Transaction analysis and the basic accounting equation) Bounce House Party Supply
Ltd. rents bouncy castles and inflatable slides for parties, school fairs, and company picnics. The company also sells party supplies such as balloons, streamers, and piñatas. The company started business in
September and had the following transactions in its first month:
Date:
Sept. 1
Bounce House Party Supply Ltd. issued 40,000 common shares for $260,000 cash.
1
The company took out a $160,000 bank loan with an interest rate of 6%. The loan
terms require that Bounce repay $3,000 in principal on the last day of each month,
plus interest.
3
Bounce purchased 10 inflatable slides and bouncy castles at a cost of $140,000. The
company paid $100,000 at the time of purchase, and the balance is due in 30 days.
8
Bounce purchased balloons and other party supplies costing $6,600 on account.
11
A major local company paid Bounce a $2,500 deposit to reserve all of Bounce’s
inflatables for a grand opening function that is scheduled for the second week in
October.
15
Bounce recorded the first two weeks of the month’s party supply sales. Total sales (half
in cash and half on account) amounted to $8,600, and the inventory related to these
sales was determined to have a cost of $5,700.
19
Bounce paid its suppliers $1,700 for goods previously purchased on account.
23
Collections from customers on account totalled $3,400.
30
Bounce made the loan payment required under the terms of the borrowing agreement.
Required
Analyze and record these transactions using the template method.
Assets
Date/Ref.
Cash
A/R
Inv.
Liabilities
Inflatable
Equip.
A/P
Deferred
Revenue
S/H Equity
Loan
Payable
Common
Shares
Retained
Earnings
R/E/DD
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C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
AP2-6A (Transaction analysis and the basic accounting equation) Nearly Meat Ltd. (NML) is a
commercial distributor of plant-based meat substitutes to grocery stores and chains in Western Canada. NML
and the company’s management team have successfully grown the operation to the point where they are able
to distribute their products nationally. NML had the following transactions in the month of September:
Sept.
1
NML borrowed $20,000 from the bank. The interest rate on the loan is 3% per annum,
and the terms of the loan state that the loan is to be repaid at the end of each month in
the amount of $1,500 per month plus interest.
1
NML renewed the annual insurance policy covering its warehouse and paid the
premium for the 12-month policy in the amount of $3,300. The term of the policy is
from September 1 to August 31 of the following year.
4
The company purchased inventory at a cost of $36,000 from a producer on account.
10
NML recorded its sales for the first 10 days of the month. Total sales (half in cash and
half on account) amounted to $22,200, and the inventory related to these sales was
determined to have a cost of $15,600.
19
Paid $5,000 to suppliers who had previously sold NML inventory on account.
27
Paid employee wages in the amount of $5,100.
29
NML accepted a payment of $5,000 from a local independent grocer who placed
an order for 500 kg of plant-based sausages to be delivered in mid-October for an
Oktoberfest promotion.
30
NML made the necessary month-end entry related to the insurance policy.
30
NML made the necessary month-end entry related to record the bank loan.
Required
Analyze and record these transactions using the template method.
Assets
Date/Ref.
Cash
A/R
Liabilities S/H Equity
Prepaid
Inv.
Ins.
Deferred
Revenue
A/P
Loan
Payable
Retained
Earnings
R/E/DD
AP2-7A (Transaction analysis and the basic accounting equation)
Required
For each of the following transactions, indicate how (a) net earnings and (b) cash flows are affected. For
each, state whether there will be an increase, a decrease, or no effect, and the amount (if any):
i. Issued shares to investors for $60,000.
ii. Purchased inventory from suppliers for $2,500, on account.
iii. Purchased office supplies for $500.
iv. Sold a unit of inventory for $500, on account. The unit cost $300 and was already in inventory prior
to its sale.
v. Purchased equipment for $10,000 cash.
vi. Made a payment of $1,000 on accounts payable.
vii. Used $300 of the supplies purchased in transaction (iii).
viii. Received a payment of $700 from a customer for inventory previously sold on account.
ix. Declared (but did not yet pay) a dividend of $2,000.
x. Paid the $2,000 dividend that was declared above.
xi. Depreciated equipment by $500.
AP2-8A
(Transaction analysis and the basic accounting equation)
Required
Analyze the following transactions and show their effects on the basic accounting equation by preparing
a template as follows:
Assets
Date/Ref.
Cash
A/R
Inv.
Supplies
Liabilities
Equip.
A/P
Loan
Payable
S/H Equity
Common
Shares
Retained
Earnings
R/E/DD
Application Problems Series A
a. Received $150,000 from investors buying shares in the company.
b. Bought equipment for $50,000. Paid half in cash, with the remainder to be paid in six months.
c. Bought inventory costing $45,000, on account.
d. Sold inventory costing $35,000 to customers, on account, for $52,000.
e. Made a payment of $1,000 on accounts payable.
f. Borrowed $25,000 from a bank. The interest on the loan is 6% per year.
g. Depreciated equipment by $1,200.
h. Paid $750 for supplies to be used in the future.
i. Paid $250 to the power company for electricity used during the period.
j. Declared and paid dividends of $8,000.
AP2-9A (Transaction analysis and the basic accounting equation)
Required
Show the effect of each of the following transactions on the basic accounting equation by preparing a
template like the one below. The company’s fiscal year end is December 31.
Assets
Date/Ref.
Cash
A/R
Inv. Equipment
Liabilities
A/P
Wages
Payable
S/H Equity
Loan
Payable
Common
Shares
R/E R/E/DD
a. On January 1, the company issued shares for $75,000.
b. On January 1, the company borrowed $60,000 from the bank.
c. On January 1, the company bought equipment for $10,000 cash.
d. Purchases of inventory on account during the year totalled $87,500.
e. Sales for the year totalled $147,500, of which $17,500 was for cash and the remainder was on
account.
f. The cost of the products sold from inventory during the year in transaction (e) was $85,000.
g. Payments to suppliers for inventory purchases totalled $73,000 during the year.
h. Collections on account from customers totalled $116,000 for the year.
i. Employees earned wages of $48,400 during the year. All of the wages were paid by the end of the
year except the wages for the last week in December, which totalled $1,200.
j. On December 31, the company paid the interest on the bank loan in transaction (b). The interest rate
is 6%.
k. Dividends were declared and paid in the amount of $1,000.
l. On December 31, the company recorded depreciation on the equipment, using the straight-line
method. The equipment has an estimated useful life of six years and an estimated residual value of
$1,000.
AP2-10A
(Determination of the missing amounts using financial statement relationships)
Required
For the two independent cases that follow, determine the missing amount for each letter. (Hint: You
might not be able to calculate them in the order in which they appear.)
Case 1
Case 2
Revenues
A
850,000
Expenses
510,000
550,000
Net income
215,000
A
Dividends declared during the year
100,000
B
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C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
Retained earnings:
Beginning
850,000
C
B
965,000
1,890,000
1,880,000
C
2,200,000
D
850,000
860,000
D
Ending
Total assets:
Beginning
Ending
Total liabilities:
Beginning
Ending
Common shares:
Beginning
E
250,000
Ending
350,000
350,000
Proceeds from issuing additional common shares
during the year
100,000
E
AP2-11A (Determination of revenues, expenses, and dividends) The following information for
the current year was obtained from the accounting records of Safari Supplies Corporation:
Retained earnings, beginning
$ 96,000
Retained earnings, ending
105,600
Sales revenue
448,800
Cost of goods sold
272,000
Selling expenses
63,300
General and administrative expenses
38,800
Dividend revenue
4,800
Interest revenue
2,200
Interest expense
1,200
Income tax expense
26,400
Required
Calculate the following items:
a. Total revenues
b. Total expenses
c. Net earnings
d. Dividends declared
AP2-12A (Determination of statement of income and statement of financial position amounts)
Trepanier Ltd. had the following transactions in its first month of operations:
1. Issued 20,000 common shares in exchange for $100,000 cash.
2. Took out a $22,000 loan from the bank.
3. Paid $25,000 to purchase inventory.
4. Equipment costing $36,000 was purchased for $6,000 cash, with the balance on account.
5. Made sales of $48,000 to customers, with $10,000 being cash sales and the balance on account.
6. The cost of the inventory sold to customers was $22,000.
7. Paid employee wages totalling $7,000.
8. Operating expenses of $2,200 were paid during the month.
9. Deprecation of $600 was recorded for the month.
10. Dividends of $1,000 were declared and paid during the month.
Application Problems Series A
Required
a. Calculate the following amounts for the month:
i. Sales revenue
ii. Cost of goods sold
iii. Total expenses other than cost of goods sold
iv. Net income or loss
b. Calculate the following amounts as at the end of the month:
i. Cash on hand
ii. Total assets other than cash
iii. Total liabilities
iv. Share capital
v. Retained earnings
AP2-13A (Preparation of statement of income and statement of financial position) The
­Wizard’s Corner, a company that sells video games and related items, had the following account balances
at the end of June 2024:
Cost of goods sold
$103,000
Common shares
Advertising expense
Equipment
Depreciation expense
Dividends declared
33,000
6,000
11,000
2,000
3,000
Accounts payable
11,000
Inventory
28,000
Wages expense
36,000
Sales revenue
190,000
Accounts receivable
15,000
Rent expense
12,000
Cash
40,000
Prepaid rent
1,000
Wages payable
2,000
Retained earnings (as at July 1, 2023)
21,000
Required
a. Prepare a statement of income for the year ended June 30, 2024.
b. Calculate the amount of retained earnings as at June 30, 2024.
c. Prepare a classified statement of financial position as at June 30, 2024.
AP2-14A (Transaction analysis and financial statement preparation) Singh Company started
business on January 1, 2024. The following transactions occurred in 2024:
1. On January 1, the company issued 10,000 common shares for $250,000.
2. On January 2, the company borrowed $50,000 from the bank.
3. On January 3, the company purchased land and a building for a total of $200,000 cash. The land was
recently appraised at a fair market value of $60,000. (Note: Because the building will be depreciated in
the future and the land will not, these two assets should be recorded in separate accounts.)
4. Inventory costing $130,000 was purchased on account.
5. Sales to customers totalled $205,000. Of these, $175,000 were sales on account.
6. The cost of the inventory that was sold to customers in transaction 5 was $120,000.
7. Payments to suppliers on account totalled $115,000.
8. Collections from customers on account totalled $155,000.
9. Payments to employees for wages were $55,000. In addition, there was $2,000 of unpaid wages at
year end.
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C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
10. The interest on the bank loan was recognized for the year. The interest rate on the loan was 6%.
11. The building was estimated to have a useful life of 30 years and a residual value of $20,000. The company uses the straight-line method of depreciation.
12. The company declared dividends of $7,000 on December 15, 2024, to be paid on January 15, 2025.
Required
a. Analyze the effects of each transaction on the basic accounting equation, using a template like the
one below:
Assets
Date/Ref.
Cash
A/R
Inv.
Liabilities
Building
Land
A/P
Wages
Payable
Interest
Payable
S/H Equity
Dividends
Payable
Loan
Payable
Common
Shares
R/E
R/E/DD
b. Prepare a statement of income, a statement of changes in equity, a statement of financial position
(unclassified), and a statement of cash flows for 2024.
AP2-15A (Transaction analysis and financial statement presentation) Hughes Tools Company
started business on October 1, 2023. Its fiscal year runs through to September 30 of the following year.
The following transactions occurred in the fiscal year that started on October 1, 2023, and ended on
September 30, 2024.
1. On October 1, 2023, Jill Hughes invested $175,000 to start the business. Hughes is the only owner.
She was issued 10,000 common shares.
2. On October 1, Hughes Tools borrowed $225,000 from a venture capitalist (a lender who specializes
in start-up companies) and signed a note payable.
3. On October 1, the company rented a building. The rental agreement was a two-year contract requiring quarterly rental payments (every three months) of $15,000, payable in advance. The first payment was made on October 1, 2023 (covering the period from October 1 to December 31). Thereafter,
payments were due on December 31, March 31, June 30, and September 30 for each three-month
period that followed. All of the rental payments were made as specified in the agreement.
4. On October 1, the company purchased equipment costing $220,000 for cash.
5. Initial inventory was purchased for $90,000 cash.
6. Additional purchases of inventory during the year totalled $570,000, all on account.
7. Sales during the year totalled $800,000, of which $720,000 were on account.
8. Collections from customers on account totalled $650,000.
9. Payments to suppliers on account totalled $510,000.
10. The cost of the inventory that was sold during the year was $560,000.
11. Selling and administrative expenses totalled $86,500 for the year. Of this amount, $4,000 was unpaid
at year end.
12. Interest on the note payable from the venture capitalist was paid at year end (September 30, 2024).
The interest rate on the note is 10%. In addition, $25,000 of the note principal was repaid at that
time.
13. The equipment was depreciated based on an estimated useful life of 10 years and an estimated residual value of $20,000.
14. The company declared and paid a dividend of $7,000.
Required
a. Show the effects of the transactions on the basic accounting equation by preparing a template like
the one below:
Assets
Date/Ref.
Cash
A/R
Prepaid
Rent
Inventory
Liabilities
Equipment
A/P
Notes
Payable
S/H Equity
Common
Shares
R/E
R/E/DD
Application Problems Series B
b. Prepare a statement of income, a statement of changes in equity, a statement of financial position,
and a statement of cash flows for the year.
c. Comment on the results of the company’s first year of operations.
Application Problems Series B
AP2-1B (Qualitative characteristics of the conceptual framework)
Required
Identify which of the fundamental qualitative characteristics each of the following traits are related to: R
(relevance) or F (faithful representation):
a. Confirmatory value
b. Neutrality
c. Completeness
d. Predictive value
e. Materiality
f. Freedom from error
AP2-2B (Cash basis versus accrual basis)
Required
Based on the following transactions, calculate the revenues, expenses, and net income that would be
reported on (a) the cash basis and (b) the accrual basis:
i. Inventory costing $70,000 was purchased on account.
ii. Inventory costing $60,000 was sold for $100,000. Eighty percent of the sales were for cash.
iii. Cash collected from credit customers (those who bought on account) totalled $20,000.
iv. A lease was signed at the beginning of the year, requiring monthly payments of $1,000. The rent for
the first month was paid when the lease was signed. After that, the $1,000 rent was paid on the last
day of each month, to cover the following month.
v. Supplies costing $5,500 were purchased for cash. At the end of the year, $500 of the supplies were
still unused.
vi. Wages of $37,500 were paid during the year. Also, wages of $500 remained unpaid at year end.
AP2-3B (Transaction analysis and the basic accounting equation)
Required
For each of the following transactions, indicate the effect on the basic accounting equation (Assets =
Liabilities + Shareholders’ Equity):
a. Purchase of equipment for cash.
b. Receipt of a loan from a bank.
c. Purchase of inventory on account.
d. Sale of services to a customer for cash.
e. Payment of account payable.
f. Recorded wages owed to employees.
g. Payment of interest on loan.
h. Repayment of loan principal.
i. Payment of wages owed to employees that were recorded in transaction (f).
j. Purchase of inventory on credit.
k. Payment of utility expenses.
l. Recorded depreciation on the equipment.
AP2-4B (Transaction analysis)
Required
For each transaction below, indicate which accounts are affected and whether they are increased or decreased:
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C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
a. Issued shares in exchange for cash.
b. Purchased land for cash.
c. Purchased inventory on account.
d. Purchased equipment for cash.
e. Took out and paid a one-year insurance policy on the new equipment.
f. Received an invoice for advertising in the local paper that is due in 15 days.
g. Sold inventory to a customer on account. (Hint: Your answer should deal with both the revenue and
the related expense.)
h. Paid the advertising bill from transaction (f).
i. Paid the supplier for the goods purchased in transaction (c).
j. Received a payment from the customer for the goods sold in transaction (g).
k. Recorded the insurance expense for the month for the insurance policy taken out in transaction (e).
l. Recorded depreciation for the month on the equipment purchased in transaction (d).
AP2-5B (Transaction analysis and the basic accounting equation) The following transactions
of Carswell Wholesale Inc. occurred in the month of September:
Date:
Sept.
1
Issued 200 common shares for $20,000.
4
To raise additional capital, Carswell borrowed $10,000 from the bank on a long-term loan.
7
Purchased equipment for $4,500.
9
Purchased inventory costing $2,500 on account.
15
Sold units from inventory to customers, on account, for $4,000.
19
Purchased additional inventory, on credit, at a cost of $2,100 to replace the units sold.
20
Made payments of $2,700 on its accounts payable.
21
Purchased a used delivery van for $15,000.
28
At month end, counted inventory and determined that the cost of the units sold on
September 15 totalled $1,800.
28
Paid employee wages of $700 for the month.
29
Received an invoice from the local newspaper for $400 for advertising run during the
month of September. The invoice is due on October 15.
30
Paid utilities costs of $150 for the month.
30
During the month, Carswell received $2,200 from customers as payments on their accounts.
Required
Analyze and record these transactions using the template method.
Assets
Date/Ref.
Cash
A/R
Inv.
Equip.
Liabilities
Delivery
Van
A/P
Bank Loan
Payable
S/H Equity
Common
Shares
R/E
R/E/DD
AP2-6B (Transaction analysis and the basic accounting equation) Primrose Beauty Supplies
Ltd. was incorporated in January. Primrose had the following transactions in its first month:
Date:
Jan. 1
Received $150,000 in exchange for issuing 15,000 common shares.
1
Borrowed $100,000 from the local bank at 9%. The terms of the borrowing agreement
state that the loan is to be repaid at the end of each month in the amount of $5,000 per
month plus interest.
2
Leased a commercial warehouse, paying $8,000, of which $5,000 represented a damage
deposit and $3,000 was the rent for January.
8
Purchased nail art kits, which it expects will become a best sellng-product line, costing
$26,200 on account.
Application Problems Series B 2-55
12
A chain of beauty salons paid Primrose a deposit of $6,500 related to a special order of
hair products that were to be custom packaged under the salon’s logo. Primrose agreed
to deliver these products on February 15.
16
Recorded its sales of the first two weeks of the month. Total sales (half in cash and
half on account) amounted to $18,200, and the inventory related to these sales was
determined to have a cost of $9,200.
19
Paid the suppliers $7,000 for goods previously purchased on account.
25
Collections from customers on account totalled $7,100.
31
Made the loan payment required under the terms of the borrowing agreement.
Required
Analyze and record these transactions using the template method.
Assets
Date/Ref.
AP2-7B
Cash
A/R
Liabilities
Inv.
Prepaid
Rent
A/P
Deferred
Revenue
S/H Equity
Loan Payable
Common
Shares
R/E
R/E/DD
(Transaction analysis and the basic accounting equation)
Required
For each of the following transactions, indicate how (i) net earnings and (ii) cash flows are affected. For
each, state whether there will be an increase, a decrease, or no effect, and the amount (if any):
a. Took out a loan for $125,000.
b. Purchased equipment for $100,000, paying $40,000 cash and financing the balance with a one-year
note payable.
c. Purchased $35,000 of inventory from suppliers on account.
d. Paid $1,200 for advertising.
e. Sold inventory for $38,200 to customers, on account. The goods sold had cost $11,900.
f. Paid $20,000 on the accounts owing to suppliers.
g. Paid employee wages of $5,000.
h. Received payments of $26,400 from customers on their accounts.
i. Declared and paid dividends of $2,000.
j. Made a loan payment of $2,900 on the loan from transaction (a), of which $2,000 was repayment of
loan principal and $900 was interest.
k. Recorded depreciation of $2,000 on the equipment purchased in transaction (b).
l. Recorded $300 in interest owing on the one-year note payable from transaction (b).
AP2-8B (Transaction analysis and the basic accounting equation)
Required
Analyze the following transactions and show their effects on the basic accounting equation by preparing
a template as follows:
Assets
Date/Ref.
Cash
A/R
Inv.
Liabilities
Equip.
A/P
Dividends
Payable
S/H Equity
Loan
Payable
Common
Shares
a. Received $250,000 from the issuance of shares.
b. Borrowed $100,000 from the bank at 6% per year.
c. Purchased equipment for $178,000.
d. Purchased inventory costing $75,000, paying $50,000, with the balance on account.
e. Recorded sales of $92,000 (half cash and half on account) to customers. The inventory related to
these sales had a cost of $49,000.
f. Paid $20,000 to suppliers related to the purchase of inventory in transaction (d).
R/E
R/E/DD
2-56
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
g. Paid $3,700 in wages to employees.
h. Repaid loan principal of $4,000 plus interest of $1,200 related to the bank loan.
i. Recorded depreciation of $22,600 on the company’s equipment.
j. Declared dividends of $8,000.
AP2-9B
(Transaction analysis and the basic accounting equation)
Required
Show the effect of each of the following transactions on the basic accounting equation by preparing a
template like the one below. The fiscal year end of the company (which has been operating for several
years) is December 31.
Assets
Date/Ref.
Cash
A/R
Prepaid
Insurance
Liabilities
Inv.
Equip.
A/P
S/H Equity
Dividends
Payable
Common
Shares
R/E
R/E/DD
a. Purchased equipment costing $10,000, paying cash.
b. Purchased $42,000 of inventory on account during the year.
c. Made sales of $60,000 during the year, of which $24,000 were cash sales.
d. Collected $34,000 due from customers on accounts receivable.
e. Paid $36,000 owed to suppliers on accounts payable.
f. Paid an insurance premium of $900 on March 31 that provides coverage for the 12-month period
starting April 1. The company had no insurance prior to this.
g. Determined that the cost of the inventory sold during the year was $39,000.
h. Paid $7,000 for utilities expenses during the year.
i. On December 31, the company recognized the amount of insurance expense incurred during the
period. (Refer to transaction (f).)
j. Recorded $3,600 of depreciation for the year on the company’s equipment.
k. Declared (but did not immediately pay) dividends of $400 for each quarter, for a total of $1,600.
l. By the end of the year, $1,200 of the dividends were paid.
AP2-10B
(Determination of the missing amounts using financial statement relationships)
Required
For the two independent cases that follow, determine the missing amount for each letter. (Hint: You
might not be able to calculate them in the order in which they appear.)
Case 1
Case 2
$123,000
A
45,000
E
158,000
77,000
Dividends declared
B
20,000
Retained earnings:
Beginning of year
End of year
278,000
311,000
321,000
F
Total assets:
Beginning of year
End of year
387,000
C
587,000
726,000
Total liabilities:
Beginning of year
End of year
9,000
408,000
216,000
273,000
Revenues
Expenses
Net income
(continued)
Application Problems Series B
Case 1
Common shares:
Beginning of year
End of year
Case 2
100,000
150,000
50,000
G
D
H
Proceeds from common shares issued during the year
AP2-11B (Determination of revenues, expenses, and dividends) The following information for
the current year was obtained from the accounting records of Ozaki Ltd.:
Retained earnings, beginning
$145,000
Retained earnings, ending
185,500
Sales revenue
510,000
Cost of goods sold
364,000
Selling expenses
43,700
General and administrative expenses
38,000
Dividend revenue
1,800
Interest revenue
2,600
Interest expense
200
Income tax expense
22,700
Required
Calculate the following items:
a. Total revenues
b. Total expenses
c. Net earnings
d. Dividends declared
AP2-12B (Determination of statement of income and statement of financial position amounts)
Matachewan Corp. had the following transactions in its first month of operations:
1. On incorporation, the company had issued 1,000 common shares in exchange for $15,000 cash and
equipment worth $12,000.
2. Additional equipment costing $4,000 was purchased for cash.
3. Supplies costing $500 were purchased for cash.
4. Inventory costing $6,000 was acquired on account. Later in the month, the company paid half of the
amount owed. It will pay the remainder next month.
5. The entire inventory was sold to customers for $9,000. The company received half of this amount in
cash and will receive the remainder next month.
6. By the end of the month, $100 of the supplies were used up.
7. The equipment was depreciated $200 for the month.
8. Operating expenses paid in cash during the month were $1,900.
9. Dividends of $300 were declared and paid during the month.
Required
a. Calculate the following amounts for the month:
i. Sales revenue
ii. Cost of goods sold
iii. Total expenses other than cost of goods sold
iv. Net earnings or loss
b. Calculate the following amounts as at the end of the month:
i. Cash on hand
ii. Total assets other than cash
iii. Total liabilities
iv. Share capital
v. Retained earnings
(continued)
2-57
2-58
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
AP2-13B (Preparation of statement of income and statement of financial position) Insomniacs
Coffee Ltd., a mobile coffee company, had the following account balances at the end of December 2024:
Cash
$ 120,000
Accounts payable
340,000
Dividends declared
180,000
Sales revenue
2,910,000
Inventory
305,000
Advertising expense
78,000
Common shares
100,000
Prepaid insurance
23,000
Wages expense
510,000
Equipment
1,240,000
Rent expense
180,000
Wages payable
45,000
Cost of goods sold
1,650,000
Depreciation expense
82,000
Loan payable
790,000
Interest expense
42,000
Accounts receivable
185,000
Retained earnings (as at January 1, 2024)
410,000
Required
a. Prepare a statement of income for the year ended December 31, 2024.
b. Calculate the amount of retained earnings as at December 31, 2024.
c. Prepare a classified statement of financial position as at December 31, 2024.
AP2-14B (Transaction analysis and financial statement preparation) Moksh Ltd. started business on January 1, 2024. The following transactions occurred in 2024:
1. On January 1, the company received $700,000 when it issued 10,000 common shares.
2. On January 1, the company borrowed $250,000 from the bank at 6% annual interest. The loan principal is due in three years.
3. On January 3, the company purchased land and a building for a total of $700,000 cash. The land was
recently appraised at a fair market value of $400,000. (Note: Because the building will be depreciated
in the future and the land will not, these two assets should be recorded in separate accounts.)
4. Inventory costing $190,000 was purchased, of which $100,000 was on account.
5. Sales to customers totalled $310,000. Half of these sales were on account, and the balance were cash sales.
6. The cost of the inventory that was sold to customers in transaction 5 was $128,000.
7. Collections from customers on account totalled $132,000.
8. Payments to suppliers on account totalled $95,000.
9. During the year, employees earned wages of $96,000, of which $4,200 was unpaid at year end.
10. The interest on the bank loan was recognized and paid for the year.
11. The building was estimated to have a useful life of eight years and a residual value of $20,000. The
company uses the straight-line method of depreciation.
12. The company declared dividends of $15,000 during the year, of which half were to be paid in
January 2025.
Required
a. Analyze the effects of each transaction on the basic accounting equation, using a template like the
one below:
Assets
Date/Ref.
Cash
A/R
Inv.
Building
Liabilities
Land
A/P
Wages
Payable
Dividends
Payable
S/H Equity
Loan
Payable
Common
Shares
R/E
R/E/DD
User Perspective Problems 2-59
b. Prepare a statement of income, a statement of changes in equity, a statement of financial position
(unclassified), and a statement of cash flows for 2024.
AP2-15B (Transaction analysis and financial statement preparation) A. J. Smith Company
started business on January 1, 2024, and the following transactions occurred in its first year:
1. On January 1, the company issued 12,000 common shares at $25 per share.
2. On January 1, the company purchased land and a building from another company in exchange for
$80,000 cash and 6,000 shares. The land’s value is approximately one-quarter of the total value of
the transaction. (Hint: You need to determine a value for the shares using the information given in
transaction 1, and the land and building should be recorded in separate accounts.)
3. On March 31, the company rented out a portion of its building to Frantek Company. Frantek is
required to make quarterly payments of $7,500 on March 31, June 30, September 30, and December
31 of each year. The first payment, covering the period from April 1 to June 30, was received on
March 31, and the other payments were all received as scheduled.
4. Equipment worth $120,000 was purchased on July 1, in exchange for $60,000 cash and a one-year
note with a principal amount of $60,000 and an interest rate of 10%. No principal or interest payments were made during the year.
5. Inventory costing $250,000 was purchased on account.
6. Sales were $300,000, of which credit sales were $250,000.
7. The inventory sold had a cost of $190,000.
8. Payments to suppliers totalled $205,000.
9. Accounts receivable totalling $200,000 were collected.
10. Operating expenses amounted to $50,000, all of which were paid in cash.
11. The building purchased in transaction 2 is depreciated using the straight-line method, with an estimated useful life of 20 years and an estimated residual value of $30,000.
12. The equipment purchased in transaction 4 is depreciated using the straight-line method, with an
estimated useful life of 10 years and an estimated residual value of $5,000. Because the equipment
was purchased on July 1, only a half year of depreciation is recognized in 2024.
13. Dividends of $20,000 were declared during the year, of which $5,000 remained unpaid at year end.
14. Interest expense on the note payable from transaction 4 was recorded.
Required
a. Show the effects of the transactions on the basic accounting equation by preparing a template like
the one below. (Hint: For item 3, record the four quarterly collections of rent as one transaction).
Assets
Date/
Ref. Cash A/R Inventory Land Building Equipment
Liabilities
A/P
Deferred
Revenue
Interest
Payable
Dividends Notes Common
Payable Payable
Shares R/E/DD
b. Prepare a statement of income, statement of changes in equity, statement of financial position
(unclassified), and statement of cash flows for 2024.
c. Comment on the company’s results for its first year of operations.
User Perspective Problems
UP2-1
S/H Equity
(Accounting standards)
Required
Assume that you are a member of the Accounting Standards Board (AcSB) and are a guest speaker at
a commercial lender. You have been asked to explain why the board concluded that it would be useful
to have a different set of accounting standards for privately held companies from those used by public
companies. Prepare your remarks.
2-60
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
UP2-2
(Accounting standards)
Required
You are a member of an investment club. To date, all of the club’s investments have been in Canadian
public companies trading on the TSX. At a recent meeting, the members were discussing the possibility
of investing in a couple of Canadian public companies that were interlisted on the TSX and the NYSE.
One of your members, who had been tasked with analyzing the financial statements of these companies,
noted that one of the companies prepared its financial statements using IFRS, while the other used U.S.
GAAP. She wasn’t sure why this was the case. As one of the club’s most experienced members, you were
asked to explain why these companies may have chosen to use these different standards. Write a response.
UP2-3
(Areas of risk in a new company)
Required
Assume that you are a commercial loan officer for a bank and are preparing to meet with a corporate
client. The client has approached you seeking an increase in the loan it has with the bank. Prepare a list
of things that you would want to know about the company’s operations before you decide whether to
approve the increase in the loan.
UP2-4 (Cash basis of accounting) Under the cash basis of accounting, the purchase of a new piece of
equipment for cash would be treated as an expense in the accounting period when the purchase occurred.
Required
a. If you were a shareholder, how would this treatment affect your assessment of the company’s earnings and financial position?
b. If you were a prospective buyer of the company (someone who wanted to purchase all of the company’s shares), how would this treatment affect your assessment of the company as a potential
acquisition?
UP2-5
(Accrual basis of accounting and revenue recognition)
Required
Assume that all of the students of your university or college registering in courses offered in the fall
semester had to pay their tuition fees by August 31. These courses begin on September 4 and run for 13
weeks. Assuming that your university or college follows the accrual basis of accounting, explain when it
should recognize this tuition revenue.
UP2-6
(Accrual basis of accounting versus cash basis of accounting)
Required
You have been asked to give a presentation to your colleagues in the commercial lending unit of a bank
explaining why it is important to request both a statement of cash flows and a statement of income, along
with a statement of financial position, from clients seeking loans. Many of your colleagues think that a
statement of income and a statement of financial position are sufficient. Prepare your remarks.
UP2-7 (Accrual basis of accounting versus cash basis of accounting) At a meeting, one of your
colleagues states, “I cannot understand why we don’t use the cash flow inflows from sales revenue less
the cash outflows related to our expenses to determine our net income. Wouldn’t this be the best way of
calculating net income? What is problematic with this approach?”
Required
Respond to your colleague’s statement and address her questions.
UP2-8 (Cash flow patterns)A friend came to you to discuss a potential investment she was considering making. A quick look at the company’s statement of cash flows shows the company had a −/+/+
(operating/investing/financing) cash flow pattern.
Required
What does this tell you about the company? What would you advise your friend to do?
UP2-9 (Cash flow patterns) You are considering accepting a job offer as a marketing manager for a
national retail chain that is publicly traded. Before accepting, you decide to review the most recent financial statements. A quick look at the company’s statement of cash flows shows that in each of the past two
years, the company had a −/−/+ (operating/investing/financing) cash flow pattern.
Reading and Interpreting Published Financial Statements 2-61
Required
What does this tell you about the company? How would this affect your decision to accept the job?
Work in Progress
WIP2-1 (Cash versus accrual basis of accounting) You are studying with some classmates and
are reviewing each other’s responses to the following question:
A company offering legal services requires all of its clients to pay a deposit of $500 during their initial
appointment with a wills and estates lawyer. The lawyers normally take 10 days to draft the will. Once
the will has been completed, clients come back to the office to review it with the lawyer. If everything is
satisfactory, they take the will and are billed the balance ($700). All clients are given 30 days to make their
payment. When would the revenue related to the legal services be recognized if the company used the
cash basis of accounting? What about if it used the accrual basis of accounting?
Your classmate responded as follows: “If the company followed the cash basis of accounting, it would
recognize $1,200 as revenue when the client pays their bill. At this point, the revenue has been earned
and all of the cash has been received.
“If the company followed the accrual basis of accounting, it could recognize $500 after the initial
meeting, because the lawyer has provided the service, so the revenue has been earned. The remaining
$700 could be recognized when the client comes into the office and picks up their will.”
Required
Identify how your classmate’s answer could be substantively improved.
WIP2-2 (Shareholders’ equity) You are studying with some classmates and are reviewing each other’s responses to the following question:
What does shareholders’ equity represent?
Your classmate responded as follows: “Shareholders’ equity is the amount of money a company would
have after all of the company’s assets were liquidated and all of the company’s liabilities were settled.”
Required
Identify how your classmate’s answer could be substantively improved.
WIP2-3 (Retained earnings) During a study session, one of your classmates states the following:
“Companies that have a large amount of retained earnings have been profitable. They should distribute
the retained earnings as dividends, or pay off any debt, or invest the amount to generate some extra
income for the company.”
Required
Evaluate your classmate’s response. Identify the elements that are correct and incorrect.
WIP2-4 (Financial statement analysis) You are analyzing the financial statements of a company with a few of your classmates for a group assignment. One of your group members makes the
following statement: “The company has a very small amount of debt despite having made significant purchases of land, buildings, equipment, and inventory. I cannot understand how the company
financed these purchases.”
Required
Prepare a plausible explanation for your group members.
Reading and Interpreting Published Financial Statements
RI2-1 (Determination of items from a Canadian company’s financial statements) Saskatoonbased Nutrien Ltd. is the world’s largest provider of crop inputs and services. Excerpts from its 2020
financial statements are in Exhibits 2.20A and 2.20B.
2-62
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
EXHIBIT 2.20A Nutrien Ltd.’s
2020 Consolidated Statements
of Earnings.
NUTRIEN LTD.
Consolidated Statements of Earnings
(in millions of U.S. dollars)
For the years ended December 31
Note
2020
2019
$20,908
$20,084
Sales
3
Freight, transportation and distribution
4
855
768
Cost of goods sold
4
14,814
13,814
Gross margin
5,239
5,502
Selling expenses
4
2,813
2,505
General and administrative expenses
4
429
404
Provincial mining and other taxes
4
204
292
5
69
104
13, 14
824
120
Share-based compensation
Impairment of assets
Other (income) expenses
6
(2)
Earnings before finance costs and income taxes
Finance costs
7
Earnings before income taxes
Income tax (recovery) expense
8
Net earnings
EXHIBIT 2.20B Nutrien Ltd.’s
2020 Consolidated Balance
Sheets
215
902
1,862
520
554
382
1,308
(77)
$
316
459
$
992
NUTRIEN LTD.
Consolidated Balance Sheets
(in millions of U.S. dollars)
As at December 31
Note
2020
2019
Assets
Current assets
Cash and cash equivalents
$ 1,454
$
671
Receivables
11
3,581
3,542
Inventories
12
4,930
4,975
Prepaid expenses and other current assets
1,505
1,477
11,470
10,665
Non-current assets
Property, plant and equipment
13
19,660
20,335
Goodwill
14
12,198
11,986
Other intangible assets
14
2,388
2,428
Investments
15
562
821
Other assets
16
Total Assets
914
564
$47,192
$46,799
$
$
Liabilities
Current liabilities
Short-term debt
17
159
976
Current portion of long-term debt
18
14
502
Current portion of lease liabilities
19
249
214
Payables and accrued charges
20
8,058
7,437
8,480
9,129
10,047
8,553
Non-current liabilities
Long-term debt
18
(continued)
Reading and Interpreting Published Financial Statements
EXHIBIT 2.20B Nutrien Ltd.’s
2020 Consolidated Balance
Sheets (continued)
NUTRIEN LTD.
Consolidated Balance Sheets
(in millions of U.S. dollars)
Lease liabilities
19
891
859
8
3,149
3,145
Pension and other post-retirement benefit
liabilities
21
454
433
Asset retirement obligations and accrued
environmental costs
22
1,597
1,650
209
161
24,827
23,930
15,673
15,771
Contributed surplus
205
248
Accumulated other comprehensive loss
(119)
(251)
Deferred income tax liabilities
Other non-current liabilities
Total Liabilities
Shareholders’ equity
Share capital
Retained earnings
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
2-63
23
6,606
7,101
22,365
22,869
$47,192
$46,799
Required
Use the financial statements to answer the following questions.
a. Calculate the growth in the following accounts from December 31, 2019, to December 31, 2020:
i. Sales
ii. Cost of Goods Sold
iii. Net Earnings
iv. Total Assets
v. Total Shareholders’ Equity
Would you expect each of these accounts to grow at the same rate? Why or why not? Comment on
the growth rates you calculated.
b. Based on your analysis from part (a), did the equity investors finance more of the company in 2020
than they did in 2019?
c. Calculate the following ratios for each of the two years presented. (Note that, in order to be able to
calculate these ratios for each of the years, you will have to use the total assets for each year and the
total shareholders’ equity for each year in your ratios, rather than average total assets and average
shareholders’ equity.)
i. Profit margin ratio
ii. Return on assets
iii. Return on equity
Comment on your results. Do the results from part (a) help you interpret the changes in these ratios?
Why or why not?
RI2-2 (Determination of items from a Canadian company’s financial statements) Excerpts
from the 2020 statement of income, statement of operations, and notes to the financial statements
of High Liner Foods Inc. are in Exhibits 2.21A to 2.21C. Although it is a Canadian company,
based in Lunenburg, Nova Scotia, High Liner prepares its financial statements in U.S. dollars. However, the general format and accounting policies are similar to the financial statements you have
seen so far.
2-64
C H A PTE R 2
Analyzing Transactions and Their Effects on Financial Statements
EXHIBIT 2.21A High Liner
Foods Incorporated’s 2020
Consolidated Statement of
Income
HIGH LINER FOODS INCORPORATED
Consolidated Statement of Income
(in thousands of United States dollars, except per share amounts)
Notes
Fifty-three
weeks ended
Fifty-two
weeks ended
January 2,
2021
December
28, 2019
$827,453
$942,224
Cost of sales
649,529
756,364
Gross profit
177,924
185,860
45,076
45,759
73,736
90,019
—
974
2,957
1,572
56,155
47,536
19,483
33,012
36,672
14,524
Sales
24
Distribution expenses
Selling, general and administrative expenses
Impairment of property, plant and equipment
8
Business acquisition, integration and other
expenses
Results from operating activities
Finance costs
28
Income before income taxes
Income taxes
Current
18
6,535
3,356
Deferred
18
1,335
879
Income tax expense
Net income
EXHIBIT 2.21B High Liner
Foods Incorporated’s 2020
Consolidated Statement of
Financial Position
7,870
4,235
$ 28,802
$ 10,289
January 2,
2021
December
29, 2019
HIGH LINER FOODS INCORPORATED
Consolidated Statement of Financial Position
(in thousands of United States dollars)
Notes
ASSETS
Current assets
Cash
Accounts receivable
$ 32,935
6
Inventories
3,144
60,927
85,089
2,609
3,494
25
211
236
7
Income taxes receivable
Other financial assets
$
250,861
294,913
Prepaid expenses
4,176
4,322
Total current assets
351,719
391,198
Non-current assets
Property, plant and equipment
8
107,221
108,986
Right-of-use assets
9
15,018
11,792
Deferred finance costs
11
287
—
Deferred income taxes
18
2,401
2,134
Other receivables and assets
25
47
34
(continued)
Reading and Interpreting Published Financial Statements 2-65
EXHIBIT 2.21B High Liner
Foods Incorporated’s 2020
Consolidated Statement of
Financial Position (continued)
HIGH LINER FOODS INCORPORATED
Consolidated Statement of Financial Position
(in thousands of United States dollars)
Intangible assets
10
142,168
148,893
Goodwill
10
157,697
157,457
424,839
429,296
$776,558
$820,494
$
—
$ 37,546
Total non-current assets
Total assets
11,14
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Bank loans
11
Accounts payable and accrued liabilities
12
114,326
141,238
Contract liability
19
4,351
3,581
Provisions
13
3,327
329
Other current financial liabilities
25
2,735
861
Other current liabilities
17
2,731
4,881
41
2,102
20,185
14,511
Income taxes payable
Current portion of long-term debt
14
Current portion of lease liabilities
9
Total current liabilities
4,866
4,582
152,562
209,631
268,048
289,020
Non-current liabilities
Long-term debt
14
Other long-term financial liabilities
25
329
292
Other long-term liabilities
17
6,510
3,031
Long-term lease liabilities
9
10,722
7,198
Deferred income taxes
18
31,071
30,182
Future employee benefits
15
16,314
12,970
Total non-current liabilities
332,994
342,693
Total liabilities
485,556
552,324
112,739
112,887
Shareholders’ equity
Common shares
Contributed surplus
16
16,551
16,028
Retained earnings
183,649
162,773
Accumulated other comprehensive loss
(21,937)
(23,518)
Total shareholders’ equity
Total liabilities and shareholders’ equity
291,002
268,170
$776,558
$820,494
24. Geographic information
Sales earned outside of Canada for the fifty-three weeks ended January 2, 2021 were $626.2
million (fifty-two weeks ended December 29, 2019: $712.4 million). Sales by geographic area are
determined based on the shipping location.
Required
Use the exhibits to answer the following questions.
a. In the shareholders’ equity section, what does the $112,739 thousand in common shares represent?
b. In the shareholders’ equity section, what does the $183,649 thousand in retained earnings represent?
EXHIBIT 2.21C Excerpt
from High Liner Foods
Incorporated’s 2020
Consolidated Financial
Statements
2-66
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c. What percentage of High Liner’s assets was financed by liabilities? Has this percentage increased or
decreased from 2019?
d. How much did total assets change in 2020 over 2019? What were the major areas (or accounts) that
accounted for the increase?
e. If High Liner were to pay the income taxes payable, in the current liabilities section, what would be
the effect on the basic accounting equation?
f. What was High Liner’s gross profit as a percentage of revenues in 2020? How did this compare with 2019?
g. In the accompanying notes to the financial statements, High Liner discloses separately the sales
earned outside of Canada. Determine the change in High Liner’s sales outside of Canada. How does
this compare with the change in the company’s Canadian sales? Base your answers on High Liner’s
note 24, Geographic information (Exhibit 2.21C).
RI2-3 (Determination of items from a Canadian company’s financial statements) Maple
Leaf Foods Inc. is a major Canadian producer of food products. Excerpts from the company’s financial
statements for the year ended December 31, 2020, are in Exhibits 2.22A to 2.22C.
EXHIBIT 2.22A Maple Leaf
Foods Inc.’s 2020 Consolidated
Balance Sheet
MAPLE LEAF FOODS INC.
Consolidated Balance Sheets
(In thousands of Canadian dollars)
Notes
As at December As at December
31, 2020
31, 2019
Assets
Current assets
Cash and cash equivalents
Accounts receivable
$ 100,828
$
97,285
4
159,750
31,550
31,699
Inventories
5
398,070
385,534
Biological assets
6
125,648
119,016
Income and other taxes recoverable
7
Notes receivable
1,830
—
64,517
51,494
575
34,293
882,768
874,290
9
1,721,487
1,386,482
10
222,705
227,426
15,910
3,448
Prepaid expenses and other assets
Assets held for sale
Property and equipment
Right-of-use assets
154,969
8
Investments
Other long-term assets
9,568
12,497
7
14,070
—
Goodwill
11
652,501
657,179
Intangible assets
12
Deferred tax asset
Total assets
341,196
352,713
$3,860,205
$3,514,035
$ 501,529
$ 445,774
1,529
3,973
Liabilities and Equity
Current liabilities
Accounts payable and accruals
Current portion of provisions
13
Current portion of long-term debt
14
900
899
Current portion of lease obligations
15
79,601
39,505
7
27,639
205
16
55,849
44,698
667,047
535,054
Income taxes payable
Other current liabilities
(continued)
Reading and Interpreting Published Financial Statements 2-67
EXHIBIT 2.22A Maple Leaf
Foods Inc.’s 2020 Consolidated
Balance Sheet (continued)
MAPLE LEAF FOODS INC.
Consolidated Balance Sheets
Long-term debt
14
745,048
358,429
Lease obligations
15
160,636
204,013
Employee benefits
17
188,946
116,742
Provisions
13
44,230
44,929
11,918
3,026
109,916
121,972
1,927,741
1,564,165
838,969
840,005
1,124,973
1,137,450
5,866
—
Other long-term liabilities
Deferred tax liability
Total liabilities
Shareholders’ Equity
Share capital
18
Retained earnings
Contributed surplus
Accumulated other comprehensive
(loss) income
(13,414)
Treasury stock
2,793
(23,930)
Total shareholders’ equity
Total liabilities and equity
(30,378)
1,932,464
1,949,870
$3,860,205
$3,514,035
EXHIBIT 2.22B Maple Leaf
Foods Inc.’s 2020 Consolidated
Statements of Net Earnings
MAPLE LEAF FOODS INC.
Consolidated Statements of Net Earnings
(In thousands of Canadian dollars, except share amounts)
Notes
December
31, 2020
December
31, 2019
$4,303,722
$3,941,545
3,600,669
3,350,566
Gross profit
703,053
590,979
Selling, general and administrative expenses
490,659
457,681
Earning before the following:
212,394
133,298
Sales
Cost of goods sold
Restructuring and other related costs
13
Other expense
Earnings before interest and income taxes
Interest expense and other financing costs
20
Earnings before income taxes
Income tax expense
Net earnings
7
4,284
11,004
16,757
3,268
191,353
119,026
31,480
32,031
159,873
86,995
46,596
12,367
$ 113,277
$
74,628
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EXHIBIT 2.22C Maple Leaf
Foods Inc.’s 2020 Consolidated
Statements of Cash Flows
MAPLE LEAF FOODS INC.
Consolidated Statements of Cash Flows
(In thousands of Canadian dollars)
Notes
December
31, 2020
December
31, 2019
$113,277
$74,628
Cash provided by (used in):
Operating activities
Net earnings
Add (deduct) items not affecting cash:
Change in fair value of biological assets
6
Depreciation and amortization
Share-based compensation
22
(687)
5,545
196,266
176,796
17,301
17,935
Deferred income taxes
7
(5,945)
(1,323)
Income tax current
7
52,541
13,690
20
31,480
32,031
(2,024)
(4,164)
Interest expense and other financing costs
Gain on sale of long-term assets
Asset impairment
Change in fair value of non-designated derivatives
1,377
19
Change in net pension obligation
Net income taxes paid
7
Interest paid
Change in provision for restructuring and other
related costs
Change in derivatives margin
—
(3,947)
5,785
9,286
4,730
(26,212)
(40,682)
(28,839)
(28,137)
13
(3,509)
8,144
19
(8,074)
(2,210)
5,041
1,779
Other
Change in non-cash operating working capital
(25,883)
Cash provided by operating activities
5,633
321,449
270,180
(78,932)
(71,824)
Financing activities
Dividends paid
Net increase in long-term debt
14
215,601
169,491
Payment of lease obligation
15
(37,554)
(34,690)
1,012
7,760
Exercise of stock options
—
(20,347)
Payment of financing fees
Repurchase of shares
(599)
(5,635)
Purchase of treasury stock
—
(14,978)
Cash provided by financing activities
99,528
29,777
(432,540)
(268,095)
Investing activities
Additions to long-term assets
Acquisition of business, net of cash acquired
23
—
(847)
Interest paid and capitalized
(8,214)
(2,650)
Proceeds from sale of long-term assets
37,373
7,727
Purchase of investments
Payment of income tax liabilities assumed on
acquisition
Cash used in investing activities
Increase in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
(14,053)
—
(417,434)
—
(11,385)
(275,250)
3,543
24,707
97,285
72,578
$100,828
$97,285
Reading and Interpreting Published Financial Statements 2-69
Required
a. How much cash and cash equivalents did Maple Leaf have available to use at the end of fiscal 2020?
b. What percentage of Maple Leaf’s assets was financed by shareholders in 2020? Did this represent an
increase or decrease relative to 2019? What does this change mean?
c. How much did Maple Leaf’s accounts receivable increase from 2019 to 2020? How did this compare
with the change in sales during the same period? What does this tell you?
d. Determine Maple Leaf’s gross profit margin percentage for 2020. How did this compare with 2019?
Comment on what this analysis tells you about the company.
e. Did the company pay dividends during fiscal 2020? How did you determine this?
f. How much cash did the company pay for additions to long-term assets in 2020? How did this compare with the proceeds it received from the sale of long-term assets during the year?
g. Calculate the following ratios for fiscal 2020 and 2019. (Note that, in order to be able to calculate these
ratios for each of the years, you will have to use the total assets for each year and the total shareholders’
equity for each year in your ratios, rather than average total assets and average shareholders’ equity.)
i. Profit margin ratio
ii. Return on assets
iii. Return on equity
h. Comment on your results in part (g).
RI2-4 (Determination of items from a Canadian company’s financial statements) Sleep
Country Canada Holdings Inc. is a retailer operating three retail banners, Sleep Country,
­
­Dormez-vous?, and Endy. Excerpts from its 2020 financial statements are in Exhibits 2.23A to 2.23D.
EXHIBIT 2.23A Sleep Country
Canada Holdings Inc.’s 2020
Consolidated Statements of
Financial Position
SLEEP COUNTRY CANADA HOLDINGS INC.
Consolidated Statements of Financial Position
(In thousands of Canadian dollars)
Notes
December 31,
2020
December 31,
2019
Assets
Current assets
Cash
Trade and other receivables
Inventories
Prepaid expenses and deposits
$ 38,317
$ 44,040
5
9,668
20,899
6
68,717
65,361
13
6,611
6,008
123,313
136,308
Property and equipment
7
68,151
71,486
Right-of-use assets
8
258,231
263,777
Deferred tax assets
13
4,338
3,029
Intangible assets
9
147,434
141,568
Goodwill
9
300,884
300,884
$902,351
$917,052
$ 91,741
$ 68,156
26,145
24,415
Liabilities
Current liabilities
Trade and other payables
10
Customer deposits
Lease liabilities
8
35,671
33,309
Other liabilities
11
25,000
—
178,557
125,880
Other liabilities
11
867
18,406
Deferred tax liabilities
13
18,810
21,060
(continued)
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EXHIBIT 2.23A Sleep Country
Canada Holdings Inc.’s 2020
Consolidated Statements of
Financial Position (continued)
Lease liabilities
8
268,302
271,112
Long-term debt
3,12
77,273
175,084
543,809
611,542
354,210
350,858
Shareholders’ Equity
Share capital and other
15
Retained earnings (deficit)
EXHIBIT 2.23B Sleep Country
Canada Holdings Inc.’s 2020
Consolidated Statements of
Income and Comprehensive
Income
4,332
(45,348)
358,542
305,510
$902,351
$917,052
SLEEP COUNTRY CANADA HOLDINGS INC.
Consolidated Statements of Income and Comprehensive Income
(In thousands of Canadian dollars, except per share amounts)
Notes December 31, December 31,
2020
2019
Revenues
Cost of sales
$757,699
$712,372
513,203
489,082
244,496
223,290
134,926
125,826
109,570
97,464
25,363
21,149
6,14
Gross profit
General and administrative expenses
14
Income before finance related expenses, interest
and other expenses and income taxes
Finance related expenses
12
Interest and other expenses (income)—net
200
Income before provision for income taxes
Provision for income taxes
25,563
20,361
84,007
77,103
24,259
18,294
13
Current
Deferred
Net income and comprehensive income for
the year
EXHIBIT 2.23C Sleep Country
Canada Holdings Inc.’s 2020
Consolidated Statements of
Changes in Shareholders’
Equity
(788)
(3,559)
3,349
20,700
21,643
$ 63,307
$ 55,460
SLEEP COUNTRY CANADA HOLDINGS INC.
Consolidated Statements of Changes in Shareholders’ Equity
(In thousands of Canadian dollars)
Share Capital and Other
Retained
Number of Common Contributed earnings
shares
shares
surplus
(Deficit)
Balance—January 1, 2019
37,059,430 $346,206
$6,982
Total
equity
$(66,357) $286,831
Net income for the year
—
—
—
55,460
55,460
Dividends declared and paid
—
—
—
(29,208)
(29,208)
(continued)
Reading and Interpreting Published Financial Statements 2-71
EXHIBIT 2.23C Sleep Country
Canada Holdings Inc.’s 2020
Consolidated Statements of
Changes in Shareholders’
Equity (continued)
SLEEP COUNTRY CANADA HOLDINGS INC.
Consolidated Statements of Changes in Shareholders’ Equity
(In thousands of Canadian dollars)
Shares issued on exercise of
share-based compensation
option/unit
93,584
Share-based compensation
(note 19)
—
Share repurchase (note 15)
(1,707)
—
2,432
—
2,432
(10,005)
—
—
(10,005)
5,243
—
(5,243) —
—
(510,829)
Excess of purchase price over
average cost
1,707
—
—
Balance—December 31, 2019
36,642,185
343,151
7,707
(45,348)
305,510
Balance—January 1, 2020
36,642,185
343,151
7,707
(45,348)
305,510
Net income for the year
—
—
—
63,307
63,307
Dividends declared and paid
—
—
—
(13,627)
(13,627)
2,096
(2,096)
—
—
3,352
—
3,352
36,700,764 $345,247
$8,963
$ 4,332
$358,542
Shares issued on exercise of
share-based compensation
option/unit
58,579
Share-based compensation
(note 19)
Balance—December 31, 2020
—
—
EXHIBIT 2.23D Sleep Country
Canada Holdings Inc.’s 2020
Consolidated Statements of
Cash Flows
SLEEP COUNTRY CANADA HOLDINGS INC.
Consolidated Statements of Cash Flows
(In thousands of Canadian dollars)
Notes
December
31, 2020
December
31, 2019
$ 63,307
$ 55,460
Cash provided by (used in):
Operating activities
Net income for the year
Items not affecting cash
Depreciation of property and equipment
7
15,306
14,252
Depreciation of right-of-use assets
8
36,576
35,724
Amortization of intangible assets
9
4,991
4,473
Share-based compensation
19
3,352
2,432
Finance related expenses
12
25,363
21,149
Warranty liability
(23)
(26)
(Gain) loss on disposal of property and
equipment
(42)
45
37
28
Decommissioning liabilities
Deferred income taxes
13
(3,559)
145,308
3,349
136,886
(continued)
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EXHIBIT 2.23D Sleep Country
Canada Holdings Inc.’s 2020
Consolidated Statements of
Cash Flows (continued)
Changes in non-cash items relating to
operating activities
Trade and other receivables
12,381
(6,749)
Inventories
(3,356)
(10,632)
Prepaid expenses and deposits
(603)
Trade and other payables
(464)
18,240
11,055
1,730
1,964
Customer deposits
28,392
(4,826)
173,700
132,060
(10,838)
(17,595)
(58)
(35)
(6,761)
(17,819)
(17,657)
(35,449)
(10,005)
Investing activities
Purchase of property and equipment
Purchase of right-of-use assets
Purchase of intangible assets
Financing activities
Shares repurchased
15
—
Increase in senior secured credit facility
12
34,200
26,700
Repayment of senior secured credit facility
12
(132,000)
(19,500)
(358)
(28)
Dividends paid
(13,627)
(29,208)
Interest paid
(17,416)
(18,489)
(32,565)
(32,029)
(161,766)
(82,559)
Financing costs on senior secured credit
facility
Repayment of principal portion of lease
liabilities
8
(Decrease) increase in cash during the year
(5,723)
14,052
Cash—Beginning of the year
44,040
29,988
38,317
$ 44,040
Cash—End of the year
$
Required
a. Determine the amount of dividends declared during fiscal 2020. Where did you find this information?
b. How does the declaration of dividends affect the accounting equation?
c. Determine the amount of dividends paid during fiscal 2020. Where did you find this information?
d. How does the payment of dividends affect the accounting equation?
e. Determine Sleep Country’s gross profit margin for 2020 and 2019. Explain the results of your gross
margin calculations.
f. What was Sleep Country’s cash flow pattern in 2020? Did it fit the “normal” pattern discussed in the
chapter?
RI2-5 (Determination of items from a company’s financial statements)
Required
Find the annual report of a Canadian company in the retailing business and answer the following
questions:
a. How important is inventory relative to the other assets on the company’s statement of financial
position (or balance sheet)?
b. Does the company finance its business primarily with debt (funds borrowed from creditors) or with
equity (funds invested by owners)?
Cases
c. Read through the management discussion and analysis (which was covered in Chapter 1) and determine whether there is any information there that is not included in the financial statements. If you
were a shareholder, would you think the extra information is important? Why or why not?
d. How many directors does the company have? What positions do they hold? Are any of them directors of other companies?
Cases
C2-1 Wroad Wrunner Courier Service
At the end of her first year of university, Nola Lam decided that she should start a business to help
finance her education, so she set up her own courier service. She invested savings of $1,800 in the company, which she called Wroad Wrunner Ltd. In addition, her parents lent the company $3,000 to help
it get started. Since this was a business venture, Nola insisted on paying interest on this loan, and her
parents agreed to charge a rate of 6% per year.
Nola then negotiated the purchase of a used car for the business for $8,000. The company made a
down payment of $3,000 on the car and financed the remainder of the purchase price at an interest rate
of 9% per year. Due to all of the kilometres that would be put on the car while it was used in the courier
business, Nola estimated that the car could be sold at the end of the summer for $6,000.
Wroad Wrunner began operations on May 1 and continued until August 31. Although Nola did not
keep any formal accounting records, at the end of the summer she put together the following additional
information related to the business:
1. During the summer, the company made payments of $623 on the car, which included interest of
$123 and principal of $500.
2. No payments (of either interest or principal) were made on the loan from her parents.
3. Nola paid herself a salary of $1,500 per month for the four months that the business operated.
4. Payments for other operating costs (including advertising, insurance, and gas) totalled $9,600. In
addition, there were unpaid bills totalling $100 at the end of August.
5. Courier charges collected from customers totalled $19,200. In addition, customers still owed $300
for services performed in the last two weeks of August.
6. After the close of business on August 31, there was a balance of $4,694 in the company’s bank
account, plus a “float” of $83 in the car.
Required
a. Analyze the transactions that affected the business during the summer. Prepare a statement of
income for Wroad Wrunner for the four-month period ending on August 31 and an unclassified
statement of financial position at that date.
b. Comment on the profitability of the business during its four-month period of operations. How much
did Nola make from her venture during the summer?
c. Comment on the company’s financial position on August 31. If Nola dissolves the business before
she returns to university, will there be enough cash to pay off the liabilities?
C2-2 Daisy-Fresh Dry Cleaning
Daisy-Fresh Dry Cleaning is in the process of preparing its annual financial statements. The owner of the
business, Petr Radmanovich, is not an accountant but likes to prepare the financial statements himself.
Most of the business transactions are straightforward and can be easily recorded; however, Petr is having
trouble determining how to account for the following events that occurred during the year:
1. On January 1, the company purchased a three-year insurance policy for $3,000. Because the entire
amount had to be paid when the policy took effect, Petr expensed all $3,000 in the current year.
2. On July 1, the company bought a new dry-cleaning machine for $10,000. Although it is expected to
have a five-year life, Petr thinks he would get only $2,000 for it if he sold it now, so he recorded an
asset of $2,000 and an expense of $8,000.
3. On October 31, the company borrowed $10,000 from a bank. Since the loan does not have to be
repaid until four years later, Petr does not think it should be reported as a payable on this year’s
statement of financial position.
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4. No interest has to be paid on the loan until October 31 of next year, so Petr did not record any interest
this year.
5. On December 31, the company declared and paid a dividend of $10,000. Petr recorded this payment
as an expense.
Required
Advise Petr as to how the above transactions should be recorded and reported in the financial statements
for the current year.
C2-3 Mega Manufacturing
Mega Manufacturing has calculated the following financial ratios, based on the company’s comparative
financial statements for 2024 and 2023:
2024
2023
Industry Average
Profit margin ratio
18%
20%
16%
Return on assets
10%
8%
12%
Return on equity
12%
10%
14%
Required
Briefly explain what each ratio indicates, and comment on the company’s performance during this twoyear period.
C2-4 Canadian Cookies and Cakes Ltd.
One of the shareholders of Canadian Cookies and Cakes Ltd. is considering selling her shares,
which represent one-third of the company’s outstanding shares. The company is preparing its financial statements, which will be used by the shareholder to help determine the value of her shares.
The following transactions have occurred since the shop started operations at the beginning of this
year:
1. The company borrowed $30,000 from the bank to help get the business started and repaid $10,000
of this before year end. Shareholders also paid a total of $30,000 for their shares when the company started.
2. Ingredients costing $42,000 were purchased on account, and 80% of these ingredients were used
in goods that were baked and sold during the year. Before the end of the year, payments of $37,000
were made for these ingredients.
3. Baking ovens were rented for $12,000 cash, paid at a rate of $1,000 per month. At the end of the year,
the company purchased its own ovens for $46,000 cash.
4. Employees earned wages of $30,000 during the year. The company withheld income taxes of $3,000
from their paycheques, which it will forward to the Canada Revenue Agency (CRA) early next year.
In other words, although the employees’ wages were $30,000, the company deducted income taxes
and paid only the remaining $27,000 net amount to the employees; it will pay the $3,000 of income
taxes directly to the CRA. (Note that these income taxes relate to the employees’ earnings, not the
company’s earnings. Consequently, they are recorded as part of the company’s wage expense, not as
income tax expense.)
5. Interest on the bank loan for the year totalled $1,600 but has not yet been paid.
6. Various other expenses totalled $15,000 for the year, but only $13,500 of this amount was paid before
the end of the year.
7. After $98,000 was collected from the sale of goods (which was the full sales amount), the cash balance at the end of the year was $12,500, and net income of $5,800 was reported.
Required
a. Show calculations to prove that the ending cash balance was $12,500 and the net income for the year
was $5,800.
b. Prepare an unclassified statement of financial position for Canadian Cookies and Cakes Ltd. as at
the end of the year.
c. If the shareholder sells her one-third ownership interest in the company, what does the foregoing
tell you regarding how much she should expect to get for her shares?
Endnotes
Endnotes
1
Nutrien 2018 Business Acquisition Report; Nutrien corporate website, www.nutrien.com; Nutrien 2020
annual report.
2
TSX Interlisted Companies; https://www.tsx.com/trading/market-data-and-statistics/market-statistics-and-reports/interlisted-companies; downloaded January 15, 2021.
3
Analogy shared by Gordon Holyer, a retired professor from Vancouver Island University.
4
CPA Standards and Guidance Collection; Part 1 – International Financial Reporting Standards; The
Conceptual Framework.
5
HUB Cycling, 2019/20 Annual Report; HUB Cycling website, https://bikehub.ca/about-us/annualgeneral-meeting/annual-report-2019-2020.
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Radharc Images/Alamy Stock Photo
CHAPTER 3
Double-Entry Accounting and the
Accounting Cycle
Radharc Images/Alamy Stock Photo
Balancing the Books When
Bartering
When the Hudson’s Bay Company (HBC) was established
under a royal charter from King Charles II in 1670, it had
18 shareholders who invested a total of £10,500. The company’s fur-trading operations, which would eventually span
the upper half of North America, were complicated by the
lack of any monetary system. Instead, the company largely
worked by bartering, trading things like blankets and kettles for furs.
For over 150 years, HBC valued items in units equivalent to one prime beaver pelt, called a “made beaver” (MB),
and this became the standard of currency used in trading. For
example, trappers could trade 11 MB for a gun, 3 MB for a yard
of cloth, and 6 MB for a three-gallon kettle. Even other furs
were translated into MB. An otter or fox pelt was worth 2 MB,
whereas a marten was worth one-third of an MB.
HBC required its chief factors, who commanded the company’s trading posts, to record these transactions and maintain
a complete set of accounts. Across the various trading posts,
the company used standardized accounting practices, many
of which are similar to those still in use 350 years later. The
company required a journal and a ledger to be maintained at
each post, together with inventory records and a reconciliation
between the goods traded and the MBs received in exchange.
These records were sent to HBC’s London headquarters for
review and to inform the company’s decision-making for the
next trading period.
Coming back to the company’s earlier practice of bartering, it is worth noting that barter transactions should not
result in profits, because goods of equivalent values are being
exchanged. In spite of this, the accounting records of virtually all of HBC’s trading posts reported an amount known as
“overplus.” This represented profits that resulted from traders
altering the standard of trade in the company’s favour, such
as requiring 8 MB in exchange for a kettle rather than 6 MB.
Overplus added to the company’s profits from the eventual
sale of the furs. Between 1670 and 1857, HBC produced profits
of at least £20 million, some of which it returned to shareholders. While those initial 18 shareholders had to wait 15 years
for their first dividend, on the strength of its profits, HBC paid
dividends in 249 of the 314 years between its inception in 1670
and 1984!
HBC is the world’s oldest commercial enterprise that still
carries on its original line of business, operating stores under
banners such as Hudson’s Bay, Saks Fifth Avenue, Lord &
Taylor, and Home Outfitters in Canada and the United States;
Galeria Kaufhof in Germany; and Galeria INNO in Belgium.
On March 3, 2020, HBC’s shareholders approved the privatization of the company in a $1.1-billion cash deal. The privatization of HBC means that its financial statements are no longer
publicly available. In spite of this, you can bet that keeping
good accounting records continues to contribute to the company’s success, as it has for over 350 years.1
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CORE QUESTIONS
If you are able to answer the following questions, then you
have achieved the related learning objectives.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
The Double-Entry System
• How does the double-entry accounting system work
and how does it overcome the limitations of the
template method?
1. Explain how the double-entry accounting system
works, including how it overcomes the limitations of
the template approach.
The Normal Balance Concept
• What is the normal balance concept and how is it
used?
2. Explain the normal balance concept and how it is
used within the double-entry accounting system.
Understanding the Accounting Cycle
• What are the steps in the accounting cycle?
3. Identify and explain the steps in the accounting
cycle.
The Chart of Accounts
• What is the chart of accounts?
• Can companies change their chart of accounts and
what are the implications if they do?
4. Explain the significance of a company’s decisions
regarding its chart of accounts and the implications
of subsequent changes.
Opening Balances
• What is the difference between permanent and
temporary accounts?
5. Explain the difference between permanent and
temporary accounts.
Transaction Analysis and Recording
• How are transactions identified?
• How are transactions recorded in the general journal?
6. Identify and record transactions in the general
journal and general ledger.
• Why are transactions also recorded in the general
ledger?
• What is the purpose of preparing a trial balance?
Adjusting Entries
• What are adjusting entries and why are they
necessary?
7. Explain why adjusting entries are necessary and
prepare them.
• What is the purpose of preparing an adjusted trial
balance?
Preparing Financial Statements and Closing Entries
• What are closing entries and why are they necessary?
• What do we know if a company has retained earnings?
8. Explain why closing entries are necessary and
prepare them.
The Double-Entry System 3-3
3.1
The Double-Entry System
LEARNING OBJECTIVE 1
Explain how the double-entry accounting system works, including how it overcomes the limitations of the template approach.
Now that you understand the basic accounting equation and can work through the analysis of
some transactions, we are going to take you further into the practical side of accounting. We
are going to show you how data are recorded in an accounting system so that organizations
can easily extract information and summarize it into financial statements and other reports.
Of course, today’s technology makes financial record-keeping far easier than in the early days
of the Hudson’s Bay Company.
How Does the Double-Entry Accounting System
Work and How Does It Overcome the Limitations
of the Template Method?
As we discussed in Chapter 2, recording transactions in a template or spreadsheet, with columns reflecting the basic accounting equation, is adequate for small entities with few transactions to record. However, it is cumbersome when large numbers of accounts and transactions
are involved. To address this, accountants developed the double-entry accounting system.
One of the reasons it is called this is because it requires that each transaction be recorded in a
way that affects at least two accounts, with the transaction amount recorded in each account.
(In other words, the transaction amount is recorded twice, which is the “double” in the term
double-entry accounting.) The total effects of these entries will be equal and offsetting. This is
similar to what we did in the template method, which required that each line balance.
For Example
The double-entry accounting system has been around for
more than 700 years! The first acknowledged use of the
­system was in 1299. The system was first documented in 1494
by Franciscan friar and mathematician Luca Pacioli in his
book Summa de Arithmetica, Geometria, Proportioni et Proportionalità. This book was a mathematical compendium that
included 27 pages of detailed instructions on double-entry
bookkeeping. Five hundred years later, the method and principles outlined by Pacioli provide the foundation upon which
Art Collection 3/Alamy Stock Photo
today’s accounting systems work. His book was widely copied
and translated into multiple languages, allowing the system
to be widely disseminated. As a result of this, Pacioli is known as the “Father of Accounting.”
While the main steps in the system have not changed significantly since the time of Pacioli, there
have been refinements to accommodate such things as the evolution of the corporate form of business, an increased focus on periodicity, and an ever-growing amount of financial reporting data.2
The most significant limitation of the template method is the number of columns that
can be manageably used. This significantly limits the information that management can capture and analyze in managing the business. For example, an organization may have multiple
types of inventory that it wishes to track and would need specific accounts (or columns) for
each. Think of the bookstore at your university or college. At a minimum, management would
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CH A PT ER 3
Double-Entry Accounting and the Accounting Cycle
want to track the major categories of inventory separately (such as new textbooks, digital
textbooks, used textbooks, clothing, office supplies, and information technology). They may
also want some of this information further broken down by program or faculty. Obviously, the
number of accounts (or columns) would quickly become too large for a workable spreadsheet.
The double-entry accounting system overcomes this limitation by enabling companies
to use hundreds or even thousands of accounts to capture information at the level of detail
required to manage the business effectively. It enables businesses to capture transaction details
while making it easy to summarize information by account.
For Example
The level of detail required to manage the operations of
a major Canadian company or university is significant.
According to the director of financial services at Vancouver-based Simon Fraser University, the university
has “8,500 cost centres that have detailed object accounts
below them, so that translates into more than 100,000
general ledger accounts.” Imagine trying to work with a
spreadsheet having 100,000 columns!3
DeymosHR/Shutterstock
DeymosHR/Shutterstock
Loblaw Companies Limited, which is Canada’s
largest retailer, reported that it processes more than 1 billion transactions annually. So, in addition to the challenge of the number of columns required in the spreadsheet, there could also
be more than 1 billion rows! Clearly, the template method would not meet the needs of these
organizations.
The accounting systems of most companies are computerized. Some are stand-alone accounting
systems, which are focused on generating financial reporting information but are not integrated
with the company’s other information systems. Others are a module within an enterprise resource
planning (ERP) system, which are much larger information systems, integrating all of the company’s processes, such as manufacturing, supply chain management, and human resources. When an
accounting system is integrated within an ERP system, it enables management to analyze data more
broadly than is possible when a stand-alone system is used. This makes it possible to determine
­relationships among a wider variety of data. A discussion of computerized accounting ­systems
and ERP systems is beyond the scope of an introductory text, but it is important to understand
that, regardless of the type of accounting system, the principles and procedures of the ­double-entry
accounting system and the various steps of the accounting cycle are still being followed.
3.2
The Normal Balance Concept
LEARNING OBJECTIVE 2
Explain the normal balance concept and how it is used within the double-entry
accounting system.
What Is the Normal Balance Concept
and How Is It Used?
Before discussing the double-entry accounting system further, we have to learn about the
normal balance concept. First, picture yourself as a crew member on a sailboat out on a
local lake or bay. Your duties include working with the sails, hoisting them up and down, and
moving them from one side of the boat to the other. Your friend, the captain, loves to shout
out orders, referring to “port” or “starboard.” If you aren’t a regular sailor, you would likely
The Normal Balance Concept 3-5
be confused by these terms. Is the captain referring to the left side of the boat or the right
side? If you don’t understand, you probably can’t follow the captain’s orders and may even get
knocked out of the boat by a sail boom that you had no idea was coming!
Just as sailors have invented their own terms for left (port) and right (starboard), so have
accountants. Understanding what these mean is one of the keys to the double-entry accounting system. While you will not literally get hit by a sail boom while working with accounting
information, it may feel as though you have been figuratively knocked overboard if you don’t
understand what the terms debit and credit mean.
While these terms are the accounting equivalents of left and right, you are likely wondering “left and right of what?” The easiest way to explain this is to revisit the accounting
equation, through which we will draw a big “T” to divide it in half as shown in Exhibit 3.1.
EXHIBIT 3.1
ASSETS
LIABILITIES +
SHAREHOLDERS’ EQUITY
“LEFT”
“RIGHT”
DEBIT
CREDIT
DR
CR
This illustrates the normal balance concept. Basically, accountants say that accounts on
the left side of the T (asset accounts) normally have a debit balance, while accounts on the
right side of the T (liabilities and shareholders’ equity accounts) normally have a credit balance (see the Key Points).
Using the normal balance concept, we can determine whether an account normally has
a debit or a credit balance. Once we know this, we will use the account’s normal balance to
increase it and do the opposite to decrease it. Let’s look at a couple of examples.
• Cash is an asset. It is on the left side of the T and, therefore, it normally has a debit balance. Therefore, to record an increase in the Cash account, we would debit it. To record
a decrease, we would do the opposite: we would credit it. At the end of a period, when
we tally up the debits and credits, we would expect there to be more debits than credits,
because this account normally has a debit balance.
• Accounts payable is a liability. It is on the right side of the T and, therefore, it normally
has a credit balance. Therefore, to record an increase in the Accounts Payable account,
we would credit it. To record a decrease, we would do the opposite: we would debit it.
At the end of a period, when we tally up the debits and credits, we would expect there
to be more credits than debits, because this account normally has a credit balance.
For Example
Accountants use DR as an abbreviation for debit and CR as an abbreviation for credit. These
abbreviations stem from the first and last letters of the old English terms debitor (or debtor) and
creditor (much like Mr. is used as an abbreviation for Mister or Dr. for doctor). While the term
debitor is seldom used anymore, creditor is still commonly used, as are the abbreviations for both.
Under the template system, each account had its own column in which the transactions
affecting it were recorded. These columns were organized just like the accounting equation;
that is, the asset accounts came first, then the liability accounts, and finally the shareholders’
equity accounts. When thinking about the structure of the double-entry accounting system
further, it helps to picture a box of playing cards, organized by suit (hearts, clubs, spades, and
diamonds) and order (such as 2, 3, 4, 5 or Jack, Queen, King, Ace). If you were looking for a
specific card, say the 8 of clubs, it is easy to find it within the organized box of cards. Continuing with this analogy, picture each account in the double-entry accounting system having its
own card, with the box of cards organized by type of account; that is, the asset cards coming
The Accounting Equation
KEY POINTS
• Asset accounts
normally have a debit
balance.
• Liabilities and
shareholders’ equity
accounts normally
have a credit balance.
• An account’s normal
balance is used to
increase it.
• The opposite of an
account’s normal
balance is used to
decrease it.
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first, followed by the cards for the liability accounts, and then the cards for the shareholders’
equity accounts. Within each type of account, the cards will also be in order of liquidity. That
is, the most current assets will come before the non-current assets and the current liabilities
will come before the non-current liabilities. Just as with the deck of cards, if we know which
account we are looking for, it is easy to find it within the box of cards. The box of cards is known
as the general ledger (or G/L), so each account is referred to as a general ledger account.
Each card will have the account name written on top of a big T as shown in Exhibit 3.2.
EXHIBIT 3.2
T Accounts
CASH
All of the transactions affecting that account are recorded as debits or credits on that particular card. For example, since cash is an asset that normally has a debit balance, transactions
increasing the account are recorded on the debit side (or left side), while transactions that
decrease the account are recorded on the credit side (or right side). After all of the transactions
for the period are recorded, each side is totalled, but the account is expected to end up with a
net debit balance (that is, with more debits than credits).
Another key difference between the template method and the double-entry accounting
system is that there are cards for revenue accounts, expense accounts, and the Dividends
Declared account. You will recall that transactions affecting these accounts were recorded
in the retained earnings column in the template method. This is not the case under the double-entry accounting system. Instead, we will use specific accounts for them. At the end of
each accounting period, we will transfer the balances of the revenues, expenses, and dividends
declared accounts to the Retained Earnings account. This is the closing entry process, which
we will discuss later in the chapter. For now, it is important to understand that we can no
longer make entries directly to the Retained Earnings account. The ability to easily track revenues and expenses is essential for managing any business, and this is one of the significant
advantages of the double-entry accounting system.
Given that each revenue account, each expense account, and the Dividends Declared
account will have its own card, it is important to understand what their normal balances are.
The easiest way to think of this is to reflect on the impact each of these has on retained earnings. In Chapter 2, we discussed retained earnings, as shown in Exhibit 3.3.
EXHIBIT 3.3
How to Calculate Retained
Earnings
Retained Earnings =
+ Revenues
Opening Retained Earnings
− Expenses
+ Net Income
Net Income
− Dividends Declared
Ending Retained Earnings
From this we can deduce the following:
• Revenues ultimately increase Retained Earnings because they increase net income,
which increases retained earnings.
• Expenses ultimately decrease Retained Earnings because they decrease net income, and
a lower net income means lower retained earnings.
• Dividends declared decrease Retained Earnings because they are a distribution of
retained earnings.
The Normal Balance Concept 3-7
If we know the above and we know that Retained Earnings normally has a credit balance
(that is, it is on the right side of the T), then we also know the following:
• Revenue accounts will normally have a credit balance. This is because revenue accounts
increase Retained Earnings and Retained Earnings normally has a credit balance, so it
must be credited to increase it.
• Expense accounts will normally have a debit balance. This is because expense accounts
decrease Retained Earnings and Retained Earnings normally has a credit balance, so it
must be debited to decrease it.
• Dividends Declared will normally have a debit balance. This is because Dividends
Declared decreases Retained Earnings and Retained Earnings normally has a credit balance, so it must be debited to decrease it.
KEY POINTS
• Revenue accounts
normally have a credit
balance.
• Expense accounts
normally have a debit
balance.
• The Dividends
Declared account
normally has a debit
balance.
Exhibit 3.4 presents a visual summary of the normal balance rules, and they are also summarized in the Key Points. The Helpful Hint explains how to record increases in accounts.
EXHIBIT 3.4
Normal Balance Illustration
A = L + S/H Equity
DR
CR
Revenues
Retained Earnings
Normal
Expenses
Normal
Dividends
Declared
Normal
Normal
Helpful Hint
Remember that increases in accounts are recorded in the same way as the account’s normal balances:
• Asset accounts normally have debit balances; increases in assets are also recorded as debits.
• Liability and shareholders’ equity accounts normally have credit balances; increases in liabilities and shareholders’ equity are also recorded as credits.
• Revenue accounts normally have credit balances; increases in revenues are recorded as credits.
• Expense and dividends declared accounts normally have debit balances; increases in expenses
and dividends declared are recorded as debits.
Exhibit 3.5 presents an expanded version of the normal balance illustration, with the
specific rules for each type of account, including revenues, expenses, and dividends declared.
EXHIBIT 3.5 Expanded Normal Balance Illustration
Assets
Shareholders’
Equity
Liabilities
Normal
Normal
Revenues
Normal
Normal
Expenses
Normal
Dividends
Declared
Normal
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Double-Entry Accounting and the Accounting Cycle
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 3-1
• Demonstration Problem 3-1 in Wiley’s course resources
3.3
Understanding the Accounting Cycle
LEARNING OBJECTIVE 3
Identify and explain the steps in the accounting cycle.
What Are the Steps in the Accounting Cycle?
We are now ready to look at the whole system by which transactions are first measured,
recorded, and summarized, and then communicated to users through financial statements.
This system is called the accounting cycle because it is repeated each accounting period.
Exhibit 3.6 illustrates the complete cycle. Each of the steps will be discussed in the subsections that follow.
EXHIBIT 3.6
The Accounting Cycle
Chart of
Accounts
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Opening
balances
Closing entries
are journalized
and posted
Transaction
analysis
Financial
statements are
prepared
Transactions
are recorded in
general journal
Adjusted trial
balance is
prepared
Journal entries
are posted to
general ledger
Adjustments are
journalized and
posted
Trial balance
is prepared
The Chart of Accounts 3-9
As we proceed through a discussion of the accounting cycle, we will demonstrate
each stage by revisiting the Sample Company Ltd. (SCL) example that we used in Chapter 2. In that chapter, we analyzed and recorded SCL’s January transactions using the
template method and then prepared the company’s financial statements for the month
of January. In this chapter, we will use these same transactions to explain how they are
recorded within the double-entry accounting system and to illustrate each of the steps in
the accounting cycle. You can refer back to the transaction analysis in Chapter 2 for any
of the transactions if necessary as we learn how to record them within the double-entry
accounting system.
A system for maintaining accounting records can be as simple as a notebook, in
which everything is processed by hand, or as sophisticated as a computerized system. We
will use a simple manual system to illustrate the accounting cycle. However, the same
underlying processes apply to any accounting system, no matter how simple or sophisticated it is.
3.4
The Chart of Accounts
LEARNING OBJECTIVE 4
Explain the significance of a company’s decisions regarding its chart of accounts
and the implications of subsequent changes.
What Is the Chart of Accounts?
Accounting systems are information systems. When a company is formed, one of the most
critical initial decisions management makes as they set up the accounting system is to determine what information they need to manage the business. They would ask themselves the
following questions:
Chart of
Accounts
• What information is needed by the management team to make well-informed decisions?
• What information is needed by outside users?
• What information is needed to comply with the applicable financial reporting standards?
The information needs of managers differ, so companies will develop their own unique
Closing entries
information systems and capture different information or summarize information in differentare journalized
and posted
ways.
Each type of information that management wishes to capture requires its own account in
which it can be recorded. In Chapter 2, each column within the template was considered an
account and all of the transactions affecting that account were recorded in that column.Financial
As we
are
discussed above, the double-entry accounting system also uses accounts, but rather statements
than
colprepared
umns, there are cards (although they are generally virtual because most accounting systems
are computerized), one for each account.
The list of all of a company’s accounts is known as its chart of accounts. Establishing
the chart of accounts is the starting point for a company’s initial accounting cycle. However,
Adjusted trial
the chart of accounts is dynamic and can be changed. As a company grows, management
balance is
prepared
may need to add different types of accounts, such as when different types of property, plant,
and equipment are purchased or when new types of products and services are offered to customers. Although there are certain account titles that are commonly used, an account can
Adjustments are
journalized and
be given any name that makes sense to the company and describes the account’s purpose. In
posted
most accounting systems, each of the accounts in the chart of accounts is also identified by a
number that indicates the sequence of the accounts and makes it easier to record transactions.
In this textbook, accounts are designated only by their names and we will not use account
numbers.
Opening
balances
Transaction
analysis
Transact
are record
general jo
Journal entrie
are posted to
general ledge
Trial balance
is prepared
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Double-Entry Accounting and the Accounting Cycle
Exhibit 3.7 shows the chart of accounts for Sample Company Ltd. It consists of all the
accounts that were used to record SCL’s transactions in Chapter 2. There is an account for
each column that was used in the template method. There are also accounts for revenues,
expenses, and dividends declared because transactions affecting these accounts will no longer
be recorded directly to Retained Earnings.
EXHIBIT 3.7
Sample Company Limited’s
Chart of Accounts
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Assets
Revenues
Cash
Sales Revenue
Accounts Receivable
Expenses
Inventory
Cost of Goods Sold
Prepaid Insurance
Wages Expense
Equipment
Rent Expense
Land
Utilities Expense
Liabilities
Depreciation Expense
Accounts Payable
Insurance Expense
Interest Payable
Interest Expense
Bank Loan Payable
Dividends Declared
Shareholders’ Equity
Dividends Declared
Common Shares
Retained Earnings
Notice that the accounts are listed in the chart of accounts in the order in which they
will appear on the financial statements. Accounts are kept in this order so that it is easy to
locate them in the general ledger and easier to prepare the financial statements. Account
numbers are normally assigned to the accounts, with a different set of account numbers
for each section of the financial statements. For example, many companies using four-digit
account numbers will assign numbers between 1000 and 1999 to assets, 2000–2999 to liabilities, 3000–3999 to shareholders’ equity, 4000–4999 to revenues, 5000–5999 to expenses,
and so on.
Can Companies Change Their Chart of Accounts
and What Are the Implications if They Do?
Yes, companies can and do make changes to their chart of accounts. Companies can add new
accounts when they enter into new types of operations, open new locations, wish to capture information at a different level of detail, and so on. They can also delete accounts that
are no longer required. Changes to permanent accounts (assets, liabilities, and shareholders’
equity accounts) within the chart of accounts can be made anytime. However, changes to
temporary accounts (revenue and expense accounts) are generally made only at the beginning of an accounting period. This is because management normally wants to capture annual
data related to the company’s revenues and expenses. Introducing new revenue and expense
accounts during a cycle would require the company to go back and adjust the accounting for
any such revenues or expenses already recorded in the period or else it would have incomplete
information. Of course, if the revenue or expense account being added is related to a new
activity, this is not a problem.
Transaction Analysis and Recording
3.5
3-11
Opening Balances
LEARNING OBJECTIVE 5
Explain the difference between permanent and temporary accounts.
What Is the Difference between Permanent and
Temporary Accounts?
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Chart of
Accounts
When a company begins operations, none of its accounts will have an opening balance.
This will not be the case once a company completes its first accounting cycle because all
of the accounts on its statement of financial position (its assets, liabilities, and shareholders’ equity accounts) will have balances at the end of the cycle. These ending balances will become the opening balances for the next cycle; that is, the cash that the
Opening
company had at the end of its accounting cycle will be the cash it begins the next cycle
balances
with. Accounts with balances that carry over from one period to the next are known as
Closing entries
Transaction
permanent accounts.
are journalized
analysis
and posted
Management normally wants to track its revenues and expenses each period (such as
each year) in order to assess things such as the profitability of operations and the outcome
of their decisions. They are less interested in cumulative numbers, such as sales revenues
earned or total wages incurred during the life of the company. As a result, it is necessary
for
Transactions
Financial
KEY POINTS
are recorded in
statements are
the balances in all the accounts that appear on the statement of income (that is,
all
revenues
general journal
prepared
• Asset, liability,
and expenses) to be “reset” at the end of each accounting cycle or period. Accounts with
and shareholders’
balances that are closed at the end of each accounting period are known as temporary
equity accounts are
accounts. The amount of dividends declared is also tracked period to period and the Divipermanent accounts.
dends Declared account is a temporary account. The balance in each temporary account is
Adjusted trial
Journal entries
transferred to Retained Earnings, so that it starts each accounting cycle with zerobalance
or nilis bal• Revenue, expense, and
are posted to
prepared
ances. This transfer/reset process is accomplished through closing entries. These entries are
dividends declared general ledger
discussed a little later in the chapter. The Key Points show which accounts are temporary
accounts are temporary
and which are permanent.
accounts.Trial balance
Adjustments are
journalized and
posted
3.6
is prepared
Transaction Analysis and Recording
LEARNING OBJECTIVE 6
Identify and record transactions in the general journal and general ledger.
How Are Transactions Identified?
The next step in the accounting cycle is transaction analysis. This involves identifying whether an
Closing entries
event or transaction has occurred and, if so, determining its effects on the company’s
accounts.
are journalized
and posted
Evidence of a transaction or event is usually some sort of “source document”—a document that is received or created by the company indicating that a transaction has taken place
that needs to be recorded. Examples of source documents include invoices, cheques, cash
register tapes, bank deposit slips, time sheets, and shipping documents.Financial
statements are
When a transaction or event has occurred, the accountant must
analyze it to deterprepared
mine what accounts have been affected and how the transaction should be recorded in
the accounting system. We introduced this phase of the process in Chapter 2, where
Adjusted trial
balance is
Chart of
Accounts
Opening
balances
Transaction
analysis
Transactions
are recorded in
general journal
Journal entries
are posted to
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Double-Entry Accounting and the Accounting Cycle
we analyzed the effects of various transactions on the basic accounting equation and
recorded the results by entering positive and negative amounts in the template columns.
In this chapter—and throughout the remainder of this book—we will analyze the effects
of transactions to see how they should be recorded as debits and credits in a company’s
accounts.
Chart of
Accounts
Opening
balances
How Are Transactions Recorded in
the General Journal?
Transaction
analysis
Transactions
are recorded in
general journal
Journal entries
are posted to
general ledger
KEY POINTS
Trial balance
• Transactions
is prepared
are
initially recorded in the
general journal.
• Subsequently, they are
posted to the general
ledger.
EXHIBIT 3.8
Basic Journal Entry Format
After an accountant has decided how to record transactions, appropriate entries must be
made in the accounting system (see the Key Points). The initial entries are usually made in
the general journal. The journal is a chronological listing of all the events that are recorded
in the accounting system. It is similar to the diary or travel journal that many people keep of
their daily life or travels. A journal could be as simple as a book in which a chronological list
of transactions is recorded, but most organizations’ journals are computerized. Each entry
in the journal shows the effects of a transaction on the company’s accounts and is called a
journal entry.
Journal entries are always dated and are normally numbered sequentially. Then, the
names of the accounts affected by the transaction, and the amounts involved, are listed. The
accounts being debited are listed first, followed by the accounts being credited. The credit portions are indented. Finally, an explanation of the transaction is generally included for future
reference.
In this book, we will not include explanations with each journal entry because they would
just be a repetition of the wording in the question. As such, the format we will use to record
journal entries is shown in Exhibit 3.8.
Basic Journal Entry Format
Date and/or
DR Name of Account
Amount debited
entry number CR Name of Account Amount credited
KEY POINTS
• The total dollar value
of debits must be equal
to the total dollar value
of credits within each
journal entry.
• Record debits before
credits.
• Indent all credit
entries.
EXHIBIT 3.9
SCL’s Transactions for
January 2024
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As illustrated in Exhibit 3.8, when journal entries are made, the customary practice is
to list the accounts that are being debited before the accounts that are being credited, and
to indent the accounts that are being credited. Of course, each journal entry must keep the
accounting system balanced. As such, the total debits must equal the total credits. Also, the
dollar signs are omitted from journal entries; in this text, assume all amounts in journal entries
are in dollars. See the Key Points for what to remember when recording journal entries.
We will now illustrate the process of analyzing transactions and recording them as journal
entries by working through SCL’s January transactions (see Exhibit 3.9). Each transaction will
be presented and analyzed to determine what accounts are affected and whether they should
be debited or credited. Then the journal entry to record the transaction will be presented. You
should study this material carefully to ensure that you understand how debits and credits are
applied and how journal entries are used to record transactions in an accounting system.
#
Date
Description
1
Jan. 1
SCL issued 10,000 common shares in exchange for $250,000 cash.
2
Jan. 1
To raise additional financing, SCL borrowed $100,000 from its bank. The
loan principal is due in three years, while the interest rate on the loan is 6%
per year. The interest is payable every three months.
3
Jan. 1
The company rented a retail location, paying $1,100 in rent for the month
of January.
Transaction Analysis and Recording
#
EXHIBIT 3.9
Date
Description
4
Jan. 1
The company paid $65,000 to purchase equipment.
5
Jan. 1
SCL paid $1,800 cash for a one-year insurance policy covering the new
equipment for the period January 1 to December 31.
6
Jan. 6
SCL purchased some land for $180,000 on which it plans to build a
warehouse in the future.
7
Jan. 10
The company bought $23,000 of inventory from suppliers on account. SCL
will pay for the goods at a later date.
8
Jan. 12
SCL sold products to customers for $34,000, of which $21,000 was received in
cash and the balance was on account. SCL’s customers will pay the balance
owing at a later date. The products that were sold had cost SCL $17,000.
9
Jan. 20
SCL received $11,000 from its customers as payments on their accounts
that originated from the sales on January 12.
10
Jan. 22
The company made payments of $13,500 to its suppliers, settling part of
the account that originated from the purchases on January 10.
11
Jan. 25
SCL paid monthly utility costs of $1,900.
12
Jan. 26
SCL paid advertising costs for the month of $2,200.
13
Jan. 28
SCL paid $2,900 in wages to its employees for the month of January.
14
Jan. 31
Dividends in the amount of $400 were declared by SCL’s board of directors
and paid.
Transactions 15, 16, and 17 are adjusting entries, rather than normal journal entries, so we will
discuss them later in the chapter.
Transaction 1: Issuing Shares for Cash
SCL issued 10,000 common shares in exchange for $250,000 cash.
Analysis of Transaction
Assets (specifically, Cash) increased by $250,000
Shareholders’ Equity (specifically, Common Shares) increased by $250,000
This analysis must be translated into debits and credits. As we have learned, asset accounts
normally have a debit balance; therefore, an increase to the Cash account is recorded as a
debit. Shareholders’ equity accounts normally have a credit balance; therefore, the increase to
the Common Shares account is recorded as a credit.
Jan. 1
DR Cash
250,000
CR Common Shares
250,000
From this transaction, we can see that the total amount debited in the transaction
equals the total amount credited. This is required in order to keep the accounting records
in balance.
Transaction 2: Taking Out a Bank Loan
To raise additional financing, SCL borrowed $100,000 from its bank. The loan principal is due
in three years, while the interest rate on the loan is 6% per year. The interest is payable every
three months.
SCL’s Transactions for
January 2024 (continued)
3-13
3-14
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
Analysis of Transaction
Assets (specifically, Cash) increased by $100,000
Liabilities (specifically, Bank Loan Payable) increased by $100,000
Because asset accounts normally have a debit balance, the increase to the Cash account is
recorded as a debit. Liability accounts normally have a credit balance; therefore, the increase
to the Bank Loan Payable account is recorded as a credit.
Jan. 1
DR Cash
100,000
CR Bank Loan Payable
100,000
Transaction 3: Paying Rent for the Month
The company rented a retail location, paying $1,100 in rent for the month of January.
Analysis of Transaction
Assets (specifically, Cash) decreased by $1,100
Expenses (specifically, Rent Expense) increased by $1,100
Because asset accounts normally have a debit balance, a decrease to the Cash account is
recorded as a credit. Since they ultimately reduce retained earnings, expense accounts normally have a debit balance. Therefore, the increase to the Rent Expense account is recorded
as a debit.
Jan. 1
DR Rent Expense
1,100
CR Cash
1,100
Transaction 4: Purchasing Equipment
The company paid $65,000 to purchase equipment.
Analysis of Transaction
Assets (specifically, Equipment) increased by $65,000
Assets (specifically, Cash) decreased by $65,000
Asset accounts normally have a debit balance. Therefore, the Equipment account must
be debited to record the increase (the new equipment) and the Cash account must be credited
(that is, the opposite of its normal balance) to record the decrease.
Jan. 1
DR Equipment
65,000
CR Cash
65,000
Transaction 5: Purchasing Insurance Coverage
SCL paid $1,800 cash for a one-year insurance policy covering the new equipment for the
period January 1 to December 31.
Transaction Analysis and Recording
Analysis of Transaction
Assets (specifically, Cash) decreased by $1,800
Assets (specifically, Prepaid Insurance) increased by $1,800
Asset accounts normally have a debit balance. Therefore, the Prepaid Insurance account
must be debited to record the increase and the Cash account must be credited (that is, the
opposite of its normal balance) to record the decrease.
Jan. 1
DR Prepaid Insurance
1,800
CR Cash
1,800
Transaction 6: Purchasing Land
SCL purchased some land for $180,000 on which it plans to build a warehouse in the future.
Analysis of Transaction
Assets (specifically, Cash) decreased by $180,000
Assets (specifically, Land) increased by $180,000
Asset accounts normally have a debit balance. Therefore, the Land account must be debited to record the increase (the new land) and the Cash account must be credited (that is, the
opposite of its normal balance) to record the decrease.
Jan. 6
DR Land
180,000
CR Cash
180,000
Transaction 7: Purchasing Inventory
The company bought $23,000 of inventory from suppliers on account. SCL will pay for the
goods at a later date.
Analysis of Transaction
Assets (specifically, Inventory) increased by $23,000
Liabilities (specifically, Accounts Payable) increased by $23,000
Asset accounts normally have a debit balance. Therefore, the Inventory account must be
debited to record the increase (the additional inventory). Liabilities normally have a credit
balance. Therefore, the Accounts Payable account must be credited to record the increase.
Jan. 10
DR Inventory
23,000
CR Accounts Payable
23,000
Transaction 8: Selling Products to Customers
SCL sold products to customers for $34,000, of which $21,000 was received in cash and the
balance was on account. SCL’s customers will pay the balance owing at a later date. The products that were sold had cost SCL $17,000.
3-15
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C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
Analysis of Transaction
Part 1
Assets (specifically, Cash and Accounts Receivable) increased by $34,000
Revenues (specifically, Sales Revenue) increased by $34,000
Part 2
Assets (specifically, Inventory) decreased by $17,000
Expenses (specifically, Cost of Goods Sold) increased by $17,000
As discussed in Chapter 2, when a company sells products to customers, it is useful to
separate the transaction into two parts. Part 1 is to account for the sales revenue and the cash
and/or accounts receivable that flow into the company as a result. Part 2 is to account for the
inventory that has been provided to the customer and has become an expense (known as cost
of goods sold) to the company.
For part 1, because asset accounts normally have a debit balance, the Cash and Accounts
Receivable accounts must each be debited to record the increases in both accounts. Revenue
accounts normally have a credit balance because they ultimately increase retained earnings.
Therefore, the Sales Revenue account must be credited. The selling price ($34,000) is used to
determine the sales revenue.
For part 2, expense accounts, like Cost of Goods Sold, normally have a debit balance
because they ultimately reduce retained earnings. Asset accounts like Inventory normally
have a debit balance, so this account must be credited to reduce it to reflect the cost of the
goods that have been removed from inventory and provided to customers. The cost of the
inventory ($17,000) is used to determine the cost of goods sold.
Jan. 12
DR Cash
21,000
DR Accounts Receivable
13,000
CR Sales Revenue
Jan. 12
DR Cost of Goods Sold
34,000
17,000
CR Inventory
17,000
Notice that the journal entry for part 1 affects three accounts. However, the total of the two
debits ($21,000 and $13,000) is equal to the amount of the credit entry ($34,000), so the entry, as a
whole, balances. This illustrates the fact that, although every journal entry must have at least one
debit and one credit, a journal entry can have any number of debit and credit parts, as long as the
sum of the amounts debited is equal to the sum of the amounts credited. The term compound
journal entry is used for a journal entry that affects more than two accounts.
Transaction 9: Collecting Payments from Customers
SCL received $11,000 from its customers as payments on their accounts that originated from
the sales on January 12.
Analysis of Transaction
Assets (specifically, Cash) increased by $11,000
Assets (specifically, Accounts Receivable) decreased by $11,000
Asset accounts normally have a debit balance. Therefore, the Cash account must be debited to record the increase. The opposite must be done to the Accounts Receivable account to
reduce it. Therefore, the account must be credited.
Jan. 20
DR Cash
CR Accounts Receivable
11,000
11,000
Transaction Analysis and Recording
Transaction 10: Paying Suppliers
The company made payments of $13,500 to its suppliers, settling part of the account that originated from the purchases on January 10.
Analysis of Transaction
Assets (specifically, Cash) decreased by $13,500
Liabilities (specifically, Accounts Payable) decreased by $13,500
Asset accounts normally have a debit balance. Therefore, to reduce the Cash account,
it must be credited to record the decrease. Liabilities normally have a credit balance, so the
opposite must be done to the Accounts Payable account to reduce it. Therefore, the account
must be debited.
Jan. 22
DR Accounts Payable
13,500
CR Cash
13,500
Transaction 11: Paying Utility Costs
SCL paid monthly utility costs of $1,900.
Analysis of Transaction
Assets (specifically, Cash) decreased by $1,900
Expenses (specifically, Utilities Expense) increased by $1,900
Asset accounts normally have a debit balance. Therefore, to reduce the Cash account, it
must be credited to record the decrease. Expenses normally have a debit balance because they
reduce retained earnings. As such, the Utilities Expense account must be debited.
Jan. 25
DR Utilities Expense
1,900
CR Cash
1,900
Transaction 12: Paying Advertising Costs
SCL paid advertising costs for the month of $2,200.
Analysis of Transaction
Assets (specifically, Cash) decreased by $2,200
Expenses (specifically, Advertising Expense) increased by $2,200
Asset accounts normally have a debit balance. Therefore, to reduce the Cash account, it
must be credited to record the decrease. Expenses normally have a debit balance because they
reduce retained earnings. As such, the Advertising Expense account must be debited.
Jan. 26
DR Advertising Expense
2,200
CR Cash
Transaction 13: Paying Wages to Employees
SCL paid $2,900 in wages to its employees for the month of January.
2,200
3-17
3-18
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
Analysis of Transaction
Assets (specifically, Cash) decreased by $2,900
Expenses (specifically, Wages Expense) increased by $2,900
Asset accounts normally have a debit balance. Therefore, to reduce the Cash account, it
must be credited to record the decrease. Expenses normally have a debit balance because they
reduce retained earnings. As such, the Wages Expense account must be debited.
Jan. 28
DR Wages Expense
2,900
CR Cash
2,900
Transaction 14: Declaring and Paying Dividends
Dividends in the amount of $400 were declared by SCL’s board of directors and paid.
Analysis of Transaction
Assets (specifically, Cash) decreased by $400
Shareholders’ Equity (specifically, Dividends Declared) decreased by $400
Asset accounts normally have a debit balance. Therefore, to reduce the Cash account, it
must be credited to record the decrease. The declaration of dividends reduces retained earnings, so this account normally has a debit balance. As such, the Dividends Declared account
must be debited.
Jan. 31
DR Dividends Declared
400
CR Cash
400
This completes the journal entries required to record SCL’s transactions for January 2024
in the company’s general journal. These journal entries are an example of how companies
initially record their transactions. While companies need the detailed information that is captured in the general journal, they also require information at a summary level.
Assess Your Understanding
Attempt the following problems and review the solutions provided:
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• Chapter End Review Problem 3-2, part (a)
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• Demonstration Problems 3-2 and 3-3 in Wiley’s course resources
Let’s continue to think of a company’s general journal as being similar to a tourist’s travel
journal. We can visualize how the entries in the travel journal would provide the details of each
art gallery or museum visited during the trip. However, if the traveller wanted to know how
many galleries or museums they had visited during their trip, they would need to flip through
the journal and count up the number of entries in which they recorded visits to galleries and
Transaction Analysis and Recording
museums. This may not be too difficult on a short trip, but the longer their travels, the longer
it would take to obtain the information. This is exactly the same for companies when they
require summary information. For example, while they want to record the details of each sale,
they also want to know the amount of their total sales. Summarizing the information from the
general journal is known as posting to the general ledger (or posting) and is the next step in
the accounting cycle.
Why Are Transactions Also Recorded
in the General Ledger?
3-19
Chart of
Accounts
Opening
balances
Closing entries
are journalized
and posted
While the general journal provides an important chronological record of the effects of each
Financial
transaction, companies require summarized information. For example,
if a manager wanted
statements are
to know the balance in the Cash account, the accountant would haveprepared
to take the beginning
balance of Cash and add or subtract all the journal entries that affected Cash. To prepare financial statements, the accountant would have to go through this process for all of the accounts
in order to determine their ending balances. If the company had hundreds or thousands of
journal entries, this would be extremely time-consuming and inefficient.Adjusted
Therefore,
to provide
trial
balance is on individual
more efficient access to information about the cumulative effects of transactions
prepared
accounts, the next step in the accounting cycle transfers or posts the data in the journal to the
accounts in the general ledger. The Key Points show the differences between the general
journal and the general ledger.
Adjustments are
and
Earlier in the chapter, we discussed using the analogy of the general ledger asjournalized
a posted
box of
cards. We noted that each account would have its own card and that the debits and credits
affecting that account would be recorded on it. These would then be totalled at the end of each
period and an ending debit or credit balance would be determined for each general account.
The process of transferring the debit or credit information from the journal entries to the general ledger accounts is known as posting.
For Example
Luca Pacioli referred to the ledger as the quaderno grande, which translates into the “big
book.” The French term for the general ledger is grand livre, which also translates as “big
book.” Thinking of the general ledger as the big box of cards or the big book is useful as
we learn about smaller boxes of cards or smaller books as we move though subsequent
­chapters. These smaller boxes of cards or smaller books are known as subledgers. They are
used to capture additional detail related to information in the general ledger. For example,
the accounts receivable subledger will have all of the detailed information on each customer’s account, and all of their purchase and payment information. The aggregate of this
subledger information will be equal to the balance in the Accounts Receivable account in
the general ledger.4
Each account in the ledger represents a separate, specific T account, and includes the
account name (and its number, if applicable), its beginning balance, all of the postings that
affected the account during the period, and its ending balance. Each posting includes the
transaction date and number, as well as the amount debited or credited. Including the date
and transaction number enables users to trace the amount posted to the related journal entry
and, thus, to the transaction details.
The posting process itself is very mechanical and, while we will not focus on it, it is
important that you have a basic understanding of it. As such, let’s look at how the January
transactions affecting SCL’s Cash account are posted to the company’s Cash account. This is
shown in Exhibit 3.10.
Transaction
analysis
Transactions
are recorded in
general journal
Journal entries
are posted to
general ledger
Trial balance
is prepared
KEY POINTS
• The general journal
contains detailed
information on each
transaction.
• The general ledger
contains summary
information for each
account.
3-20
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
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EXHIBIT 3.10 SCL’s Cash Account after the January Transactions Have Been Posted
Cash
Opening Bal.
Jan. 1
Entry #1
Jan. 1
250,000
–*
Entry #2
Jan. 1
100,000
Entry #8 (part 1)
Jan. 12
21,000
Entry #9
Jan. 20
11,000
Ending Bal.
1,100
Jan. 1
Entry #3
65,000
Jan. 1
Entry #4
1,800
Jan. 1
Entry #5
180,000
Jan. 6
Entry #6
13,500
Jan. 22
Entry #10
1,900
Jan. 25
Entry #11
2,200
Jan. 26
Entry #12
2,900
Jan. 28
Entry #13
400
Jan. 31
Entry #14
113,200**
*Cash is a permanent account that would normally have an opening balance (carried forward from the prior period).
However, because this is SCL’s first year of operations, there is no opening balance.
**The ending balance is equal to the total debits ($382,000) less the total credits ($268,800). As an asset, Cash would
normally be expected to have a debit balance, which it does in this case.
As a result of the posting references, a user can determine the details for any of the postings to the account. For example, if they want to determine what the $180,000 cash payment
on January 6 was related to, they can go to the general journal and look at entry 6. Then they
can see the cash was spent to purchase land.
Posting to the ledger can be done daily, weekly, monthly, or at any frequency desired.
The timing of the postings is determined to some extent by management’s (or the shareholders’) need for up-to-date information. If managers need to know the balance in a particular
account, say Cash, on a daily basis, then the postings have to be done at least daily. If management needs to know the amount of cash available on an hourly basis, then the postings have to
be done at least hourly. Computerized accounting systems can post journal entries instantly,
so that the information in the company’s general ledger is always up to date. Other computer
systems collect journal entries in batches and post them all at the same time (for example,
twice a day, after they have been reviewed by management).
For Example
Perhaps the double-entry accounting system should be known as the “double double-entry” system. Earlier in the chapter, we discussed how the first “double” in the double-entry accounting
system is that every transaction affects at least two accounts. We know that at least one account
will be debited and at least one other account will be credited. The second “double” occurs when
journal entries are posted to the general ledger. When posting has been completed, each transaction has been recorded twice, once in the general journal and again in the general ledger.
While the double-entry accounting system has been around for more than 700 years, Tim
Hortons might object to rebranding it to use the “double double” name because the company
has trademarked this term. We will discuss trademarks and their importance to companies in
Chapter 8.
Transaction Analysis
and Recording
Opening
3-21
balances
entries
At this point, it is important to note that a system consisting only of journal entriesClosing
would
are journalized
and posted
make it difficult for managers to know the balances in the accounts. On the other hand,
a
system of only ledger accounts, without the original journal entries, would make it difficult to
understand the sources of the amounts in the accounts. Accounting systems need both journal entries and ledger accounts in order to collect information in a way that makes it readily
Financial
accessible and as useful as possible.
statements are
Transaction
analysis
Transactions
are recorded in
general journal
prepared
What Is the Purpose of Preparing a Trial Balance?
Adjusted trial
The trial balance is a listing of all the account balances in the general ledger at
a specific
balance is
prepared final
point in time. The final balances of each account are listed, with the accounts having
debit balances in one column and accounts having final credit balances in another. A check
can then be done to ensure that the total of all accounts with debit balances equals the total of
Adjustments are
all accounts with credit balances. If these amounts are not equal, an error has been made in journalized and
the journal entries or the posting process. It must be found and corrected before proceeding. posted
SCL’s trial balance as at January 31, 2024, is presented in Exhibit 3.11.
Account Names
Cash
Debit
Balances
$113,200
Accounts receivable
2,000
Inventory
6,000
Prepaid insurance
1,800
Equipment
65,000
Accumulated depreciation, equipment
Land
Credit
Balances
$
0
180,000
Accounts payable
9,500
Interest payable
0
Bank loan payable
100,000
Common shares
250,000
Retained earnings
Dividends declared
0
400
Sales revenue
Cost of goods sold
34,000
17,000
Wages expense
2,900
Utilities expense
1,900
Rent expense
1,100
Advertising expense
2,200
Insurance expense
0
Depreciation expense
0
Interest expense
0
Totals
$393,500
$393,500
Notice that the accounts are presented in the trial balance in the same order that they
appear in the ledger. The permanent accounts are presented first (in the same order as they will
appear on the statement of financial position), followed by the temporary accounts (dividends
declared, revenues, and expenses). This makes it easier to prepare the financial statements.
Journal entries
are posted to
general ledger
Trial balance
is prepared
EXHIBIT 3.11 SCL’s Trial
Balance as at January 31, 2024
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3-22
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
The purpose of a trial balance is to assist in detecting errors that may have been made in the
recording process. Something is wrong if the ledger does not balance; that is, if the total of all
the accounts with debit balances does not equal the total of all the accounts with credit balances.
In such cases, there is no point in proceeding until the errors have been found and corrected.
This makes the preparation of a trial balance a useful step in the accounting cycle. However, it is
important to realize that the trial balance will not identify all types of errors. For example:
• The trial balance will still balance if the correct amount was debited or credited, but to
the wrong account; for example, if a purchase of equipment was debited to the Inventory
account, rather than to the Equipment account.
• The trial balance will still balance if an incorrect amount was recorded. An example is if a $450
transaction was recorded as a $540 transaction, for both the debit and credit portions of the entry.
• The trial balance will also not detect the complete omission of an entire journal entry. If
neither the debit nor the credit portions of a journal entry were posted, the totals on the
trial balance will still be equal.
Despite these limitations, preparing a trial balance is helpful in detecting common errors
in the recording process, and is an important step in the accounting cycle. See the Helpful
Hints for more information on the trial balance and how to detect errors in it.
Helpful Hint
Do not confuse a trial balance with a statement of financial position (also known as a balance
sheet). A trial balance lists the balances in all the accounts, while a statement of financial position
includes only the asset, liability, and shareholders’ equity accounts.
Helpful Hint
If you prepare a trial balance that does not balance, here are some tips for finding your error:
• First, calculate the difference between the total debits and the total credits, and look for a transaction for this amount that may have been recorded or posted incorrectly.
Chart of
Accounts
• Divide the difference from the first step by 2, and check to see whether a debit for this amount
has been recorded as a credit, or vice versa.
• Divide the difference from the first step by 9. If it divides evenly—with no decimals—check for a
transposition error: two digits that have been reversed. An example is 765 written as 756, or 432
written as 234.
Opening
balances
Closing entries
are journalized
and posted
3.7
Financial
statements are
prepared
Transaction
analysis
Adjusting Entries
Transactions
are recorded in
general journal
LEARNING OBJECTIVE 7
Explain why adjusting entries are necessary and prepare them.
Journal entries
are posted to
general ledger
Adjusted trial
balance is
prepared
Adjustments
are journalized
and posted
What Are Adjusting Entries and Why Are They
Necessary?
Trial balance
is prepared
Most of a company’s transactions are easy to identify because there are obvious indications
that a transaction has taken place. For example, cash is received or paid, receipts are issued,
invoices are received, and so on. However, there are other events that lack any obvious
Adjusting Entries 3-23
indications that a transaction has taken place. At the end of each accounting period, a number
of additional journal entries are normally required to adjust the company’s accounts to reflect
these transactions. These entries are known as adjusting entries and are classified into two
broad categories: accruals and deferrals (see Key Points).
Accruals are required when a company needs to recognize a revenue or expense before
the receipt or payment of cash. A common example of an adjusting entry for an accrued revenue is where a company has made interest-bearing loans to a customer or an employee that
involve the interest being paid sometime in the future. Each month, the company would need
to accrue the interest revenue earned on these loans.
Month end
DR Interest Receivable
XXX
CR Interest Revenue
XXX
If we analyzed the impact of this adjusting entry on the financial statements, we would
see the following:
Statement of Income
Revenues increase
Statement of Financial Position
Assets increase
Statement of Cash Flows
No effect
For Example
Clearwater Seafoods Incorporated’s statement of financial
position at January 2, 2021, included trade and other receivables
of $60,927,000. Of this, $59,401,000 were trade receivables due
from customers. These receivables result from Clearwater having provided goods to its customers before any cash has been
received. This is an example of an accrued revenue.
V
Matthew/Shutterstock
V JJ Matthew/Shutterstock
A common example of an adjusting entry for accrued expenses is the entry to recognize
the wages expense for employees who have worked but have not yet been paid.
Month end
DR Wages Expense
XXX
CR Wages Payable
XXX
If we analyzed the impact of this adjusting entry on the financial statements, we would
see the following:
Statement of Income
Expenses increase
Statement of Financial Position
Liabilities increase
Statement of Cash Flows
No effect
For Example
Kumpol Chuansakul/Shutterstock
Chuansakul/Shutterstock
Kumpol
New Look Vision Group Inc. is a Montreal-based eye care
company. The company’s statement of financial position at
December 31, 2020, included current liabilities of $11,826,000
related to salaries and accrued benefits. These related to wages
and benefits that were earned by the company’s employees, but
were unpaid at year end. This is an example of accrued expenses.
KEY POINTS
• There are two types
of adjusting entries:
accruals and deferrals.
• Accrual entries are
required when a
revenue or expense
needs to be recognized
before cash is received
or paid.
• Deferral entries are
required when a
revenue or expense
needs to be recorded
after cash has been
received or paid.
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Deferrals are required when a company needs to recognize a revenue or expense in an
accounting period after the cash has been received or paid. For example, when a customer
or client has prepaid for goods or services, a deferral adjusting entry is required to recognize
the revenue that had been earned during the period between prepayment and the end of the
accounting period. For example, your university or college would normally require you to
prepay tuition for your semester within the first few weeks of the term. At that time, the
institution would record the receipt of cash and a related liability (deferred revenue). Over the
course of the semester, the institution would use adjusting entries each month to recognize
the revenues earned in that period and the reduction of the deferred revenue liability.
Month end
DR Deferred Revenue
XXX
CR Tuition Revenue
XXX
If we analyzed the impact of this adjusting entry on the financial statements, we would
see the following:
Statement of Income
Revenues increase
Statement of Financial Position
Liabilities decrease
Statement of Cash Flows
No effect
For Example
Fotokostic/Shutterstock
Fotokostic/Shutterstock
New Look Vision Group Inc.’s statement of financial position
at December 31, 2020, included current liabilities of $8,734,000
related to customer deposits. These deposits related to products
that customers had paid for in whole or in part, but that had yet
to be delivered to them. Once the products are delivered, New
Look would recognize revenue and reduce the related customer
deposit liability. This is an example of deferred revenue.
An example of a deferral adjusting entry related to expenses is the entries necessary to
recognize insurance or rent expense. Both of these are normally paid in advance (that is, they
are prepaids), and an adjusting entry is required each month to recognize rent expense or
insurance expense and reduce the amount of the prepaid expense.
Month end
DR Insurance Expense
CR Prepaid Insurance
XXX
XXX
If we analyzed the impact of this adjusting entry on the financial statements, we would
see the following:
Statement of Income
Expenses increase
Statement of Financial Position
Assets decrease
Statement of Cash Flows
No effect
For Example
Taina Sohlman/123 RF
Vancouver-based Finning International Inc. sells and rents
heavy equipment and power and energy systems. The company’s
statement of financial position at December 31, 2020, included
prepaid expenses totalling $26 million. Insurance coverage is
a typical prepaid expense, as the company pays the insurance
premiums in advance of the coverage period. As the insurance
coverage elapses, it will become an expense, and the company
will record the insurance expense and reduce the related prepaid expense asset. This is an example of a deferred expense.
Adjusting Entries 3-25
Another example of a deferral adjusting entry related to expenses is the depreciation
of property, plant, and equipment. These assets may be paid for years before the accounting
period in which they are depreciated (expensed). Some accountants consider depreciation
entries to be a third category of adjusting entries. However, because they are really a form of
deferral, we will consider them to be part of that category of adjusting entries.
Month end
DR Depreciation Expense
CR Accumulated Depreciation, Equipment
XXX
XXX
If we analyzed the impact of this adjusting entry on the financial statements, we would
see the following:
Statement of Income
Expenses increase
Statement of Financial Position
Assets decrease
Statement of Cash Flows
No effect
From the analysis of all of the adjusting entries, a couple of key points about adjusting entries are apparent. First, adjusting entries never involve cash. This is because whenever cash is paid or received, companies would account for it at that time. They would not
wait until the end of the accounting period, which is when adjusting entries are made.
Notice also that the types of items that need to be adjusted generally relate to the passage
of time: the depreciation of property, plant, and equipment; the expiration of prepaid
expenses; the accrual of interest; and the consumption of supplies all occur daily. However, they are typically updated only at the end of the accounting period, through adjusting entries. In most situations, there is no external transaction at the end of a period to
signal that an adjustment needs to be made. Only the passage of time triggers the need
for an adjustment. As a result, the ending balances in the accounts have to be carefully
reviewed to determine those that need to be adjusted.
The second key point about adjusting entries is that they always involve at least one
statement of income account (such as a revenue or expense account) and at least one statement of financial position account (such as an asset or liability account). The third key point
is that adjusting entries are made at the end of each accounting period, such as the end of
a month, the end of a quarter, or the end of a year (see the Key Points about adjusting
entries).
KEY POINTS
Adjusting journal entries:
• never involve cash
• always involve at
least one statement of
income account (such
as a revenue or expense;
account) and one
statement of financial
position account (such
as an asset or liability
account);
• are made at the end of
each accounting period
(such as each month,
quarter, or year end).
The Conceptual Framework
Adjusting Entries and Comparability
Comparability is one of the enhancing qualitative characteristics included in the conceptual framework. Accounting standard
setters have concluded that financial information is more useful
when it can be compared with financial information from a previous period prepared on a comparable basis. Preparing adjusting
entries each period to accrue expenses such as interest and wages
helps to enhance the period-to-period comparability of financial
information.5
We will now illustrate the process of analyzing transactions involving adjusting entries
and recording the adjusting entries themselves. We will use transactions 15, 16, and 17 because
these were all related to adjusting entries. Transaction 15 recorded the depreciation of SCL’s
equipment for the month of January. Transaction 16 was the recognition of the company’s
monthly insurance expense for which premiums for one year’s coverage had been paid in
advance. These transactions were both examples of deferral entries. Transaction 17 recorded
SCL’s interest expense on its bank loan for the month of January. This was an example of an
accrual entry. Note that none of these entries involved the Cash account.
3-26
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
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#
Date
Description
15
Jan. 31
SCL’s accountant determined that the depreciation expense on the
company’s equipment was $850 per month.
16
Jan. 31
SCL’s insurance expense was recorded for January.
17
Jan. 31
SCL recorded the interest expense on the bank loan for the month.
Although the principal of the loan does not have to be repaid for three
years, the company is incurring interest expense each month that the
loan is outstanding.
Transaction 15: Recording Depreciation of Equipment
SCL’s accountant determined that the depreciation expense on the company’s equipment was
$850 per month. This transaction was discussed in Chapter 2 and is based on the equipment,
which had a cost of $65,000, having an estimated useful life of six years and an estimated
residual value of $3,800.
= $65,000 − $3,800 = $10,200/12 months = $850
6 years
Analysis of Transaction
Contra-assets (specifically, Accumulated Depreciation, Equipment)
increased by $850
Expenses (specifically, Depreciation Expense) increased by $850
KEY POINTS
• Accumulated
Depreciation is a
contra-asset account.
• Its normal balance is a
credit.
• The carrying amount
of property, plant,
and equipment is its
cost less accumulated
depreciation.
As discussed in the previous chapter, companies allocate the cost of property, plant,
and equipment to those periods in which the asset is expected to help generate revenues.
We learned about the straight-line depreciation method, which allocates a consistent portion of the asset’s cost to each period. In Chapter 2, the depreciation expense for the period
was recorded directly to the Equipment account as a reduction in that column. While the
net effect of doing this is correct, it is not what is done in practice. Instead of reducing the
Equipment account, accountants use the Accumulated Depreciation account. This is
a contra-asset account, which is an asset account, but its normal balance is contrary or
opposite to what an asset account would normally have. As such, a contra-asset account
normally has a credit balance rather than a debit balance. Using this account to record the
cumulative portion of the asset’s cost that has been expensed allows accountants to leave the
asset’s original cost intact in the Equipment account. This enables financial statement users
to assess the relative age of a company’s property, plant, and equipment by comparing the
asset’s costs with the amount recorded in its related contra-asset account. We will explore
this concept further in Chapter 8. For now, it is important to know that we will make entries
in a property, plant, and equipment account only when an asset is purchased or sold, but not
when recording depreciation.
Property, plant, and equipment are carried on the statement of financial position at
their carrying amount. Carrying amount is the cost of the property, plant, and equipment
less the accumulated depreciation on that asset. It represents the portion of the asset’s cost
that has yet to be expensed. It does not represent the asset’s market value (the amount for
which it could be sold). Carrying amount is also known as net book value. The Key Points
provide a summary of this information. It is useful to view carrying amount as shown in
Exhibit 3.12.
Adjusting Entries 3-27
EXHIBIT 3.12
Equipment
Carrying Amount
Accumulated
Depreciation,
Equipment
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Carrying Amount
In terms of recording the journal entry for depreciation expense, we will debit the Depreciation Expense account because expense accounts normally have a debit balance. The normal
balance of a contra-asset account is a credit, so we will credit the Accumulated Depreciation,
Equipment account as the balance in this account is increasing.
Jan. 31
DR Depreciation Expense
850
CR Accumulated Depreciation, Equipment
850
Transaction 16: Recording Insurance Expense
SCL’s insurance expense was recorded for January. This transaction was discussed in Chapter
2 and involved a one-year insurance policy with a cost of $1,800.
$1,800/12 months = $150
Analysis of Transaction
Assets (specifically, Prepaid Insurance) decreased by $150
Expenses (specifically, Insurance Expense) increased by $150
Asset accounts normally have a debit balance. Therefore, to reduce the Prepaid Insurance
account, it must be credited. Expenses normally have a debit balance because they reduce
retained earnings. As such, the Insurance Expense account must be debited.
Jan. 31
DR Insurance Expense
CR Prepaid Insurance
150
150
Transaction 17: Recording Interest Expense
SCL recorded the interest expense on the bank loan for the month. Although the principal of
the loan does not have to be repaid for three years, the company is incurring interest expense
each month that the loan is outstanding, which also increases Interest Payable. This transaction was discussed in Chapter 2 and involved a $100,000 loan with an interest rate of 6%.
$100,000 × 6% × 1/12 = $500
Analysis of Transaction
Liabilities (specifically, Interest Payable) increased by $500
Expenses (specifically, Interest Expense) increased by $500
Liabilities normally have a credit balance. Therefore, to increase the Interest Payable
account, it must be credited. Expenses normally have a debit balance because they reduce
retained earnings. As such, the Interest Expense account must be debited.
3-28
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
Jan. 31
DR Interest Expense
500
CR Interest Payable
500
The Helpful Hint explains which accounts are used for adjusting entries.
Helpful Hint
Notice that adjusting entries involve both a statement of financial position account and a statement of income account. That is, one-half of each adjusting entry (either the debit or the credit)
is an asset or liability account, while the other half of the entry is a revenue or expense account.
Ethics in Accounting
Many adjusting entries require management to make estimates
and exercise judgement, providing opportunities for managers
to manipulate earnings or balances on the statement of financial
position. For other adjusting entries, there is no obvious evidence
that a transaction has taken place and should be recorded.
For example, suppose that you, as an accountant for a
company, are asked by your manager to postpone making the
adjusting entry to accrue the interest on a company bank loan.
Your manager has proposed this because it will increase net
income, enabling the companyChart
to meet
the earnings target it had
of
Accounts
­forecasted. The manager has said
that the underaccrual of interest
Opening
balances
Closing entries
are journalized
and posted
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can be corrected in the next period and no one will be harmed by
your actions. What should you do?
As you consider your response to this, or any, ethical question, it is
sometimes helpful to think about who will be affected by your decision
(including yourself), and how it will help or hurt them. Particularly,
think of who the users or potential users of the financial statements are,
and how they might be affected by your action or inaction. This should
help you better understand the situation and make an ethical decision.
It is essential that financial statements not be presented in
a way that could mislead, or potentially harm, a user—such as
creditors and investors, in this case.
Assess Your Understanding
AttemptTransaction
the following problems and review the solutions provided:
analysis
• Chapter End Review Problem 3-2, part (b)
• Demonstration Problem 3-4 in Wiley’s course resources
Transactions
are recorded in
general journal
Financial
statements are
prepared
What Is the Purpose of Preparing
an Adjusted Trial Balance?
Journal entries
are posted to
Adjusted trial
balance is
prepared
Adjustments are
journalized and
posted
EXHIBIT 3.13 SCL’s Adjusted
Trial Balance as at January 31,
2024
After all the adjusting
general ledgerentries have been recorded and posted, an adjusted trial balance is
prepared, as in Exhibit 3.13. This is done to ensure that the total debits in the accounts still
equal the total credits. Any imbalance must be corrected before the financial statements are
prepared.
Trial balance
is prepared
Account Names
Cash
Debit
Balances
$113,200
Accounts receivable
2,000
Inventory
6,000
Prepaid insurance
1,650
Credit
Balances
Preparing Financial Statements and Closing Entries 3-29
Account Names
Equipment
Debit
Balances
Credit
Balances
65,000
Accumulated depreciation, equipment
Land
$
850
180,000
Accounts payable
9,500
Interest payable
500
Bank loan payable
100,000
Common shares
250,000
Retained earnings
Dividends declared
0
400
Sales revenue
Cost of goods sold
34,000
17,000
Wages expense
2,900
Utilities expense
1,900
Rent expense
1,100
Advertising expense
2,200
Insurance expense
150
Depreciation expense
850
Interest expense
500
Totals
3.8
EXHIBIT 3.13 SCL’s Adjusted
Trial Balance as at January 31,
2024 (continued)
$394,850
$394,850
Preparing Financial Statements and Closing Entries
Chart of
Accounts
LEARNING OBJECTIVE 8
Explain why closing entries are necessary and prepare them.
What Are Closing Entries and Why Are They
Necessary?
After the adjusted trial balance has been prepared, the financial statements for the period
can be prepared. As discussed in Chapters 1 and 2, the statement of income (Exhibit 3.14)
is the first statement prepared, using the information related to the revenue and expense
accounts in the adjusted trial balance. The next statement is the statement of changes in
equity (Exhibit 3.15) and then the statement of financial position (Exhibit 3.16). The final
major financial statement to be prepared is the statement of cash flows. However, because
we prepared the statement of cash flows for SCL in Chapter 2 and because Chapter 5 is
devoted entirely to this topic, we will defer any further discussion of the statement until
Chapter 5.
Opening
balances
Closing entries
are journalized
and posted
Financial
statements are
prepared
Adjusted trial
balance is
prepared
Adjustments are
journalized and
posted
3-30
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
EXHIBIT 3.14
Sample Company Limited
Statement of Income
Statement of Income
For the month ended January 31, 2024
Sales revenue
$34,000
Cost of goods sold
17,000
Gross profit
17,000
Wages expense
2,900
Utilities expense
1,900
Rent expense
1,100
Advertising expense
2,200
Insurance expense
150
Depreciation expense
850
Interest expense
500
$ 7,400
Net income
EXHIBIT 3.15
Sample Company Limited
Statement of Changes in Equity
Statement of Changes in Equity
For the month ended January 31, 2024
Number of
Common Shares
Share Capital –
Common Shares
–
$
–
Total
Balance, Jan. 1
–
Net income
–
–
Declaration of
dividends
–
–
Issuance of
common shares
10,000
250,000
–
250,000
Balance, Jan. 31
10,000
$250,000
$7,000
$257,000
EXHIBIT 3.16 Statement of
Financial Position
$
Retained
Earnings
7,400
$
–
7,400
(400)
(400)
Sample Company Limited
Statement of Financial Position
As at January 31, 2024
ASSETS
Current assets
Cash
$113,200
Accounts receivable
2,000
Inventory
6,000
Prepaid insurance
1,650
122,850
Non-current assets
Equipment (net)
Land
64,150
180,000
244,150
Total assets
$367,000
Preparing Financial Statements and Closing Entries 3-31
EXHIBIT 3.16 Statement of
Financial Position (continued)
LIABILITIES
Current liabilities
Accounts payable
Interest payable
$ 9,500
500
10,000
Non-current liabilities
Bank loan payable
100,000
Total liabilities
110,000
SHAREHOLDERS’ EQUITY
Common shares
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders’ equity
250,000
7,000
257,000
$367,000
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 3-3, part (a)
• Demonstration Problem 3-5, part (a) in Wiley’s course resources
You will recall from Chapter 2 that dividends declared are reflected on the statement of
changes in equity as a reduction to retained earnings. The sum of opening retained earnings
plus net income less dividends declared gives us the company’s ending retained earnings balance. This amount must be determined before preparing the company’s statement of financial
position.
As discussed earlier in the chapter, all of the accounts on a company’s statement of financial position are permanent accounts. That is, their balances carry over from one period to
the next. Meanwhile, all of the accounts on a company’s statement of income are temporary.
That is, the balance in each of these accounts is transferred to the Retained Earnings account
at the end of each year, so that the temporary accounts start each accounting period with a nil
balance. Dividends Declared is also a temporary account and its balance is also transferred to
Retained Earnings at the end of each accounting period.
Once the financial statements have been prepared, the balances in the temporary accounts
must be transferred to the Retained Earnings account. This resets these accounts so that they
have a nil balance to start the next year. This is referred to as closing the accounts, and the
required entries are known as closing entries.
Closing entries are required to transfer the balances in the temporary accounts (revenues, expenses, and Dividends Declared) to Retained Earnings. By doing this, the temporary accounts will start each year with nil balances. Companies are then able to measure
their revenues, expenses, and dividends declared for each year rather than having cumulative balances for multiple years. It is much more relevant for financial statement users
to know the revenues or expenses of a period, so that this amount can be compared with
prior periods, budgets, forecasts, and so on. Preparing closing entries is the last stage of the
accounting cycle.
There are a few different ways to prepare closing entries. Some accountants use a two-­
entry approach, some use three entries, while others use four entries. Some accountants even
prepare individual closing entries—one for each temporary account—which could mean
Chart of
Accounts
Opening
balances
Closing entries
are journalized
and posted
Financial
statements are
prepared
Adjusted trial
balance is
prepared
Adjustments are
journalized and
Trial balanc
3-32
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
hundreds of closing entries. We will use four closing entries to close the temporary accounts
because this method most closely replicates the format used to show the changes to a company’s retained earnings on the statement of changes in equity. On the statement of changes in
equity, a company’s ending retained earnings balance is equal to Beginning Retained Earnings
+ Net Income − Dividends Declared.
The first three closing entries will close the revenue and expense accounts while determining net income and transferring it to the Retained Earnings account. The fourth will close
the Dividends Declared account. Therefore, the four closing entries are as follows:
1. Close all revenue accounts to the Income Summary account.
2. Close all expense accounts to the Income Summary account.
3. Close the Income Summary account to Retained Earnings.
4. Close the Dividends Declared account to Retained Earnings.
The first closing entry will close all revenue accounts to the Income Summary account.
The Income Summary account is a temporary account that is opened and closed on the
last day of a company’s fiscal year. It is used to determine the amount of the company’s net
income, which is then transferred to Retained Earnings. Using the Income Summary account
minimizes the number of entries flowing through the Retained Earnings account. Because
revenue accounts normally have a credit balance, a debit for the total account balance has to
be made to each revenue account to reset the account balances to zero, and a credit is made
to the Income Summary account for the total revenue amount. If there were 100 revenue
accounts, closing entry 1 would have 100 debits, but only a single credit transferring total
revenues to the Income Summary account. Note that if the company also had gain accounts,
something that will be discussed in Chapter 8, these accounts would also be closed as part of
the first closing entry.
To illustrate the closing entry process, let’s assume that SCL’s year-end was January 31,
2024. Since SCL only has a single revenue account, Sales Revenue, closing entry 1 is:
Closing Entry 1
Year-end date
DR Sales Revenue
34,000
CR Income Summary
34,000
The second closing entry will close all expense accounts to the Income Summary account.
Because expense accounts normally have a debit balance, a credit for the total account balance
has to be made to each expense account to reset the account balances to zero, and a debit is
made to the Income Summary account for the total expense amount. Again, if there were 100
expense accounts, closing entry 2 would have 100 credits, but only a single debit transferring total expenses to the Income Summary account. Note that if the company also had loss
accounts, something that will be discussed in Chapter 6, these accounts would also be closed
as part of the first closing entry.
In the case of SCL, there were eight expense accounts, so closing entry 2 is:
Closing Entry 2
Year-end date
DR Income Summary
CR Cost of Goods Sold
26,600
17,000
CR Wages Expense
2,900
CR Utilities Expense
1,900
CR Rent Expense
1,100
CR Advertising Expense
2,200
CR Insurance Expense
150
CR Depreciation Expense
850
CR Interest Expense
500
Preparing Financial Statements and Closing Entries 3-33
Preparing a T account for Income Summary after the first two closing entries enables us
to easily determine net income (see Exhibit 3.17).
EXHIBIT 3.17
Income Summary
34,000 Closing Entry #1 (Revenues)
Closing Entry #2 (Expenses)
T Account for First Two
Closing Entries
26,600
7,400 Net Income
It is also worth noting that, if a temporary account had a debit or a credit prior to the
closing entries, it continues to have this in the Income Summary account. As such, the total
revenue amount is reflected as a credit balance in the Income Summary account and the total
expense amount is reflected as a debit balance in the Income Summary account. Because
revenues exceed expenses for most companies, we would normally expect to have a net credit
balance in the Income Summary account, meaning that the company has net income. It is
possible to have a net debit balance in the Income Summary account if the company has a net
loss for the period; that is, expenses exceed revenues. In the case of SCL, the company was
profitable. We know that net income ultimately increases retained earnings. This is what is
accomplished through closing entry 3, which closes the income summary account to retained
earnings. In the case of SCL it is:
Closing Entry 3
Year-end date
DR Income Summary
7,400
CR Retained Earnings
7,400
The final closing entry is required to close the Dividends Declared account to Retained
Earnings. We know that dividends are a distribution to shareholders of retained earnings—a
company’s profits from current and prior years. If a company declared dividends in the year,
then Retained Earnings must be reduced accordingly. The Dividends Declared account normally has a debit balance, so the account must be credited to close it. Retained Earnings,
which normally has a credit balance, is debited to reflect the reduction in the account balance
resulting from the declaration of dividends. In the case of SCL, the company declared dividends of $400 during the year, so closing entry 4 is as follows:
Closing Entry 4
Year-end date
DR Retained Earnings
400
CR Dividends Declared
400
If we prepared a T account for the Retained Earnings account after the four closing
entries, it would be as shown in Exhibit 3.18.
Retained Earnings
–
Closing Entry #4 Dividends Declared
Opening Balance
7,400
Net Income, Closing Entry #3
7,000
Ending Balance
400
EXHIBIT 3.18 T Account for
Retained Earnings after Four
Closing Entries
3-34
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
This ending retained earnings balance equals the amount of retained earnings on SCL’s statement of changes in equity (Exhibit 3.15) and the company’s statement of financial position
(Exhibit 3.16).
Exhibit 3.19 provides an overview of the four closing entries, including their effects on
the Income Summary and Retained Earnings accounts.
EXHIBIT 3.19 Overview of
Closing Entry Process
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Revenues
Normal
1 Balance
—
Expenses
Normal
Balance 2
—
Dividends
Declared
Normal
Balance 4
—
Income
Summary
Expenses
2
1 Revenues
3
Net Income
—
Retained
Earnings
Opening
Balance
Dividends
Declared 4 3 Net Income
Ending
Balance
KEY POINTS
Closing entries:
• transfer the balances in
all temporary accounts
to Retained Earnings;
• reset all temporary
account balances to
zero;
• are made at the end of
each year.
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The closing entry process has achieved two key objectives (see also the Key Points):
• The balance in the Retained Earnings account has been brought up to date by adding the
net income for the period and deducting the dividends declared during the period.
• The balances in all of the temporary accounts have been reset to zero, so that the accounts
are ready to use at the start of the next accounting period.
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 3-3, part (b)
• Chapter End Review Problem 3-4
• Demonstration Problem 3-4, part (b) in Wiley’s course resources
What Do We Know if a Company Has Retained
Earnings?
If a company has retained earnings, then we know a few key things. First, we know that the
company is not new and is in at least its second year of operations. We know this because
until the closing entries are prepared at the end of the first year, no balances would have been
transferred to the Retained Earnings account. The second thing we know if a company has
retained earnings is that the company has historically been profitable (that is, its cumulative
revenues have exceeded its cumulative expenses) and that at least a portion of these profits
or earnings has been retained and reinvested in the company rather than being distributed as
dividends to shareholders.
This completes our review of the accounting cycle. As with any cycle, the end of one cycle
is the beginning of the next. With the exception of the closing entry process, which happens
only once a year, most companies will have monthly cycles, meaning they will prepare adjusting entries and financial statements at the end of each month.
Summary
3-35
Review and Practice
Summary
1
Explain how the double-entry accounting system
works, including how it overcomes the limitations of the
template approach.
4
• Every transaction must be recorded in a way that affects at least
two accounts, with the effects of these entries being equal and
offsetting.
• The chart of accounts outlines the type of information management wishes to capture to assist them in managing the business.
• The double-entry accounting system enables the use of a huge
number of accounts and is not limited to a fixed number of columns as is the case with the template approach. This allows the
company to capture information at the level of detail required to
manage the business, yet makes it easy to summarize the information for reporting purposes.
Explain the normal balance concept and how it is
used within the double-entry accounting system.
2
• The normal balance concept is used to determine whether an
account normally has a debit or credit balance.
• To determine an account’s normal balance, a “T” is drawn
through the middle of the accounting equation. Accounts on the
left side of the T (assets) normally have a debit (DR) balance,
while accounts on the right side of the T (liabilities and shareholders’ equity) normally have a credit (CR) balance.
• An account’s normal balance illustrates what needs to be done
to increase that account. The opposite is done to decrease it.
Explain the significance of a company’s decisions
regarding its chart of accounts and the implications of
subsequent changes.
• The chart of accounts is dynamic and can be changed when
the company enters into new types of operations, opens new
locations, requires more detailed information, or requires less
detailed information.
• Changes to the chart of accounts are most often introduced at
the beginning of a fiscal year.
Explain the difference between permanent and
temporary accounts.
5
• Permanent accounts have balances that are carried over from
one accounting period to the next.
• Temporary accounts have balances that are closed to Retained
Earnings at the end of each accounting period. That is, they are
reset to zero.
• All of the accounts on the statement of financial position (assets,
liabilities, and shareholders’ equity accounts) are permanent
accounts.
• All of the accounts on the statement of income (revenues and
expenses) and Dividends Declared are temporary accounts.
• Because Retained Earnings is a shareholders’ equity account,
it normally has a credit balance. Therefore, to increase it, we
would credit it, and to decrease it, we would debit it.
6
• Following this, revenue accounts, which ultimately increase
retained earnings, normally have a credit balance. Expense and
dividends declared accounts, which ultimately decrease retained
earnings, normally have a debit balance.
• The general journal is a chronological listing of all transactions.
It contains detailed information on each transaction.
3
Identify and explain the steps in the accounting cycle.
• The steps in the accounting cycle are: (1) start with opening balances, (2) complete transaction analysis, (3) record transactions
in the general journal, (4) post transactions to the general ledger,
(5) prepare a trial balance, (6) record and post adjusting entries,
(7) prepare an adjusted trial balance, (8) prepare financial statements, and (9) prepare closing entries.
• At a minimum, this cycle is repeated annually, but parts of it
repeat much more frequently (quarterly, monthly, weekly, or
even daily).
Identify and record transactions in the general
journal and general ledger.
• Each journal entry must affect two or more accounts and the
total dollar amount of debits in the entry must be equal to the
total dollar amount of credits. In other words, total DR = total
CR.
• On a periodic basis (such as daily, weekly, or monthly), the information recorded in the general journal is posted to the general
ledger.
• The general ledger is used to prepare summary information for
each account. The detail from each journal entry affecting a specific account is recorded in the general ledger account for that
specific account.
• A trial balance is prepared to ensure that the total of all debits
posted to the general ledger is equal to the total credits posted.
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C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
7 Explain why adjusting entries are necessary and
8 Explain why closing entries are necessary and prepare
prepare them.
them.
• Adjusting entries are required at the end of each accounting
period to record transactions that may have been missed.
• Closing entries are used to close temporary accounts and transfer the balances in these accounts to Retained Earnings.
• There are two types of adjusting entries: accruals and deferrals.
• There are four closing entries: (1) close all revenue accounts to
the Income Summary account, (2) close all expense accounts to
the Income Summary account, (3) close the Income Summary
account to Retained Earnings, and (4) close Dividends Declared
to Retained Earnings.
• Accrual entries are used to record revenues or expenses before
cash is received or paid.
• Deferral entries are used to record revenues or expenses after
cash has been received or paid.
• Depreciation is a type of deferral entry.
• Adjusting entries never involve cash.
Key Terms
Accounting cycle 3-8
Accruals 3-23
Accumulated Depreciation account 3-26
Adjusted trial balance 3-28
Adjusting entries 3-23
Carrying amount 3-26
Chart of accounts 3-9
Closing entries 3-31
Compound journal entry 3-16
Contra-asset account 3-26
Credit 3-5
Debit 3-5
Deferrals 3-24
Double-entry accounting system 3-3
General journal 3-12
General ledger (G/L) 3-6
General ledger account 3-6
Income Summary account 3-32
Journal entry 3-12
Liquidity 3-6
Normal balance 3-4
Permanent accounts 3-11
Posting 3-19
Temporary accounts 3-11
Trial balance 3-21
Abbreviations Used
CR
DR
G/L
Credit
Debit
General ledger
Synonyms
Carrying amount | Net book value
Chapter End Review Problem 3-1
Required
4. Equipment
For each of the following accounts, identify what type of account it is
and state what its normal balance would be. Use the following abbreviations for account type: A – Asset, L – Liability, SE – Shareholders’
equity, R – Revenue, E – Expense, and DD – Dividends declared.
1. Inventory
5. Wages Payable
2. Sales Revenue
3. Prepaid Rent
6. Advertising Expense
7. Dividends Declared
8. Loan Payable
9. Common Shares
10. Cost of Goods Sold
Chapter End Review Problem 3-2
STRATEGIES FOR SUCCESS
• The first step is always to identify the account type
(asset, liability, shareholders’ equity, revenue, expense, or
dividends declared).
• Consider writing out the accounting equation and
drawing a “T” through it, labelling the left side “DR” and
the right side “CR.”
3-37
• Use the Retained Earnings account to help you with
revenues, expenses, and dividends declared. If you know
that Retained Earnings normally has a credit balance
and you know the effect that revenues, expenses, and
dividends declared have on retained earnings, then
it is easier to determine the normal balance of those
accounts.
Chapter End Review Problem 3-2
This problem will reinforce and extend what you have learned in this
chapter about transaction analysis, journal entries, and adjusting
entries. You should carefully work through the following problem and
then check your work against the suggested solution.
3. The company’s employees earned wages of $37,300 during the
month.
Exhibit 3.20 shows the trial balance of Matchett Manufacturing Ltd.
(MML) at November 30, 2024.
5. Purchases of inventory, all on account, amounted to $125,000.
EXHIBIT 3.20
MML’s Trial Balance
Account
Debit (DR)
$ 37,000
Accounts receivable
298,900
Inventory
108,000
Prepaid insurance
Equipment
Building
$ 25,300
500,000
75,200
385,000
Accounts payable
135,700
Wages payable
23,000
Bank loan payable
400,000
Common shares
250,000
Retained earnings
230,800
Dividends declared
30,000
Sales revenue
1,650,000
Cost of goods sold
908,000
Wages expense
375,000
Insurance expense
12,000
Depreciation expense
29,700
Interest expense
MML also prepared adjusting entries for the following transactions:
A1. Interest on the company’s bank loan was recorded for the month
of December. The interest rate on the loan was 6% per year and
was payable on the first day of each month. (That is, the interest
for December 2024 will be paid on January 1, 2025.)
76,000
Accumulated depreciation, building
Land
Credit (CR)
8,400
Accumulated depreciation, equipment
6. During the month, the company made payments to suppliers
totalling $98,000.
7. The company declared dividends of $10,000 on its 100,000 common shares. MML had a policy of declaring quarterly dividends of
this amount. The dividends from the first three quarters had been
paid on April 15, 2024; July 15, 2024; and October 15, 2024. The
dividends from the last quarter will be paid on January 15, 2025.
MATCHETT MANUFACTURING LIMITED
Trial Balance
as at November 30, 2024
Cash
4. The company made wage payments of $41,700 to its employees
during the month.
A2. Depreciation expense for the month of December was recorded
on MML’s equipment. The equipment, which had been purchased on January 1, 2023, for $76,000, was estimated to have
a useful life of five years and a residual value of $10,000. MML
uses the straight-line method to depreciate its equipment.
A3. Depreciation expense for the month of December was recorded on
MML’s building. The building had been purchased on January 1,
2021, at a cost of $500,000. Company management had determined
that it had a useful life of 25 years and a residual value of $20,000.
MML uses the straight-line method to depreciate the building.
A4. Insurance expense for the month of December was recorded.
The company had renewed insurance coverage on its equipment
and building on July 1, 2024, when its previous policy ended. The
annual premiums of $14,400 were paid at that time.
Required
a. Prepare journal entries for transactions 1 to 7.
b. Prepare adjusting entries for transactions A1 to A4.
22,000
$2,790,000
$2,790,000
MML has a December 31 year end and had the following transactions
in December 2024:
1. Sales for the month totalled $155,000, all on account. The inventory sold had cost MML $70,000.
2. Payments received from customers during the month in relation
to their accounts receivable were $215,900.
STRATEGIES FOR SUCCESS
• As you record transactions, remember that the total
dollar value of the debits must equal the total dollar value
of the credits. In other words, the entry must balance.
• When analyzing each transaction, ask yourself:
• What accounts are being affected?
• What kind of accounts are they (assets, liabilities,
shareholders’ equity, revenues, expenses, or dividends
declared)?
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C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
• Are they increasing or decreasing? If so, by what
amount?
• What is the normal balance of each account? (See
Exhibit 3.4.)
• While not all transactions will affect the Cash account,
many do. It is often easiest to “think cash first,” as it is
usually straightforward to think about whether cash is
increasing or decreasing. This can provide you with half
of the journal entry right away.
Chapter End Review Problem 3-3
This problem will reinforce and extend what you have learned in this
chapter about preparing financial statements and the related closing
entries. After the journal entries and adjusting entries for MML had
EXHIBIT 3.21
been posted, the company prepared an adjusted trial balance (see
Exhibit 3.21).
MML’s Adjusted Trial Balance
MATCHETT MANUFACTURING LIMITED
Adjusted Trial Balance
As at December 31, 2024
Account
Debit (DR)
Cash
$ 113,200
Accounts receivable
238,000
Inventory
163,000
Prepaid insurance
Equipment
7,200
76,000
Accumulated depreciation, equipment
Building
$
26,400
500,000
Accumulated depreciation, building
Land
Credit (CR)
76,800
385,000
Accounts payable
162,700
Wages payable
18,600
Dividends payable
10,000
Interest payable
2,000
Bank loan payable
400,000
Common shares
250,000
Retained earnings
230,800
Dividends declared
40,000
Sales revenue
1,805,000
Cost of goods sold
978,000
Wages expense
412,300
Insurance expense
13,200
Depreciation expense
32,400
Interest expense
24,000
$2,982,300
Required
$2,982,300
STRATEGIES FOR SUCCESS
a. Prepare a statement of income for 2024, a statement of changes
in equity, and a classified statement of financial position.
• Remember the order in which the financial statements
are prepared.
b. Prepare the closing entries required to ready MML’s accounts for
the beginning of 2025.
• Also prepare the closing entries in order.
• After the four closing entries have been made, each of
the revenue, expense, and dividends declared accounts
should have a nil balance.
Solutions to Chapter End Review Problems
3-39
Chapter End Review Problem 3-4
This problem will reinforce what you have learned in this ­chapter about
closing entries. At September 30, 2024, the balances from ­Delaney
Development Ltd.’s adjusted trial balance were as follows:
DR
Cash
29,000
Accounts receivable
44,000
Prepaid insurance
Inventory
Construction equipment
52,000
231,000
90,000
175,000
Deferred revenue
22,000
Common shares
80,000
Retained earnings
Dividends declared
Interest revenue
Cost of goods sold
Wages expense
Insurance expense
Depreciation expense
b. Determine the closing Retained Earnings account balance.
• Only temporary accounts are closed at the end of an
accounting period. This means that only revenue,
expense, and dividends declared accounts are
closed.When a trial balance has been prepared with
the accounts ordered by type, it is helpful to draw
a line under the Retained Earnings account. All
accounts below the line are temporary and must be
closed. All accounts above the line should remain
open, so do not touch them.
310,000
• It is helpful to prepare the four closing entries in the
same order each time.
405,000
• It is helpful to use a T account for both the Income
Summary and Retained Earnings accounts when
preparing closing entries.
28,000
Sales revenue
a. Prepare the necessary closing entries for Delaney Development
Ltd. at September 30.
STRATEGIES FOR SUCCESS
8,000
Accumulated depreciation,
construction equipment
Accounts payable
CR
Required
6,000
258,000
66,000
8,000
14,000
Solutions to Chapter End Review Problems
Suggested Solution to Chapter End Review Problem 3-1
1. Inventory – A/Debit
2. Sales Revenue – R/Credit
3. Prepaid Rent – A/Debit
4. Equipment – A/Debit
5. Wages Payable – L/Credit
6. Advertising Expense – E/Debit
7. Dividends Declared – DD/Debit
8. Loan Payable – L/Credit
9. Common Shares – SE/Credit
10. Cost of Goods Sold – E/Debit
Suggested Solution to Chapter End Review Problem 3-2
The journal entries and adjusting entries for MML are shown in Exhibits 3.22 and 3.23. Extended explanations are provided for transaction 1 and the four adjusting entries because they are the more complex
transactions.
3-40
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
a. Journal entries
EXHIBIT 3.22
MML’s Journal Entries for
December 2024
1a.
Accounts Receivable
1b.
Cost of Goods Sold
2.
Cash
155,000
Sales Revenue
155,000
70,000
Inventory
70,000
215,900
Accounts Receivable
3.
Wages Expense
215,900
37,300
Wages Payable
4.
37,300
Wages Payable
41,700
Cash
5.
Inventory
6.
Accounts Payable
41,700
125,000
Accounts Payable
125,000
98,000
Cash
7.
98,000
Dividends Declared
10,000
Dividends Payable
10,000
Transaction 1: Sale of Goods
As we discussed in Chapter 2, when you see the word sale, you should think “two parts.” Part 1 is to
account for the sale and the related cash and accounts receivable. Part 2 is to account for the cost of goods
sold and inventory. The information to prepare part 1 will always be provided because a company knows
its selling price and whether the sale was for cash or on account. The information for part 2 may not be
available, because some companies may not know the cost of the products being sold at the time of sale.
b. Adjusting entries
EXHIBIT 3.23
MML’s Adjusting Entries for
December 2024
A1.
Interest Expense
2,000
A2.
Depreciation Expense
Interest Payable
2,000
1,100
Accumulated Depreciation, Equipment
A3.
Depreciation Expense
1,100
1,600
Accumulated Depreciation, Building
A4.
Insurance Expense
1,600
1,200
Prepaid Expenses
1,200
Adjusting Entry 1: Interest
MML has had an outstanding bank loan for the entire month. Even though the interest will not be paid until
January 1, the expense was incurred in December. The interest rate on the loan is 6%, and it is ­important
to remember that interest rates are stated in annual terms. As such, the interest rate must be pro-rated
to determine the monthly interest expense. The interest expense for the month is determined as follows:
$400,000 × 6% × 1/12 = $2,000
Adjusting Entry 2: Depreciation Expense (Equipment)
Depreciation expense must be recorded to allocate a portion of the equipment’s cost to each period in
which it is being used to generate revenue. As we have discussed, there are a number of different methods
that can be used to depreciate property, plant, and equipment, but for now, we will assume that companies use the straight-line method. This method allocates a consistent amount of the asset’s cost each
period. Most companies use a single account to record depreciation expense, because it is usually a single
line on the statement of income. However, companies use separate accumulated depreciation accounts
for each asset, because separate contra-asset accounts are required to report the carrying amount of each
asset category on the statement of financial position.
Solutions to Chapter End Review Problems
3-41
As we have discussed, an accumulated depreciation account is referred to as a contra asset because
its normal balance is contrary or opposite to the normal balance for that category of accounts. Assets
normally have a debit balance, so a contra-asset account will normally have a credit balance. The balance
in this account represents the portion of the asset’s cost that has been expensed to date.
MML’s depreciation expense on its equipment for the month of December is determined as follows:
$76,000 − $10,000
= $13,200 per year/12 = $1,100 per month
5 years
Adjusting Entry 3: Depreciation Expense, Building
MML’s depreciation expense on its building for the month of December is determined as follows:
$500,000 − $20,000
= $19,200 per year/12 = $1,600 per month
25 years
Adjusting Entry 4: Insurance Expense
MML had purchased a one-year insurance policy covering its equipment and building on July 1, 2024.
The total premiums of $14,400 were paid at that time and would have been recorded as an asset, Prepaid
Insurance, at that time. With each month, the coverage is being used up and the monthly insurance
expense must be recorded. The amount of the expense for December is as follows:
$14,400/12 = $1,200
Suggested Solution to Chapter End Review Problem 3-3
Exhibits 3.24 to 3.27 show the statement of income, statement of changes in equity, classified statement
of financial position, and closing entries.
a. Financial statements
EXHIBIT 3.24
MATCHETT MANUFACTURING LIMITED
Statement of Income
For the year ended December 31, 2024
Sales revenue
Statement of Income
$1,805,000
Cost of goods sold
978,000
Gross profit
827,000
Wages expense
412,300
Insurance expense
13,200
Depreciation expense
32,400
Interest expense
24,000
Net income
$ 345,100
EXHIBIT 3.25 Statement of
Changes in Equity
MATCHETT MANUFACTURING LIMITED
Statement of Changes in Equity
For the year ended December 31, 2024
Number of
Common Shares
Share Capital
Common Shares
Retained
Earnings
Total
100,000
$250,000
$230,800
$480,800
Net income
—
—
345,100
345,100
Declaration of dividends
—
—
(40,000)
(40,000)
Issuance of common shares
—
—
—
—
10,000
$250,000
$535,900
$785,900
Balance, Jan. 1
Balance, Dec. 31
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C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
EXHIBIT 3.26 Statement of
Financial Position
MATCHETT MANUFACTURING LIMITED
Statement of Financial Position
As at December 31, 2024
ASSETS
Current assets
Cash
$113,200
Accounts receivable
238,000
Inventory
163,000
Prepaid insurance
7,200
$ 521,400
Non-current assets
Equipment (net)
49,600
Building (net)
423,200
Land
385,000
857,800
TOTAL ASSETS
$1,379,200
LIABILITIES
Current liabilities
Accounts payable
$162,700
Wages payable
18,600
Dividends payable
10,000
Interest payable
2,000
$ 193,300
Non-current liabilities
Bank loan payable
400,000
TOTAL LIABILITIES
593,300
SHAREHOLDERS’ EQUITY
Common shares
250,000
Retained earnings
535,900
TOTAL SHAREHOLDERS’ EQUITY
785,900
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$1,379,200
b. Closing entries
EXHIBIT 3.27
MML’S Closing Entries
C1.
Close all revenue accounts to the Income Summary account.
Sales Revenue
1,805,000
Income Summary
C2.
Close all expense accounts to the Income Summary account.
Income Summary
C3.
1,805,000
1,459,900
Cost of Goods Sold
978,000
Wages Expense
412,300
Insurance Expense
13,200
Depreciation Expense
32,400
Interest Expense
24,000
Close the Income Summary account to Retained Earnings.
Income Summary
Retained Earnings
345,100
345,100
(continued)
Discussion Questions
C4.
3-43
EXHIBIT 3.27
Close the Dividends Declared account to Retained Earnings.
Retained Earnings
40,000
Dividends Declared
40,000
MML’S Closing Entries
(continued)
Retained Earnings
Income Summary
230,800 Opening Balance
C2 1,459,900 1,805,000 C1
345,100 Net Income C3
345,100 Net Income
C4 Dividends Declared 40,000
C3 345,100
535,900 Ending Balance
—
Note that, after posting the closing entries, all the revenue and expense accounts and the Dividends
Declared account have zero balances. They are now ready to start the new accounting cycle for 2025.
Also, the Retained Earnings account has been updated to reflect the cumulative amount as at the end of
2024.
Suggested Solution to Chapter End Review Problem 3-4
a.
C1.
Close all revenue accounts to the Income Summary account.
Sales Revenue
405,000
Interest Revenue
6,000
Income Summary
C2.
411,000
Close all expense accounts to the Income Summary account.
Income Summary
346,000
Cost of Goods Sold
258,000
Wages Expense
66,000
Insurance Expense
8,000
Depreciation Expense
C3.
14,000
Close the Income Summary account to Retained Earnings.
Income Summary
65,000
Retained Earnings
C4.
65,000
Close the Dividends Declared account to Retained Earnings.
Retained Earnings
28,000
Dividends Declared
b.
28,000
Income Summary
C2 346,000
Retained Earnings
411,000 C1
310,000 Opening
Balance
65,000 Net Income
65,000 Net Income C3
C3 65,000
C4 Dividends Declared 28,000
—
347,000 Ending Balance
Assignment Material
Discussion Questions
DQ3-1 In general terms, explain the purpose of the statement of
income and the statement of financial position. Outline the type
of information that each statement presents, and explain the basic
difference between the types of items that appear on the statement
of income and those that appear on the statement of financial
position.
3-44
DQ3-2
false:
C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
Indicate whether each of the following statements is true or
a. Under the accrual basis of accounting, when cash is collected on
accounts receivable, revenue is recorded.
b. Cash receipts from customers are debited to Accounts Receivable.
c. The cash basis of accounting recognizes expenses when they are
incurred.
d. Under the cash basis of accounting, there is no such thing as a
Prepaid Expenses account.
e. Asset accounts and expense accounts normally have debit balances.
DQ3-5 The Retained Earnings account has a normal credit balance,
and credit entries are used to record increases in this account. Why
do expense accounts, which are transferred to Retained Earnings
when they are closed, have normal debit balances? Explain why debit
entries are used to record increases in these accounts.
DQ3-6 List the steps in the accounting cycle, and briefly explain
each step.
DQ3-7 Explain the purpose of the general ledger. Why is it ne­­
cessary if all transactions have already been recorded in the general
journal?
g. Revenues are recorded with credit entries.
DQ3-8 Explain what you know about a company if the retained
earnings account balance has a credit balance at the beginning of the
year.
h. Dividends are an expense of doing business and should appear
on the statement of income.
DQ3-9 Explain the difference between deferred revenue and
accrued revenue. Provide an example of each.
DQ3-3 Indicate the type of account (asset, contra-asset, liability,
shareholders’ equity, revenue, expense, or dividends declared) and
whether it normally has a debit balance or a credit balance:
DQ3-10 In the adjusted trial balance part of the accounting cycle,
the Retained Earnings account has its beginning-of-period balance,
whereas the rest of the permanent accounts have their end-of-period
balances. Explain why this is so.
f. Credits increase asset accounts.
a. Sales Revenue
DQ3-11 Explain what is meant by the term prepaid expense, including how a prepaid expense arises and where it is reported in the financial statements.
b. Rent Expense
c. Prepaid Expenses
d. Bank Loan Payable
DQ3-12 Explain what is meant by the term accrued expense, including how an accrued expense arises and where it is reported in the
financial statements.
e. Common Shares
f. Accounts Receivable
DQ3-13 Explain how a prepaid expense differs from an accrued
expense. Provide an example of each.
g. Accounts Payable
h. Retained Earnings
DQ3-14 If a company fails to record an accrued expense at the end
of an accounting period, what effect will this omission have on the
current period’s financial statements? On the next period’s financial
statements?
i. Dividends Declared
j. Dividends Payable
k. Depreciation Expense
DQ3-4 Indicate the type of account (asset, contra-asset, liability,
shareholders’ equity, revenue, expense, or dividends declared) and
whether it normally has a debit balance or a credit balance:
DQ3-15 Explain the meaning of depreciation expense and accumulated depreciation. How do they differ? Where does each of these
items appear in the financial statements?
DQ3-16 Explain why adjusting entries are needed, and identify two
key things that should be kept in mind when preparing them.
a. Inventory
b. Cost of Goods Sold
DQ3-17 Explain why closing entries are made. What are the two
objectives that are accomplished by making closing entries?
c. Prepaid Rent
d. Wages Expense
DQ3-18 Explain the purpose of the Income Summary account. Why
is it used in the closing entry process?
e. Wages Payable
f. Interest Revenue
g. Equipment
h. Accumulated Depreciation, Equipment
i. Notes Payable
j. Common Shares
k. Cash
DQ3-19 Explain which types of accounts are considered to be temporary and why this is the case.
DQ3-20 Discuss why one company might prepare adjusting journal
entries and financial statements monthly and another might do so
on a quarterly basis. Do companies close their books after preparing
financial statements?
Application Problems Set A
AP3-1A (Account types and normal balances)
Required
For each of the following accounts, identify what type of account it is and state what its normal balance
would be. Use the following abbreviations for account type: A – Asset, L – Liability, SE – Shareholders’
equity, R – Revenue, E – Expense, and DD – Dividends declared. If the account is a contra account, put a
“C” in front of the abbreviation.
Application Problems Set A
1. Accounts Payable
2. Interest Revenue
3. Deferred Revenue
4. Buildings
5. Cost of Goods Sold
6. Prepaid Insurance
7. Bank Loan Payable
8. Inventory
9. Sales Revenue
10. Wages Payable
AP3-2A
(Account types and normal balances)
Required
For each of the following accounts, identify what type of account it is and state what its normal balance
would be. Use the following abbreviations for account type: A – Asset, L – Liability, SE – Shareholders’
equity, R – Revenue, E – Expense, and DD – Dividends declared. If the account is a contra account, put a
“C” in front of the abbreviation.
1. Common Shares
2. Dividends Declared
3. Cost of Goods Sold
4. Retained Earnings
5. Accumulated Depreciation, Equipment
6. Rent Expense
7. Deferred Revenue
8. Prepaid Insurance
9. Land
10. Dividends Payable
AP3-3A
(Identifying account types and whether temporary or permanent)
Required
For each of the following accounts, identify what type of account it is and state whether it is a temporary
or permanent account. Use the following abbreviations for account type: A – Asset, L – Liability, SE –
Shareholders’ equity, R – Revenue, E – Expense, and DD – Dividends declared. If the account is a contra
account, put a “C” in front of the abbreviation.
1. Accumulated Depreciation, Buildings
2. Interest Payable
3. Common Shares
4. Deferred Revenue
5. Cost of Goods Sold
6. Sales Revenue
7. Dividends Declared
8. Interest Revenue
9. Prepaid Expenses
10. Depreciation Expense
AP3-4A (Determining effects of transactions on statement of financial position accounts)
Ann and Greg Fenway run a small art gallery and custom framing business.
Required
Explain how the basic statement of financial position accounts of assets, liabilities, and shareholders’
equity would be affected by each of the following transactions and activities:
a. Framing materials are purchased on credit.
b. Payment is made for the framing materials that were purchased previously.
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c. Wages are paid to their assistant in the shop.
d. Pictures are purchased by the gallery for cash.
e. A picture is sold for cash, at a profit.
f. A receivable is collected on a framing project that was completed for a customer last month.
g. A loan from the bank is repaid, with interest.
h. Depreciation on the equipment is recognized.
AP3-5A (Preparing journal entries)
Required
For each of the following transactions, prepare journal entries:
a. Inventory costing $3,100 was purchased on account.
b. A payment of $3,000 was made on accounts payable.
c. Inventory costing $1,800 was sold on account for $2,700. (Hint: two journal entries are required.)
d. Accounts receivable of $2,000 were collected.
e. Supplies costing $1,400 were purchased on account.
f. Supplies costing $500 were consumed during the period.
g. New equipment costing $7,500 was purchased for cash.
h. The company borrowed $12,000 from a bank.
i. The company issued common shares for $20,000.
j. Wages totalling $6,300 were earned by employees and paid to them.
k. The company paid $2,000 on its bank loan, which included $150 of interest.
l. The company paid $2,500 for the monthly rent on its leased premises.
m. Land costing $23,000 was purchased. The company paid $3,000 in cash and the remainder was
financed with a mortgage (a long-term loan).
AP3-6A (Preparing journal entries and adjusting entries) Paratha Company started business on
January 1, 2024. Some of the events that occurred in its first year of operations follow:
Transactions
1. Equipment that cost $200,000 was purchased on February 1 for $50,000 cash plus a two-year, 4%
note with a principal amount of $150,000.
2. During the year, inventory costing $160,000 was purchased, all on account.
3. An insurance policy was purchased on March 31 for $2,700. The insurance policy was for one year
of coverage that began on April 1, 2024.
4 Sales to customers totalled $285,000. Of these, $65,000 were cash sales.
5. Payments to suppliers for inventory that had been purchased earlier totalled $80,000.
6. Collections from customers on account during the year totalled $180,000.
7. On January 30, customers paid $15,000 in advance payments for goods that will be delivered later.
8. Wages totalling $60,000 were paid to employees during the year.
9. The board of directors declared dividends of $10,000 in December 2024, to be paid in January 2025.
Adjusting items
10. A physical count at year end revealed $40,000 of unsold inventory still on hand.
11. It was determined that 30% of the goods that were paid for in advance (in item 7) had been delivered
to the customers by the end of the year.
12. Recorded the insurance expense for the year.
13. The equipment that was purchased (in item 1) on February 1, 2024, is to be depreciated using the straightline method, with an estimated useful life of 20 years and an estimated residual value of $50,000.
14. Recorded the interest expense on the note payable for the year.
15. In addition to the wages that were paid during the year, wages of $6,000 remained unpaid at the end
of the year.
Required
Prepare journal entries for each of the above transactions and adjusting items.
Application Problems Set A
AP3-7A (Journalizing, posting, and preparing trial balance) Sweet Dreams Chocolatiers Ltd.
began operations on January 1, 2024. During its first year, the following transactions occurred:
1. Issued common shares for $200,000 cash.
2. Purchased $475,000 of inventory on account.
3. Sold inventory on account for $640,000. The original cost of the inventory that was sold was
$380,000.
4. Collected $580,000 from customers on account.
5. Paid $430,000 to suppliers for the inventory previously purchased on account.
6. Bought a delivery vehicle for $36,000 cash.
7. Paid $26,000 for rent, including $2,000 related to the next year.
8. Incurred $20,000 of operating expenses, of which $18,000 was paid.
9. Recorded $2,000 of depreciation on the vehicle.
10. Declared and paid dividends of $6,000.
Required
a. Prepare journal entries to record each of the above transactions.
b. Create T accounts and post the journal entries to the T accounts.
c. Prepare a December 31, 2024, trial balance.
AP3-8A (Journal entries and adjusting entries) Pro-Medic Ltd. (PML) is a medical equipment supply company that sells, installs, and services a variety of mobility aid equipment. PML was
founded in 2021 and has seen significant growth since then. PML’s bookkeeper retired in July, and her
replacement has asked for your assistance in recording the following transactions from the month of
August 2024.
Regular entries:
Aug.
1
PML purchased a new delivery truck for $90,000, paying $50,000 cash and financing
the balance using a note payable at 2% per annum. The note payable is due in 12
months, and interest on the note must be paid on the first day of every month,
beginning on September 1, 2024. PML’s management has determined that the truck
will have a useful life of six years and a residual value of $18,000.
1
PML paid $5,100 for an insurance policy on the new truck for the period August 1,
2024, to December 31, 2025.
6
PML sold $36,000 of medical equipment, of which 50% was on account and the
balance was cash. The cost to PML of the products sold was $12,500.
13
The company purchased inventory on credit at a cost of $16,000.
20
Golden Years Retirement Group (Golden), one of PML’s largest customers,
signed an equipment installation and service contract with PML. The contract
runs from September 1, 2024, to August 30, 2025, and will mean that PML
services all of Golden’s medical equipment. In accordance with the contract
terms, Golden paid PML $10,000, representing four months’ service revenue
under the contract.
30
PML paid dividends in the amount of $25,000, which had been declared by the board
(and recorded) in July 2024.
Adjusting entries:
Aug. 31
PML made the necessary month-end adjusting entry related to the insurance policy.
31
PML made the necessary month-end adjusting entry related to the depreciation of the
new delivery truck.
31
PML made the necessary month-end adjusting entry related to the interest on the note
payable.
Required
Prepare the journal entries and adjusting entries for the above transactions. Round amounts to the nearest dollar.
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AP3-9A (Preparing adjusting entries) The trial balance for Cozy Fireplaces Inc. for December 31,
2024, follows:
Debit
balances
Cash
$
89,000
Accounts receivable
38,000
Inventory
95,000
Supplies
Prepaid rent
Land
Building
Credit
balances
5,000
46,000
80,000
150,000
Accumulated depreciation, building
$
19,500
Accounts payable
21,400
Wages payable
0
Interest payable
0
Income tax payable
0
Deferred revenue
12,400
Bank loan payable
40,000
Common shares
150,000
Retained earnings
16,700
Sales revenue
Cost of goods sold
Wages expense
840,000
482,000
95,000
Rent expense
0
Supplies expense
0
Depreciation expense
0
Interest expense
0
Miscellaneous expense
14,000
Income tax expense
0
Dividends declared
6,000
Totals
$1,100,000
$1,100,000
Additional information for adjusting entries:
1. The deposits from customers were for future deliveries. As at December 31, three-quarters of these
goods had been delivered.
2. There is $2,000 in wages owed at year end.
3. Rent is paid in advance on the last day of each month. There was a balance of $3,000 in the Prepaid
Rent account on January 1, 2024. At the end of January, $3,000 was paid for the February rent
and was debited to the Prepaid Rent account. All the rent payments during the year were treated
the same way. The rent for July to December increased to $4,000 per month. (Hint: determine the
amount of rent expense for 2024, as well as the correct amount that has been prepaid for 2025, and
make an adjustment that will bring both these accounts to the correct balances.)
4. A count of the supplies at year end revealed that $500 of supplies were still on hand.
5. The building is being depreciated over 20 years with a residual value of $20,000.
6. The bank loan was taken out on April 1, 2024. The first interest payment is due on April 1, 2025. The
interest rate is 9%.
7. Income tax for the year should be calculated using a tax rate of 30%. (Hint: after you finish the other
adjusting entries, you will have to determine the income before income tax and then calculate the tax
as 30% of this amount.)
Application Problems Set A
Required
Prepare the adjusting entries for the year 2024.
AP3-10A (Closing entries and ending retained earnings balance) Presented below are the balances from Elsie’s Electronics Ltd.’s general ledger as at September 30, 2024:
DR
Cash
28,000
Accounts receivable
35,000
Inventory
Equipment
CR
65,000
331,000
Accumulated depreciation, equipment
150,000
Accounts payable
120,000
Bank loan payable
70,000
Deferred revenue
22,000
Common shares
10,000
Retained earnings
70,000
Dividends declared
18,000
Sales revenue
488,000
Interest revenue
Cost of goods sold
2,000
316,000
Wages expense
70,000
Rent expense
26,000
Depreciation expense
43,000
Required
a. Prepare the necessary closing entries for Elsie’s Electronics at September 30.
b. Determine the closing Retained Earnings account balance.
AP3-11A (Journalizing, posting, and preparing trial balance and closing entries)
pany started business on January 1, 2024. The following transactions occurred in 2024:
Singh Com-
1. On January 1, the company issued 10,000 common shares for $250,000.
2. On January 2, the company borrowed $50,000 from the bank.
3. On January 3, the company purchased land and a building for a total of $200,000 cash. The land
was recently appraised at a fair market value of $60,000. (Note: because the building will be
depreciated in the future and the land will not, these two assets should be recorded in separate
accounts.)
4. Inventory costing $130,000 was purchased on account.
5. Sales to customers totalled $205,000. Of these, $175,000 were sales on account.
6. The cost of the inventory that was sold to customers in transaction 5 was $120,000.
7. Payments to suppliers on account totalled $115,000.
8. Collections from customers on account totalled $155,000.
9. Payments to employees for wages were $55,000. In addition, there was $2,000 of unpaid wages at
year end.
Adjusting entries:
10. The interest on the bank loan was recognized and paid. The interest rate on the loan was 6%.
11. The building was estimated to have a useful life of 30 years and a residual value of $20,000. The
company uses the straight-line method of depreciation.
12. The company declared dividends of $7,000 on December 15, 2024, to be paid on January 15, 2025.
Required
a. Prepare journal entries for each of the transactions and adjustments listed in the problem.
b. Prepare the necessary T accounts and post the journal entries to them.
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c. Prepare an adjusted trial balance at Singh’s year end of December 31, 2024.
d. Prepare the closing entries and post them to the T accounts.
AP3-12A (Journalizing, posting, and preparing trial balance and closing entries) Hughes
Tools Company started business on October 1, 2023. Its fiscal year runs through to September 30 the
following year. The following transactions occurred in the fiscal year that started on October 1, 2023, and
ended on September 30, 2024.
1. On October 1, 2023, Jill Hughes invested $175,000 to start the business. Hughes is the only owner.
She was issued 10,000 common shares.
2. On October 1, Hughes Tools borrowed $225,000 from a venture capitalist (a lender who specializes
in start-up companies).
3. On October 1, the company rented a building. The rental agreement was a two-year contract requiring quarterly rental payments (every three months) of $15,000, payable in advance. The first payment was made on October 1, 2023 (covering the period from October 1 to December 31). Thereafter,
payments were due on December 31, March 31, June 30, and September 30, for each three-month
period that followed. All the rental payments were made as specified in the agreement.
4. On October 1, the company purchased equipment costing $220,000 for cash.
5. Initial inventory was purchased for $90,000 cash.
6. Additional purchases of inventory during the year totalled $570,000, all on account.
7. Sales during the year totalled $800,000, of which $720,000 was on account.
8. Collections from customers on account totalled $650,000.
9. Payments to suppliers on account totalled $510,000.
10. The cost of the inventory that was sold during the year was $560,000.
11. Selling and administrative expenses totalled $86,500 for the year. Of this amount, $4,000 was unpaid
at year end.
12. Interest on the loan from the venture capitalist was paid at year end (September 30, 2024). The interest rate on the loan is 10%. In addition, $25,000 of the loan principal was repaid at that time.
13. The equipment was depreciated based on an estimated useful life of 10 years and a residual value of
$20,000.
14. The company declared and paid a dividend of $7,000.
Required
a. Prepare journal entries for each of the transactions and adjustments listed in the problem.
b. Prepare the necessary T accounts and post the journal entries to them.
c. Prepare an adjusted trial balance.
d. Prepare the closing entries and post them to the T accounts.
AP3-13A (Journalizing, posting, preparing statement of income and statement of financial
position, and preparing closing entries) On December 31, 2023, Clean and White Linen Supplies
Ltd. had the following account balances:
Cash
$ 90,000
Accumulated Depreciation, Equipment
Accounts Receivable
96,000
Accounts Payable
Inventory
60,000
Wages Payable
Supplies
2,000
Long-Term Investment
Equipment
80,000
330,000
$ 90,000
60,000
8,000
Bank Loan Payable
150,000
Common Shares
250,000
Retained Earnings
100,000
In 2024, the following transactions occurred:
1. On January 1, paid $3,900 for a three-year fire insurance policy.
2. Purchased additional uniform inventory on credit for $120,000.
3. Sold uniforms for $180,000 on account. The inventory that was sold had been purchased for $100,000.
4. Performed cleaning services for customers for $520,000. One-quarter of this amount was paid in
cash and the remainder was on account.
5. Paid $130,000 to suppliers to settle some of the accounts payable.
Application Problems Set A
6. Received $246,000 from customers to settle amounts owed to the company.
7. Paid $12,000 for advertising.
8. At the end of 2024, paid the interest on the bank loan for the year at the rate of 7%, as well as $30,000
on the principal. The remaining principal balance is due in three years.
9. Received a $3,000 dividend from the long-term investment.
10. Paid $15,000 for utilities for the year.
11. Declared and paid dividends of $12,000 at the end of the year.
12. Paid $102,000 for wages during the year. At year end, the company owed another $2,000 to the
employees for the last week of work in December.
13. Depreciated the equipment for the year. The company had bought its equipment at the beginning of
2021, and it was expected to last 10 years and have a residual value of $30,000.
14. Made an adjustment for the cost of the insurance that expired in 2024.
Required
a. Prepare journal entries to record each of the above transactions and adjustments.
b. Create T accounts. Enter the beginning balances from 2023, post the 2024 journal entries, and determine the ending balances for 2024.
c. Prepare an adjusted trial balance, and ensure that the total of the debit balances is equal to the total
of the credit balances.
d. Prepare a single-step statement of income for 2024.
e. Prepare the closing entries and post them to the T accounts.
f. Prepare a classified statement of financial position for 2024.
AP3-14A (Journalizing, posting, preparing statement of income and statement of financial
position, and preparing closing entries) Direnzo Panini had the following account balances at
December 31, 2023:
Cash
$24,000
Accumulated Depreciation, Equipment
25,000
Accounts Receivable
25,000
Wages Payable
Supplies
50,000
Accounts Payable
50,000
3,000
Common Shares
75,000
Retained Earnings
67,500
Prepaid Insurance
Inventory
46,500
Equipment
75,000
During 2024, the following transactions occurred:
1. Sales of paninis for cash were $650,000, and sales of paninis on account were $60,000.
2. Purchases of ingredients were $175,000, all on account.
3. Collections from customers for sales on account totalled $18,000.
4. The company paid $45,000 for utilities expenses.
5. Ingredients with a cost of $200,000 were used in paninis that were sold.
6. Payments for ingredients purchased on account totalled $220,000.
7. The company paid $95,000 for wages.
8. A dividend of $35,000 was declared and paid at the end of the year.
Information for adjusting entries:
9. The balance in the Supplies account at the end of 2024 was $1,200.
10. Wages owed to employees at the end of 2024 were $3,500.
11. At the end of 2024, the account balance in Prepaid Insurance was $1,500.
12. The equipment had an estimated useful life of eight years with a residual value of $3,000.
Required
a. Prepare journal entries for transactions 1 through 8. Create new accounts as necessary.
b. Prepare adjusting journal entries for adjustments 9 to 12.
6,000
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c. Set up T accounts, enter the beginning balances from 2023, post the 2024 entries, and calculate the
balance in each account.
d. Prepare a trial balance and ensure that the total of the debit balances is equal to the total of the credit
balances.
e. Prepare a single-step statement of income for 2024.
f. Prepare the closing entries, post them to the T accounts, and calculate the final balance in each
account.
g. Prepare a classified statement of financial position for 2024.
AP3-15A (Determining adjusted balances; preparing statement of income and statement of financial position) On December 31, 2024, Arcadia Inc. completed its fourth year
of operations. Christina Georgiou is an aspiring CPA working part-time as a clerk in the company’s accounting office. Christina assembled the following list of account balances, which are not
arranged in any particular order:
Accounts Payable
$ 45,600
Deferred Revenue
18,000
Advertising Expense
Cash
$ 66,000
15,000
Note Receivable
60,000
Land
200,000
Cost of Goods Sold
525,000
Dividends Declared
15,000
Equipment
220,000
Insurance Expense
6,000
Buildings
290,000
Interest Expense
2,500
Retained Earnings
(as at January 1, 2024)
269,100
Accumulated Depreciation,
Equipment
Inventory
190,000
Common Shares
Accumulated Depreciation, Buildings
Wages Expense
Supplies
Notes Payable
25,000
118,000
3,200
45,000
Other Expense
15,000
526,000
8,000
Accounts Receivable
175,000
Sales Revenue
954,000
Utilities Expense
4,000
These account amounts are correct; however, Christina did not consider the following information:
1. As at December 31, 2024, the supplies still on hand had a cost of $1,200.
2. On September 1, 2024, the company rented surplus space in one of its warehouses to a tenant for
$3,000 per month. The tenant paid for six months in advance, which was recorded as deferred
revenue.
3. Employees earned $5,000 of wages in December 2024 that will not be paid until the first scheduled
payday in 2025.
4. Depreciation for 2024 is $12,000 on the buildings and $25,000 on the equipment.
5. Additional dividends of $10,000 were declared in December 2024 but will not be paid until January
2025.
6. The note receivable is a six-month note that has been outstanding since October 1, 2024 (three
months). The interest rate is 5% per year. The interest will be received by the company when the note
becomes due at the end of March 2025.
7. The amount shown as insurance expense includes $1,500 for coverage over the first three months of
2025.
Required
a. Prepare adjusting journal entries.
b. Determine the amounts that would appear in an adjusted trial balance for Arcadia Inc. as at December 31, 2024. Prepare adjusting journal entries.
c. Prepare a single-step statement of income for the year ended December 31, 2024.
d. Calculate the amount of retained earnings as at December 31, 2024.
e. Prepare a classified statement of financial position as at December 31, 2024.
Application Problems Set A
AP3-16A (Determining statement of income amounts) Jake Fromowitz owns and operates a tire
and auto repair shop named Jake’s Jack’em and Fix’em Shop. During the current month, the following
activities occurred:
1. The shop charged $8,500 for repair work done during the month. All but one of Jake’s customers paid
in full. The one customer who had not yet paid owed Jake $500. Jake still has the car in the shop’s parking lot and he intends to keep it until the customer pays the bill. The $500 is included in the $8,500.
2. The total cost of parts and oil purchased during the month was $2,900. Jake pays for the parts with
cash, but the oil is purchased in bulk from a supplier on 30 days’ credit. At the end of the month, he
still owes $400 to this supplier.
3. The cost of the parts that were used in repair work during the month was $2,600.
4. Jake paid $750 monthly rent on the repair shop on the first day of the month, and since he had extra
cash on hand at the end of the month, he paid another $750 to cover the next month’s rent.
5. On the 10th of the month, Jake paid $250 to settle the bills related to the previous month’s advertising costs. At the end of the month, he received an invoice for $230 for this month’s advertising costs,
which he intends to pay on the 10th of the next month when it is due.
6. Jake paid a friend $500 for helping him in the repair shop, and also gave him a new set of tires
from the shop’s stockroom. These tires had cost Jake $300, and could have been sold to customers
for $400.
7. Utilities expenses related to operating the repair shop for the month totalled $875. All of these were
paid during the month, as well as $125 that was owed from the previous month.
8. During the last week of the month, a customer dropped off her vehicle for repair work. Jake set aside
$600 of parts to be used in these repairs, but he has not yet had time to do any work on this job.
Required
Referring to the concepts discussed so far in this textbook:
a. Determine the amounts that would properly be reported in the statement of income for Jake’s shop
this month. If an item is excluded, explain why.
b. Calculate the net income for the month.
AP3-17A (Calculating income and retained earnings; preparing statement of financial position) Little Lads and Ladies Ltd. sells children’s clothing. At the end of December 2024, it had the
following adjusted account balances, which are listed in random order:
Cash
$ 3,000
Wages Payable
Supplies Expense
500
4,200
Utilities Expense
Dividends Declared
Depreciation Expense
$
600
1,200
500
Equipment
23,000
Common Shares
Wages Expense
25,000
Telephone Expense
200
Interest Expense
300
Prepaid Rent
400
Cost of Goods Sold
32,000
Accumulated Depreciation, Equipment
Sales Revenue
66,450
Retained Earnings
Accounts Receivable
10,000
Inventory
20,000
1,500
17,600
8,000
Rent Expense
4,800
Repairs and Maintenance Expenses
400
Bank Loan Payable
3,800
Supplies
800
Interest Payable
300
Advertising Expense
Accounts Payable
750
5,000
Required
a. Identify the statement of income accounts and calculate the net income (or loss) for the year.
b. Prepare the closing entries.
c. Determine the amount of retained earnings at the end of 2024.
d. Prepare a classified statement of financial position as at December 31, 2024. The full balance of the
bank loan payable is due on June 30, 2026.
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Application Problems Set B
AP3-1B (Account types and normal balances)
Required
For each of the following accounts, identify what type of account it is and state what its normal balance
would be. Use the following abbreviations for account type: A – Asset, L – Liability, SE – Shareholders’
equity, R – Revenue, E – Expense, and DD – Dividends declared. If the account is a contra account, put a
“C” in front of the abbreviation.
1. Land
2. Common Shares
3. Insurance Expenses
4. Dividends Declared
5. Wages Expense
6. Sales Revenue
7. Land
8. Utilities Expense
9. Accumulated Depreciation, Vehicles
10. Cash
AP3-2B (Account types and normal balances)
Required
For each of the following accounts, identify what type of account it is and state what its normal balance
would be. Use the following abbreviations for account type: A – Asset, L – Liability, SE – Shareholders’
equity, R – Revenue, E – Expense, and DD – Dividends declared. If the account is a contra account, put a
“C” in front of the abbreviation.
1. Cost of Goods Sold
2. Common Shares
3. Advertising Expense
4. Buildings
5. Interest Payable
6. Dividends Declared
7. Supplies Expense
8. Rent Expense
9. Inventory
10. Prepaid Rent
AP3-3B (Identifying account type and whether temporary or permanent)
Required
For each of the following accounts, identify what type of account it is and state whether it is a temporary
or permanent account. Use the following abbreviations for account type: A – Asset, L – Liability, SE –
Shareholders’ equity, R – Revenue, E – Expense, and DD – Dividends declared. If the account is a contra
account, put a “C” in front of the abbreviation.
1. Dividends Payable
2. Utilities Expense
3. Supplies
4. Cost of Goods Sold
5. Common Shares
6. Accumulated Depreciation, Equipment
7. Dividends Declared
8. Sales Revenue
9. Deferred Revenue
10. Prepaid Rent
Application Problems Set B
AP3-4B (Determining effects of transactions on statement of financial position accounts)
Gagnon’s Autobody Ltd. repairs and paints automobiles after accidents.
Required
Explain how the basic statement of financial position accounts of assets, liabilities, and shareholders’
equity would be affected by each of the following transactions and activities:
a. Gagnon’s Autobody purchases new spray-painting equipment. The supplier gives the company 60
days to pay.
b. The company pays for the spray-painting equipment that was purchased above.
c. Supplies such as paint and putty are purchased for cash.
d. The company pays for a one-year liability insurance policy.
e. The company pays its employees for work done.
f. A car is repaired and repainted. The customer pays the deductible required by her insurance policy,
and the remainder of the bill is sent to her insurance company.
g. Cash is collected from the customer’s insurance company.
AP3-5B (Preparing journal entries)
Required
For each of the following transactions, prepare journal entries:
a. The company issued common shares for $150,000.
b. The company borrowed $75,000 from a bank.
c. Inventory costing $47,200 was purchased on account.
d. Rented a retail space and paid a damage deposit of $10,000.
e. Received a bill for advertising costs of $3,700 related to the grand opening.
f. Paid employees wages of $16,800.
g. Inventory costing $38,500 was sold for $69,400, half for cash and half on account. (Hint: two journal
entries are required.)
h. A payment of $41,600 was made on accounts payable.
i. Accounts receivable totalling $21,600 were collected.
j. New equipment costing $120,000 was purchased for cash.
k. The company paid $18,700 on its bank loan, which included $11,100 of interest.
l. The company paid $8,900 for the monthly rent on its retail location.
m. The company’s board declared and paid dividends of $12,200.
n. Paid the advertising bill related to the grand opening (see transaction (e)).
AP3-6B (Preparing journal entries) Le Petit Croissant Ltd. (LPC) is a wholesale bakery that supplies flash-frozen croissants to restaurants, hotels, and other commercial customers. LPC began operating in August 2024 and had the following transactions in its first month:
Aug. 1
LPC issued 30,000 common shares to its two founding shareholders in exchange for
$250,000 in cash and equipment valued at $50,000.
1
The company borrowed $100,000 from the Commercial Bank at an interest rate of 6%.
The borrowing agreement terms state that the loan is to be repaid at the end of each
month in the amount of $2,500 per month plus interest.
3
In order to access a commercial kitchen, LPC leased the site of a former restaurant,
paying $6,000, of which $3,000 represented the rent for August and the balance was a
damage deposit.
8
LPC purchased flour and other ingredients costing $32,800 on account.
12
LPC paid $6,800 to a local marketing company for its logo design and media planning
services.
14
LPC recorded its sales of the first two weeks of the month. Total sales (half in cash and
half on account) amounted to $50,200, and the inventory related to these sales was
determined to have a cost of $17,100.
19
Paid the suppliers $25,000 for goods previously purchased on account.
25
Collections from customers on account totalled $22,600.
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26
LPC purchased additional inventory (flour and so on) on account for $23,000.
29
LPC received an invoice from its natural gas supplier for $2,700, which is payable on
September 14.
31
LPC recorded the sales for the balance of the month. Sales for this period totalled
$60,800, of which $20,000 was on account. The cost of the ingredients from inventory
related to these sales amounted to $20,700.
31
LPC’s six full-time employees were paid $3,900 each in wages for the month.
31
LPC made the loan payment required under the terms of the borrowing agreement.
31
LPC’s board of directors declared a dividend of $1.00 per share to the holders of the
company’s common shares.
Required
Prepare all necessary journal entries related to the above transactions.
AP3-7B (Journalizing, posting, and preparing trial balance) Sparkling Clean Dry Cleaners Inc.
began operations on January 1, 2024. In its first year, the following transactions occurred:
1. Issued common shares for $150,000 cash.
2. Purchased dry cleaning equipment for $75,000 cash.
3. Purchased cleaning supplies, on account, for $9,600.
4. Used $8,400 of the supplies in cleaning operations.
5. Collected $124,000 from customers for dry cleaning services provided.
6. Borrowed $15,000 from the bank on July 1, 2024, at an interest rate of 8% per year.
7. Paid wages of $49,000 to employees. In addition to this, $1,000 of wages were owed to employees at
the end of the year.
8. Depreciated the equipment by $3,000 for the year.
9. Paid $22,000 for utilities (telephone, electricity, and water).
10. On December 31, paid interest on the bank loan described in transaction 6.
Required
a. Prepare journal entries to record each of the above transactions.
b. Create T accounts and post the journal entries to the T accounts.
c. Prepare a December 31, 2024, trial balance.
AP3-8B (Journal entries and adjusting entries) Aquarium World Ltd. (AWL) was incorporated
in 2021 and imports fish tanks and related supplies for the saltwater aquarium market. AWL primarily
imports from Asian suppliers and is a wholesaler supplying independent retailers in Western Canada.
During the month of January 2024, AWL had the following transactions:
Regular entries:
Jan. 1
In order to better service its growing business and manage its inventory more
effectively, AWL purchased new computer equipment to run its inventory system
for $145,000, paying cash. AWL’s management determined that the new computer
equipment would have a useful life of five years and a residual value of $10,000.
1
AWL also entered into an agreement to lease a warehouse. This would allow the
company to import larger shipments from its Asian suppliers and reduce the impact of
the long shipping times. In accordance with the lease terms, AWL paid $14,400, which
represented the first six months’ rent, in advance.
13
A major hotel contacted AWL about supplying it with an eight-metre saltwater
aquarium for the lobby. AWL agreed to this and received a $50,000 payment from the
hotel. AWL ordered the tank the same day and it was scheduled to arrive on February
25. AWL has guaranteed that it will be installed before the end of February.
14
AWL paid its employees $9,000 for wages earned during the first two weeks of January.
15
AWL’s board of directors declared dividends in the amount of $20,000, which will be
paid on February 15.
19
AWL made sales totalling $62,000. Of this, half was cash and the balance was on
account. The cost to AWL of the products sold was $36,000.
Application Problems Set B
Adjusting entries:
Jan. 31
The company recorded the $9,000 in wages earned by employees during the last two
weeks of the month. These wages will be paid on February 1, 2024.
31
AWL recorded the adjusting entry to depreciate the new computer equipment.
31
AWL recorded the adjusting entry for the warehouse lease.
Required
Prepare the journal entries and adjusting entries for the above transactions.
AP3-9B (Preparing adjusting entries) The following trial balance before adjustments is for Snowcrest Ltd. on December 31, 2024:
Debits
Cash
Inventory
$ 10,000
24,000
Advances to employees
2,000
Supplies
3,000
Equipment
Credits
56,000
Accumulated depreciation, equipment
$ 4,000
Deferred revenue
6,000
Bank loan payable
20,000
Common shares
40,000
Retained earnings
9,000
Sales revenue
Cost of goods sold
230,000
130,000
Wages expense
34,000
Repairs and maintenance expense
25,000
Rent expense
Miscellaneous expense
Dividends declared
Totals
6,600
15,000
3,400
$309,000
$309,000
Data for adjusting entries:
1. As at December 31, 2024, 80% of the wages that had been paid in advance to the salespeople had
been earned.
2. A count of the supplies at year end revealed that $600 of supplies were still on hand.
3. Depreciation on the equipment for 2024 was $1,000.
4. The deferred revenue was advance receipts for future deliveries of goods. By December 31, 2024,
two-thirds of these deliveries had been made.
5. The bank loan was a six-month loan taken out on October 1, 2024. The interest rate on the loan is
9%, but the interest is not due to be paid until the note is repaid on April 1, 2025.
6. Wages owed at year end and not yet recorded were $500.
7. The rent expense figure includes $600 paid in advance for January 2025.
8. Income tax for the year should be calculated using a tax rate of 25%. (Hint: after you finish the other
adjusting entries, determine the income before income tax and then calculate the tax as 25% of this
amount.)
Required
Prepare the adjusting entries for the year 2024.
AP3-10B (Closing entries and ending retained earnings balance)
ances from Biotic Environment Ltd.’s general ledger as at June 30, 2024:
Presented below are the bal-
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DR
Cash
CR
35,000
Accounts receivable
80,000
Inventory
286,000
Equipment
367,000
Accumulated depreciation, equipment
175,000
Accounts payable
140,000
Note payable
50,000
Deferred revenue
42,000
Common shares
40,000
Retained earnings
160,000
Dividends declared
55,000
Sales revenue
708,000
Service revenue
Cost of goods sold
7,000
365,000
Wages expense
80,000
Advertising expense
33,000
Depreciation expense
22,000
Required
a. Prepare the necessary closing entries for Biotic Environment Ltd. at June 30.
b. Determine the closing Retained Earnings account balance.
AP3-11B (Journalizing, posting, and preparing trial balance and closing entries) Sofia Wholesale Ltd. was incorporated on January 1, 2024. The following transactions occurred in 2024:
1. On January 1, the company issued 100,000 common shares for $3 per share.
2. On January 2, the company purchased equipment for $120,000, paying $50,000 cash and financing the
balance using a note payable. The note has a one-year term, with interest of 6% payable at maturity.
3. On January 2, the company paid $4,800 for a two-year insurance policy covering the new equipment.
4. Inventory costing $185,000 was purchased on account.
5. Sales to customers totalled $428,000, of which $192,000 were on account. The cost of the inventory
that was sold to customers was $153,000.
6. Collections from customers totalled $166,000.
7. Paid $78,000 on accounts due to suppliers.
8. Employees earned wages totalling $119,000, of which $22,000 remained unpaid at the end of the year.
9. Rent payments for the year amounted to $54,600, which was for 12 months plus one month’s rent as
a damage deposit.
Adjusting entries:
10. The company recorded the insurance expense for the year.
11. The interest on the note payable was recorded.
12. The equipment was estimated to have a useful life of five years and a residual value of $12,000. The
company uses the straight-line method of depreciation.
13. On December 20, 2024, the company’s board declared dividends of $15,200 to be paid on January 20,
2025.
Required
a. Prepare journal entries for each of the transactions and adjustments listed in the problem.
b. Prepare the necessary T accounts and post the journal entries to them.
c. Prepare an adjusted trial balance.
d. Prepare the closing entries and post them to the T accounts.
Application Problems Set B 3-59
AP3-12B (Journalizing, posting, and preparing trial balance and closing entries) A. J. Smith
Company started business on January 1, 2024, and the following transactions occurred in its first year:
1. On January 1, the company issued 12,000 common shares at $25 per share.
2. On January 1, the company purchased land and a building from another company in exchange for
$80,000 cash and 6,000 shares. The land’s value is approximately one-quarter of the total value of
the transaction. (Hint: you need to determine a value for the shares using the information given in
transaction 1, and the land and building should be recorded in separate accounts.)
3. On March 31, the company rented out a portion of its building to Frantek Company. Frantek is
required to make quarterly payments of $7,500 on March 31, June 30, September 30, and December
31 of each year. The first payment, covering the period from April 1 to June 30, was received on
March 31, and the other payments were all received as scheduled.
4. Equipment worth $120,000 was purchased on July 1, in exchange for $60,000 cash and a one-year
note with a principal amount of $60,000 and an interest rate of 10%. No principal or interest payments were made during the year.
5. Inventory costing $250,000 was purchased on account.
6. Sales were $300,000, of which credit sales were $250,000.
7. The inventory sold had a cost of $190,000.
8. Payments to suppliers totalled $205,000.
9. Accounts receivable totalling $200,000 were collected.
10. Operating expenses amounted to $50,000, all of which were paid in cash.
11. The building purchased in transaction 2 is depreciated using the straight-line method, with an estimated useful life of 20 years and an estimated residual value of $30,000.
12. The equipment purchased in transaction 4 is depreciated using the straight-line method, with an
estimated useful life of 10 years and an estimated residual value of $5,000. Because the equipment
was purchased on July 1, only a half year of depreciation is recognized in 2024.
13. Dividends of $20,000 were declared during the year, of which $5,000 remained unpaid at year end.
Required
a. Prepare journal entries for each of the transactions and adjustments listed in the problem.
b. Prepare the necessary T accounts and post the journal entries to them.
c. Prepare an adjusted trial balance.
d. Prepare the closing entries and post them to the T accounts.
AP3-13B (Preparing journal entries, trial balances, and closing entries) Evergreen Retail Company, whose fiscal year end is December 31, had the following transactions in its first year of operations:
1. Issued common shares for $65,000 cash on January 1, 2024.
2. Borrowed $15,000 of additional financing from the bank on January 1, 2024.
3. Bought equipment for $25,000 cash, also on January 1, 2024.
4. Made $60,000 of inventory purchases on account.
5. Had total sales of $92,000, of which $28,000 were on account. The cost of the products sold was
$44,000.
6. Bought supplies for $800 cash.
7. Collected payments of $24,000 from customers on their accounts.
8. Paid suppliers $25,000 for the inventory that had been purchased on account.
9. Paid employees $36,200.
10. Paid the interest on the bank loan on December 31, 2024. The interest rate was 8%.
11. Declared dividends of $2,000, which will be paid in 2025.
Information for adjusting entries:
12. The equipment purchased on January 1 has an estimated useful life of eight years and an estimated
residual value of $1,000 at the end of its life.
13. Supplies costing $200 were still on hand at the end of the year.
14. Wages in the amount of $800 were owed to employees at the end of the year. These will be paid early
in 2025.
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Required
a. Prepare journal entries for transactions 1 through 11.
b. Prepare adjusting journal entries for adjustments 12 to 14.
c. Set up T accounts, post the 2024 entries, and calculate the balance in each account.
d. Prepare a trial balance, and ensure that the total of the debit balances is equal to the total of the
credit balances.
e. Prepare the closing entries, post them to the T accounts, and calculate the final balance in each
account.
AP3-14B (Journalizing, posting, preparing statement of income and statement of financial
position, and preparing closing entries) West Coast Recycling Ltd. (WCRL) is a Nanaimo, British
Columbia–based company specializing in the collection and reprocessing of glass and plastic drinking
containers. The company also has a retail component, selling composting and recycling products. WCRL
was founded in 2021 and has positioned itself as a leading company in its field. The company’s year end
is January 31.
WCRL had the following account balances at December 31, 2023:
Cash
$268,000
Deferred Revenue
$ 80,000
Accounts Receivable
103,000
Common Shares
86,000
Inventory
136,000
Retained Earnings
133,000
Supplies
13,000
Sales Revenue
981,000
Equipment
226,000
Cost of Goods Sold
528,000
Accumulated Depreciation, Equipment
108,000
Wages Expense
132,000
Accounts Payable
80,000
Dividends Declared
9,000
Dividends Payable
9,000
Advertising Expense
29,000
Rent Expense
33,000
WCRL had the following transactions during January 2024, the last month of WCRL’s fiscal year:
Jan.
1
WCRL purchased a new collection truck for $310,000, paying $110,000 cash and
financing the balance using a note payable at 9% per annum. The note payable is due
in 12 months, but interest on the note must be paid on the first day of every month.
Management of WCRL has determined that the truck will have a useful life of five
years and a residual value of $70,000.
1
WCRL paid $3,300 for an insurance policy on the new truck for the period January 1 to
December 31, 2024.
5
The company purchased, on credit, compost bins for its inventory at a cost of $13,000.
12
Pinamalas University, one of WCRL’s largest customers, signed a new glass recycling
contract with WCRL. The contract runs from February 1, 2024, to January 31, 2025. In
accordance with the terms of the contact, Pinamalas paid WCRL $4,500, representing
the first month’s fees under the contract.
18
Made $75,500 in sales of compost bins, of which one-third was on account and the
balance was cash. The cost to WCRL of the bins sold was $52,100.
31
Recorded wages earned by employees during the month of $32,000, of which $26,000
were paid.
31
WCRL paid dividends in the amount of $9,000, which had been declared by the board
(and recorded) in December 2023.
31
Paid $3,000 rent for the month of January 2024.
The company also needed to record adjusting entries for the following:
Jan. 31
Recorded the entry to recognize that supplies costing $2,300 remained on hand at the
end of the month.
31
Recorded the entry related to its insurance expense for the policy on the new truck.
31
Recorded the entry related to the depreciation of its new truck.
(continued)
Application Problems Set B
31
Recorded the entry for depreciation of the equipment for the year in the amount of $60,000.
31
Recorded the entry related to the interest on the note payable.
31
Recorded the entry to recognize that $12,800 of the deferred revenue had been earned
during the month.
Required
a. Prepare journal entries for the first eight transactions. Create new accounts as necessary.
b. Prepare the adjusting journal entries.
c. Set up T accounts, enter the beginning balances from 2023, post the 2024 entries, and calculate the
balance in each account.
d. Prepare a trial balance, and ensure that the total of the debit balances is equal to the total of the
credit balances.
e. Prepare a single-step statement of income for 2024.
f. Prepare the closing entries, post them to the T accounts, and calculate the final balance in each account.
g. Prepare a classified statement of financial position at January 31, 2024.
AP3-15B (Determining adjusted balances; preparing statement of income and statement of
financial position) Eric Shehan is a student working on an internship at Mahon Ltd. On December
31, 2024, the company had its year end. Eric’s boss brought him the following information:
Accounts Payable
$ 217,000
Wages Expense
Cash
116,000
Notes Receivable
Notes Payable
250,000
Rent Expense
Inventory
310,000
Dividends Declared
Common Shares
348,000
Supplies
Sales Revenue
3,410,000
Insurance Expense
Retained Earnings (at January 1, 2024)
1,142,000
Equipment
Cost of Goods Sold
2,046,000
Accumulated Depreciation,
Equipment
Utilities Expense
86,000
Interest Revenue
9,000
Accounts Receivable
Interest Expense
426,000
7,000
$ 360,000
200,000
33,000
180,000
11,000
16,000
1,688,000
160,000
Miscellaneous Expense
32,000
Deferred Revenue
29,000
Advertising Expense
54,000
These account amounts are correct, but Eric’s boss advised him that the information did not reflect the
following information:
1. Accrued interest of $6,000 on the notes receivable.
2. Employees earned $80,000 in bonuses based on achieving sales targets. These are payable on January 10, 2025.
3. Accrued interest on the note payable amounting to $5,000 is due in January 2025.
4. As of December 31, 2024, the supplies still on hand had a cost of $7,000.
5. The insurance expense includes $3,000 in premiums related to coverage for 2025.
6. Depreciation for 2024 is $168,000 on the equipment.
7. The company’s board declared additional dividends of $250,000, which are payable to shareholders
on January 15, 2025.
Required
a. Determine the amounts that would appear in an adjusted trial balance for Mahon Ltd. as at December 31, 2024.
b. Prepare a single-step statement of income for the year ended December 31, 2024.
c. Calculate the amount of retained earnings as at December 31, 2024.
d. Prepare a classified statement of financial position as at December 31, 2024. (Note: the note receivable and note payable are due in 2025.)
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AP3-16B (Determining statement of income amounts) Jan Wei owns a cycle store that
sells equipment, clothing, and other accessories. During the month of June, the following activities
occurred:
1. The business earned $30,000 from the sale of bicycles, clothing, and accessories. Half the sales were
for cash and the other half were on account.
2. The merchandise that was sold originally cost $17,400.
3. Jan purchased additional merchandise on credit for $20,800.
4. Jan paid $18,000 to the suppliers of the merchandise purchased above.
5. The telephone, electricity, and water bills for the month came to $430. All but one of these bills, for
$130, was paid by the end of the month.
6. Additional expenses for the month, including depreciation expense of $600, totalled $2,100. They
were all paid in cash, except the depreciation expense, and were for repairs and maintenance done
to the store.
7. At the end of May, Jan had an 8% loan for $5,000 outstanding with the bank. On the last day of
June, Jan paid the monthly interest that was owed on the loan, and also paid $500 on the loan
principal.
8. On the last day of June, a customer ordered a $1,300 bicycle. Jan did not have it in stock, so it was
ordered and will be delivered in July. Since it was a special order, the customer paid a $300 deposit
on it.
Required
Referring to the concepts discussed so far in this textbook:
a. Determine the amounts that would properly be reported in the June statement of income for Jan’s
shop. If an item is excluded, explain why.
b. Calculate the net income for the month.
AP3-17B (Calculating income and retained earnings; preparing statement of financial
position) Your assistant prepared the following adjusted trial balance data for Commerce Company
on December 31, 2024. The accounts are arranged in alphabetical order.
Accounts payable
$ 36,000
Land
$ 82,000
Accounts receivable
67,000
Loan payable
48,000
Accumulated depreciation, buildings
20,000
Miscellaneous expenses
13,000
Buildings
72,000
Notes payable
15,000
Cash
24,000
Prepaid insurance
500
Common shares
85,000
Retained earnings
31,500
Cost of goods sold
Depreciation expense
110,000
Sales revenue
179,800
4,500
Selling expenses
27,000
Dividends declared
12,400
Service revenue
93,100
Dividends payable
4,000
Supplies
Income tax expense
8,000
Supplies expense
2,200
Income tax payable
2,000
Deferred revenue
1,200
Insurance expense
1,400
Utilities expense
2,400
Interest expense
1,700
Wages expense
60,000
Interest payable
300
Wages payable
3,000
Inventory
800
30,000
Required
a. Calculate the net income for the year ended December 31, 2024.
b. Prepare the closing entries.
c. Determine the Retained Earnings balance as at the end of the year.
d. Prepare a classified statement of financial position as at December 31, 2024. The note payable is due
in six months and the loan payable is due in five years.
User Perspective Problems
User Perspective Problems
UP3-1 (Importance of the chart of accounts) You have been asked to give a brief presentation
to members of your local chamber of commerce regarding the importance of the chart of accounts in
relation to managing their business.
Required
Prepare an overview of the key points you plan to address in your presentation.
UP3-2 (Normal balances) One of your friends, who is also a classmate, came to you in the library
and asked if you can explain the concept of normal balances to her. She was busy on social media during
the part of the class in which this topic was discussed.
Required
Prepare your response.
UP3-3 (Normal balances) While studying with one of your classmates, they ask you the following
question:
“The way the instructor explained the use of debits and credits seems backward to me. Credits
decrease assets, while debits decrease liabilities. This is the opposite of what I think it should be.
Can you please explain this to me in a way that might make sense to me?”
Required
Prepare your response.
UP3-4 (Trial balance) One of your friends, who is a small business owner, knows you are taking
introductory accounting and asked you the following question:
“If my trial balance is in balance, can I conclude that my accounting is correct? If not, what can I conclude?”
Required
Prepare your response.
UP3-5 (Trial balance) One of your friends, who is a small business owner, knows you are taking
introductory accounting and asked you the following question:
“I am looking for a new accountant to do my books and taxes. When I called one of the firms, they
asked me to bring a copy of my company’s trial balance to the introductory meeting. What can they
tell about the company by looking at that?”
Required
Prepare your response.
UP3-6 (Journal entries) One of your friends, who is also a classmate, came to you in the library and
asked you the following question:
“I don’t understand why I need to make two journal entries to record the sale of goods. For example,
if a company sold goods with a cost of $25,000 for $60,000 cash, why can’t I just record it as follows?
Cash
60,000
Inventory
25,000
Gross Profit
35,000
This entry reflects what actually happened, so why isn’t it correct?”
Required
Prepare your response.
UP3-7 (Adjusting entries) One of your friends, who is also a classmate, came to you and asked the
following:
“I’m confused about the terms deferral and accrual. For me, it is easiest to think about how the
receipt of cash compares with the timing of revenue recognition. There are times when revenue
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recognition happens before the receipt of cash and others where that happens after. How do the
deferral and accrual terms link to these before and after scenarios?”
Required
Prepare your response.
UP3-8 (Differences between the adjusted trial balance and a set of financial statements)
Assume that you are part of a commercial lending team for a bank. As part of the loan terms, one of
the bank’s clients must submit monthly financial statements for review. The client has just phoned and
left your boss a message asking if it would be enough to just provide the bank with an adjusted trial balance. Your boss has asked you to prepare a brief memo outlining any differences between the information that would be provided by the financial statements and that provided by the adjusted trial balance.
Your boss has also asked that you recommend the position the bank should take regarding this request.
Required
Respond to your boss’s requests.
UP3-9 (Purpose of closing entries) A friend came to ask you a question about accounting for a
small business she started at the beginning of the year. She said that her accounting software had a
“closing entry” option. She was uncertain what this meant, when she should select it, and what impact it
would have on her company’s accounting records.
Required
Prepare a response to your friend’s questions.
Work in Progress
WIP3-1 (Normal balances) You are studying with some classmates and are reviewing each other’s
responses to the following question:
“How does the debit and credit system work?”
Your classmate responds as follows:
“Assets normally have a debit balance, so to increase an asset, you debit the account, while to decrease
it you’d credit the account. For accounts that normally have a credit balance (liabilities and shareholders’ equity), you’d do the opposite and credit the account to increase it and debit it to decrease it.”
Required
Identify how your classmate’s answer could be substantively improved.
WIP3-2 (Temporary accounts) While preparing for an upcoming exam, you are studying with
some classmates when one of them asks the following:
“Am I correct that revenue and expense accounts are temporary extensions of retained earnings and
that this is why they are considered to be temporary or nominal accounts, while all other accounts
are considered to be permanent?”
Required
Evaluate your classmate’s response. Identify the elements that are correct and incorrect.
WIP3-3 (Closing entries) You are studying with some classmates and are reviewing each other’s
responses to the following question:
“Explain why closing entries are made. What are the two objectives that are accomplished by making closing entries?”
Your classmate responds as follows:
“Closing entries are to ensure revenue and expense accounts have a zero balance at the start of the
next accounting period. Your accounting records are improved because you will be able to tell if your
company is profitable.”
Reading and Interpreting Published Financial Statements
3-65
Required
Identify how your classmate’s answer could be substantively improved.
WIP3-4 (Closing entries) You are studying with some classmates and are reviewing each other’s
responses to the following question:
“Explain why closing entries are made. What are the two objectives that are accomplished by making closing entries?”
Your classmate responds as follows:
“Closing entries are made to zero out temporary accounts at the end of an accounting period.”
Required
Identify how your classmate’s answer could be substantively improved.
WIP3-5 (Retained Earnings) You are studying with some classmates and one of them states the
following:
“If a company has a large retained earnings balance, this signals that the corporation has been profitable in the past and has never suffered a loss. This retained earnings balance represents cash that
management has set aside to finance the company in the future.”
Required
Identify any errors in your classmate’s statement and indicate how it could be substantively improved.
WIP3-6 (Dividends) You are working with other students analyzing a set of financial statements as
part of a group project. One of your classmates states the following:
“I think there is a problem with the company’s financial statements. The statement of changes in
equity indicates that the company declared dividends during the year, but there is no dividends
payable account on the company’s statement of financial position.”
Required
Identify and explain the flaws in your classmate’s logic.
Reading and Interpreting Published Financial Statements
RI3-1 (Closing entries, deferred revenue, and prepaid expenses) Saputo Inc., which is headquartered in Montreal, produces, markets, and distributes dairy products in markets around the world.
Exhibit 3.28 contains an excerpt from the company’s consolidated financial statements dated March 31,
2020.
(in millions of Canadian dollars)
RETAINED EARNINGS
2020
2019
Balance, beginning of year
3,715.0
3,216.4
649.7
753.2
(269.7)
(254.6)
Net Income
Dividends Declared
Balance, end of year
4,095.0
3,715.0
Required
a. Prepare the closing entries that would have been required to close the Income Summary account.
Refer to Exhibit 3.28.
b. The company has prepaid expenses of $106.6 million as at March 31, 2020. Identify two of Saputo’s
likely prepaid expenses and when they would be expensed.
EXHIBIT 3.28 Excerpt from
Saputo Inc.’s Consolidated
Statements of Changes in
Equity
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C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
RI3-2 (Retained earnings, depreciation, and prepaid expenses) High Liner Foods Inc. operates in the North American packaged foods industry and primarily processes and markets frozen seafood
and distributes products to retail and food service customers. Exhibit 3.29 contains selected financial
information for 2020.
EXHIBIT 3.29 Selected 2020
Financial Information for
High Liner Foods
(in thousands of US dollars)
Net income
28,802
Retained earnings, opening balance
162,773
Dividends declared
5,518
Required
a. Determine the company’s ending Retained Earnings balance. Refer to Exhibit 3.29.
b. Identify three things that we know about the company because it has an opening balance in Retained
Earnings.
c. During the year ended December 31, 2020, High Liner Foods had depreciation expense of $6,630
thousand on its production equipment, $2,901 thousand on its building structures, and $1,104 thousand on its computer equipment. Prepare the adjusting entry that would have been required if the
company recorded all of its depreciation in a single entry.
d. The company had prepaid expenses of $4,176 thousand as at December 31, 2020. Identify two types
of likely prepaid expenses and explain when they would be expensed.
RI3-3 (Retained earnings, accrued liabilities, and carrying value) North West Company
Inc. is a leading retailer to underserved rural communities and urban markets in Northern and Western
Canada and internationally. Its stores offer a broad range of products and services with an emphasis on
food. Exhibit 3.30 contains an excerpt from the company’s consolidated financial statements for the year
ended January 31, 2021.
EXHIBIT 3.30 Excerpt from
North West Company’s 2021
Financial Statements
(in thousands of dollars)
Net income
143,560
Retained earnings, opening balance
211,252
Dividends declared
67,276
Required
a. Determine the company’s ending Retained Earnings balance. Refer to Exhibit 3.30.
b. Identify three things that we know about the company because it has an opening balance in Retained
Earnings.
c. The company had accounts payable and accrued liabilities of $205,202 thousand at January 31,
2021. Identify two possible liabilities the company may have had as part of this balance.
d. Based on the information below (given in thousands of dollars), determine the carrying value of
the North West Company’s buildings and computer equipment. Comment on how old or new these
capital assets are and how you determined this.
Buildings
Fixtures & equipment
Cost
Accumulated Depreciation
$599,930
$325,616
348,173
253,800
RI3-4 (Retained earnings, prepaid expenses, and dividends) Big Rock Brewery Inc. is a regional producer of premium craft beers and cider, which are sold across Canada. Exhibit 3.31 contains an excerpt
from the company’s consolidated financial statements for the year ended December 30, 2020.
Cases
(in thousands of Canadian dollars)
Net income (Loss)
(666)
Deficit, opening balance
Dividends declared
(79,761)
Quarterly dividends have been suspended
Required
a. Determine the company’s Retained Earnings (Deficit) balance using the information from Exhibit 3.31.
b. Identify three things that we know about the company because it has an opening deficit balance.
c. The company had $387,000 in prepaid expenses and deposits at December 30, 2020. Which financial
statement would this be presented on? Assuming these prepaid expenses related to insurance premiums, when would they be expensed?
RI3-5
(Financial statement disclosures)
Required
Find the annual report of a Canadian company that is listed on a Canadian stock exchange, and answer
the following questions about it:
a. Has the company prepared a classified statement of financial position (balance sheet)? If not, look
for an explanation and state it briefly.
b. Referring to items in the statement of financial position, explain what liquidity is and how it is
reflected in the statement of financial position.
c. Discuss how important inventory is compared with the other assets on the company’s statement of financial position. Also address how important capital assets (property, plant, and equipment) are to the
company.
d. Does the company rely more heavily on debt financing or equity financing?
RI3-6
(Additional information about a company)
Required
For the company you selected in RI3-5, find at least three articles in the financial media that discuss the
nature of this company’s markets and that forecast what the future may be for this sector of the economy.
Write a one-page summary of your findings.
Cases
C3-1 Al’s Gourmet Fish
Leadfoot Al decided to retire from a successful career in stock car racing and invest all his winnings in
a fish farm. He had majored in genetics in university, and he experimented with many different species
of fish before coming up with a catfish that had the texture and taste of ocean trout. After incorporating
Al’s Gourmet Fish Company and operating for two years, he decided to explore expansion possibilities.
He talked with his banker about getting a loan and presented a statement of income for the current year,
based strictly on cash flows, as follows:
Cash collected from sale of fish
Less: Feed purchases
$520,000
$460,000
Purchase of new fish tank
40,000
Wages paid
80,000
Other operating expenses paid
20,000
Operating loss
Plus: proceeds from sale of land
Net income
600,000
(80,000)
130,000
$ 50,000
3-67
EXHIBIT 3.31 Excerpt from
Big Rock’s 2020 Financial
Statements
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C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
From discussions with Al, the banker learned the following:
1. Of the cash collected in the current period from sales of fish, $120,000 was for shipments delivered
to customers last year. All the sales made this year were collected before the end of the year.
2. The fish feed can be stored indefinitely, and about 40% of this year’s feed purchases were still on
hand at year end.
3. Two fish tanks were purchased last year at a total cost of $80,000. These tanks, along with the one
purchased at the beginning of this year, were used all year. Each tank is expected to last five years.
4. The amount for wages includes $60,000 paid to Al, as compensation for his time devoted to the business.
5. There was a total of $1,000 in bills for other operating expenses for the current year that had not
been recorded or paid by year end.
6. The land that was sold for $130,000 had been purchased two years ago for $90,000.
Required
Provide Al and his banker with answers to the following questions:
a. What amount of revenue from the sale of merchandise should be reported in this period?
b. What amount of expense for fish feed should be reported in this period? How should the remainder
of the feed be reported?
c. Should some amount for the fish tanks be included in calculating the income for the current period?
If so, how much?
d. Is it all right for Al’s company to pay him wages? Why or why not?
e. What amount for “other operating expenses” should be included in calculating the earnings for the
current period?
f. The land was sold for more than its original purchase price. The difference between the selling price and the
purchase price of a capital asset is called a gain, and is included on the statement of income in the period
of the sale. What amount should be included in the company’s earnings as the gain on the sale of the land?
g. How much did Al earn from his business this year?
h. Comment on whether you think Al should stay in the fish business or go back to auto racing. In
addition to financial factors, briefly describe several non-financial considerations that would be relevant to this decision.
C3-2 Sentry Security Services
Samir Sarkov incorporated Sentry Security Services and began operations on January 1, 2024. After a
busy year, Samir thinks his business has done well, at least in terms of the volume of work done. However, he has asked for your help in determining the financial results.
The company’s accounting records, such as they are, have been kept by Samir’s son. Although he
kept good records of all the cash received and spent by the business during the year, he has no formal
training in accounting. At the end of the year, he prepared the following statement:
SENTRY SECURITY SERVICES
Statement of Cash Receipts and Disbursements
For the year ended December 31, 2024
Cash Receipts:
Invested in the business by the Sarkov family
$ 25,000
Received from customers for services provided
75,000
Borrowed from the Provincial Bank
15,000
$115,000
Cash Disbursements:
Paid to the Provincial Bank
Rent paid
6,500
6,500
Security equipment purchased
18,000
Wages paid
37,000
Security services truck payments made
25,000
Insurance premiums paid
Security system parts and supplies purchased
Cash remaining (equals the bank balance)
2,000
15,000
110,000
$ 5,000
Cases
After reviewing the records, you confirm that the amounts are correct, and you also discover these
additional facts:
1. The business does most of its work for cash, but at the end of the year customers owe $5,000 for
security services that were provided on account.
2. The amount borrowed from the Provincial Bank is a three-year loan, with an interest rate of 10% per
year.
3. The amount paid to the bank during the year includes $1,500 of interest on the loan and $5,000 of
principal.
4. The rental contract for the company’s space covers a two-year period and requires payments of $500
per month, paid at the beginning of each month. In addition, the last month’s rent had to be paid in
advance. All the required payments have been made as scheduled.
5. The security equipment was purchased at the beginning of the year and has an estimated five-year
lifespan, after which it will be worthless.
6. In addition to the wages that were paid during 2024, $250 is owed to employees for overtime that
was worked during the last few days of the year. This will be paid early in 2025.
7. The security services truck payments consist of $21,000 paid to purchase the truck at the beginning
of the year plus $4,000 paid for gas, oil, and repairs during the year. Samir Sarkov expects to use the
truck for four years, after which he thinks he should be able to get about $1,000 for it as a trade-in
on a new truck.
8. The $2,000 for insurance resulted from paying premiums on two policies at the beginning of the
year. One policy cost $700 for one year of insurance coverage; the other policy cost $1,300 for two
years of coverage.
9. In addition to the $15,000 of parts and supplies that were purchased and paid for during the year,
creditors have billed the business $500 for parts and supplies that were purchased and delivered but
not paid for.
10. A count at the end of the year shows that $1,750 of unused parts and supplies were still on hand.
Required
a. Prepare an accrual-basis statement of income for the year ended December 31, 2024, and a classified
statement of financial position for Sentry Security Services at the end of the year.
b. Comment on the company’s performance during its first year of operations and its financial position
at the end of the year.
C3-3 Shirley’s Snack Shop
Shirley Sze incorporated Shirley’s Snack Shop on April 30, 2024, by investing $5,000 in cash. The
following is a summary of the other events affecting the business during its first eight months of
operations:
1. On May 1, Shirley acquired a licence from the municipality at a cost of $150. The licence allows her
to operate the snack shop for one year.
2. On May 2, she borrowed $10,000 from the bank and used most of it to buy equipment costing $9,600.
The interest rate on the loan is 10%, and the interest is to be paid annually (each May). The entire
principal amount is repayable at the end of three years. Shirley estimates that the equipment will
last 10 years, after which it will be scrapped. On December 31, 2024, she estimated that the equipment could have been sold for $9,200.
3. At the beginning of September, Shirley realized that she should have liability insurance and purchased a one-year policy effective immediately. The premium paid was $750.
4. Her business is located in a small shop near the university campus. The rental cost is $900 per
month, and she has paid nine months of rent thus far.
5. Shirley paid herself a salary of $1,000 a month, and a part-time assistant earned wages of $350 each
month. However, she has not yet paid her assistant his wages for December.
6. Shirley’s purchases of food supplies, on account, cost a total of $22,500. All but $4,500 of this
has been used, and she still owes the supplier $4,000. Of the food supplies that have been used,
most went into snacks that were sold to customers; however, Shirley ate some of them herself,
as on-the-job meals. She estimates that the snacks she consumed were purchased from the
supplier at a cost of approximately $200 and were priced to sell to her customers for approximately $400.
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C H A PTE R 3
Double-Entry Accounting and the Accounting Cycle
7. According to her bank records, Shirley received $42,300 from her customers and deposited this in
the bank during the period. However, a customer still owes her $500 for snacks provided for a company party held shortly before the end of the year. The balance in her bank account on December 31
is $9,750.
8. Shirley thinks that she has had fairly successful operations since opening the business. However,
she has no idea how to calculate its net income or determine its financial position.
Required
a. Provide Shirley with a single-step statement of income for the eight-month period ended December
31, 2024, and a classified statement of financial position as at that date.
b. Comment on the snack shop’s performance during its first eight months of operations and its financial standing as at December 31, 2024.
C3-4 Mbeke’s Hardware Store
In the middle of January 2025, Mark Mbeke, the owner of Mbeke’s Hardware Store, decided to expand
the business by buying out a local lumberyard. To finance the purchase, Mark had to obtain financing
from a local bank. The bank asked Mark to provide financial statements for the year ended December 31,
2024, as support for the loan application.
Over the last year, Mark was so busy managing the store that he had no time to review the financial
aspects of its operations. However, when the company’s bookkeeper provided him with a set of hastily
prepared financial statements for 2024, Mark was pleasantly surprised to see that the hardware store’s net
income had increased from $60,000 in 2023 to $90,000 in 2024. He commented, “With financial results
like these—a 50% increase in income during the past year—we should have no trouble getting the loan.”
However, further investigation revealed the following:
1. On January 2, 2025, the company repaid a $140,000 loan in full, including interest. The loan was a
one-year, 10% term loan. No interest expense was recorded in 2024.
2. On January 3, 2025, wages of $10,000 were paid. A review of the time cards shows that these wages
relate to work done in the last week of 2024.
3. Goods that originally cost $11,000 and were sold in December 2024 for $15,000 were returned by the
customer on January 4, 2025. Accompanying the goods was a letter that stated, “As we agreed on
December 30, 2024, these goods are not what we had ordered and are therefore being returned for
full credit.”
4. Mbeke’s Hardware received bills totalling $2,000 in the first week of January 2025 for utilities and
other operating costs incurred in 2024. They were immediately recorded as accounts payable when
they were received.
Mark is concerned that some of these transactions may affect the company’s financial statements for
the year 2024 and therefore its ability to obtain the necessary bank financing.
Required
a. Calculate the effect of each of these items on the store’s net income for 2024.
b. By what percentage did the store’s net income increase (or decrease) over the last year?
c. In light of this information, how should Mark proceed?
d. What should the bank do to ensure that it is receiving accurate financial information?
C3-5 Downunder Company
You have been retained by Downunder Company to straighten out its accounting records. The company’s
trusted accountant for the past 25 years suddenly retired to a tropical island in the South Pacific and,
in his rush to get away, he seems to have misplaced the company’s accounting records. Now the bank
has asked for the latest financial statements, so it can determine whether to renew the company’s loan.
Luckily, you managed to find the following listing of accounts and their balances, in alphabetical order,
written on the back of one of the accountant’s travel brochures.
Endnotes 3-71
Accumulated Depreciation, Equipment
$ 4,000
Equipment (original cost)
Common Shares
20,000
Interest Expense
Accounts Receivable
20,200
Bank Loan Payable
Accounts Payable
13,000
Miscellaneous Expenses
Cash (in bank account and in cash box)
Cost of Goods Sold
1,100
$ 51,500
500
15,000
8,000
Sales to Customers
93,600
41,000
Wages Expense
27,500
Inventory
7,900
Wages Payable
1,200
Depreciation Expense
2,000
Required
a. Based on the information available, prepare a statement of income for the year 2024 and a statement
of financial position as at December 31, 2024. Note that there is no amount available for Retained
Earnings, so you will have to enter whatever amount is required to make the statement of financial
position balance.
b. Identify several additional pieces of information that would be needed for preparing more complete
and accurate financial statements. (Hint: think in terms of the types of adjustments that would normally be made.)
Endnotes
1
Gary P. Spraakman, “Management Accounting at the Historical Hudson’s Bay Company: A Comparison
to 20th Century Practices,” Accounting Historians Journal 26, no. 2 (December 1999): Article 3; Arthur J.
Ray, Give Us Good Measure (Toronto: University of Toronto Press, 1978); Hudson’s Bay Company, 2016
Annual Report; Hudson’s Bay Company History Foundation (website), www.hbcheritage.ca; Financial
Post, “Baker’s HBC Privatization Bid Approved after Plenty of ‘Noise and Aggravation,’” February 27,
2020; McCarthy Tetrault, “Hudson’s Bay Company (HBC) Goes Private in a C$1.11B Cash Deal,” March
3, 2020.
2
A. Sangster and G. Scataglinibelghitar, “Luca Pacioli: The Father of Accounting Education,” Accounting
Education 19, no. 4 (2010): 423–438.
3
Yan Barcelo, “Devil in the Details,” CA Magazine 146, no. 1 (January/February 2013): 26–29.
4
A. Littleton, Accounting Evolution to 1900 (Tuscaloosa, AL: University of Alabama Press, 1933).
5
CPA Canada, “The Conceptual Framework,” in The Standards and Guidance Collection, part 1, International Financial Reporting Standards.
Gorodenkoff/Shutterstock
CHAPTER 4
Revenue Recognition and the
Statement of Income
Gorodenkoff/Shutterstock
Competing in the Revenue Game
Where there are “eyeballs,” there is money to be made. Before
the Internet, those eyeballs were glued to television screens,
and broadcasters made money by selling commercials. Today,
people are spending more and more time watching mobile
and computer screens, and that captive audience can be
­“monetized”—made money from. One area in which that’s
happening is online video gaming, a business that is twice as
big as movies and professional sports combined and is projected to nearly double to U.S. $305 billion by 2025.
Toronto-based Enthusiast Gaming Holdings Inc.
describes itself as the world’s largest network of gaming communities, with more than 100 gaming-related websites and
1,000 YouTube channels, drawing in over 300 million gaming enthusiasts around the globe each month. Through its
division Luminosity Gaming, it has stakes in six professional
e-sports teams, including the Vancouver Titans in the Overwatch League and the Seattle Surge in the Call of Duty League.
Enthusiast focuses not on developing the games itself, but on
connecting the fans who watch them together and talk about
them. CEO Adrian Montgomery says the company is like a
record label. In other words, it’s a link between content creators and consumers.
Enthusiast has three sources of revenues. More than
80% of the company’s revenue comes from advertising on its
websites, which generated more than $60.8 million in 2020.
Advertisers on the company’s websites included Disney,
Gillette, Activision, and Amazon. During the 2020 U.S. presidential election, even the Joe Biden campaign bought ads on
Enthusiast’s properties to reach its younger audience. It also
gets money from subscriptions—more than $6 million in 2020.
For example, its fan site devoted to The Sims life simulation
game had more than 100,000 members paying $5 a month to
access it. The company also earned revenues of $5.9 million
from its teams that compete in six e-sports leagues. Enthusiast
also earns revenues from selling players on its e-sports teams
to other teams.
In 2020, Enthusiast’s revenues were more than $72.8 million—nearly seven times the amount of revenues in 2019. One
reason for the explosion in sales is that, during the COVID-19
pandemic, people were craving not only something to do from
home, but connection with others in a community. However,
those revenues came at a high price, including cost of sales
of $54.3 million plus other expenses, meaning that Enthusiast
had a net loss in 2020 of $26.9 million.
The company has ambitious expansion plans. As of early
2021, it planned to list on the Nasdaq stock exchange in order
to access U.S. capital to continue buying up gaming rivals,
such as it did in 2020 when it purchased Omnia Media, Inc.
Enthusiast is betting on continued increases in revenues. As the average age of fans of professional sports teams
increases, interest in e-sports by younger fans increases. Montgomery says that half of American men aged 18 to 34 visit an
Enthusiast property each month, and he expects that the company’s revenues will grow by at least 20% in 2021.1
4-1
4-2
CH A PT ER 4
Revenue Recognition and the Statement of Income
CORE QUESTIONS
If you are able to answer the following questions, then you
have achieved the related learning objectives.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Revenue and Its Significance
• What is revenue and why is it of significance to users?
• Why is understanding how a company recognizes
revenue of significance to users?
1. Explain the nature of revenue and why revenue is of
significance to users.
Revenue Recognition
2. Identify and explain the contract-based approach to
revenue recognition.
• When are revenues recognized?
Other Revenue Recognition Issues
• How do rights of return, warranties, consignment,
and third-party sale arrangements affect revenue
recognition?
3. Explain how revenue recognition is affected by rights
of return, warranties, consignment, and third-party
sale arrangements.
Statement of Income Formats
• How does a single-step statement of income differ
from a multi-step statement of income?
4. Understand the difference between a single-step
statement of income and a multi-step statement of
income.
Statement of Comprehensive Income
• What is comprehensive income and how does it differ
from net income?
5. Understand the difference between comprehensive
income and net income.
Presentation of Expenses by Nature or by Function
• How does a statement of income presenting expenses
by function differ from one presenting expenses by
nature of the items?
6. Understand the difference between presenting
expenses by function or by nature of the item on the
statement of income.
Financial Statement Analysis
• What is meant by earnings per share, and how is it
calculated?
4.1
7. Calculate and interpret a company’s basic earnings
per share.
Revenue and Its Significance
LEARNING OBJECTIVE 1
Explain the nature of revenue and why revenue is of significance to users.
In Chapters 1 through 3, four basic financial statements were described, and we saw that two
of these, the statement of income and the statement of cash flows, measure the company’s
performance across a time period. This chapter discusses the accounting concepts and principles for the recognition of income, provides more detail about the statement of income, and
considers some of the challenges that are inherent in performance measurement.
Revenue and Its Significance 4-3
What Is Revenue and Why Is It of Significance to
Users?
Take5 Video
Income is composed of two elements: revenue and gains. The distinction between these has to
do with whether the income arises in the course of a company’s ordinary activities, which
are those activities that are the company’s normal, ongoing major business activities. Revenues are defined as increases in economic benefits from a company’s ordinary operating
activities, while gains result in increases in economic benefits from activities that are outside
the course of ordinary operating activities.
In other words, revenues result in inflows of assets such as cash or accounts receivable or
decreases in liabilities such as deferred revenue and are generated by the transactions a company normally has with its customers, selling them products and/or providing services. There
is a huge range of transactions that can be considered normal operating activities because
there are so many different types of businesses. For example, the ordinary operating activities
for clothing retailers include the sale of clothing and accessories, while the provision of air
travel and vacation packages is a normal operating activity for airline companies. Your university or college has a range of activities that are considered normal operating activities. These
include providing educational services, selling goods in its bookstore or cafeteria, selling parking passes, and renting rooms in student residences. Revenue is often referred to with other
terms, such as sales, fees, interest, dividends, royalties, or rent.
As we discussed in Chapter 2, there does not have to be a receipt of cash in order for a
company to recognize revenue. This is why the term economic benefit is used when defining
revenue. While the economic benefit will normally be an inflow of cash at some point, the
sale and the receipt of cash do not have to occur at the same time. In this chapter, we will see
examples of revenue transactions for which the cash is received prior to the sale, at the time
of sale, or subsequent to the sale.
The amount of revenue (or sales) is one of the most significant amounts reported in the
financial statements. For a company to be successful, it must generate revenues from what
it is in the business of doing. A company’s total revenues must be greater than the expenses
incurred to generate them. When total revenues exceed total expenses, a company reports net
income. Financial statement users see this as a sign that the company is viable, has the ability
to sustain itself or grow, and has the ability to declare dividends. On the other hand, if total
expenses exceed total revenues, a company reports a net loss. A loss may signal that all is not
well with the company. When losses occur, it is important for management and users to evaluate both the size and cause of the loss.
When assessing revenues, financial statement users evaluate both quantity and quality.
Quantity is the amount of revenue and whether or not the trend shows an increase or decrease
over a number of accounting periods. Quality refers to the source(s) of revenue and the company’s ability to sustain the revenue over the longer term. For example, retail stores often
report a key measure: same-store sales. This helps users to determine whether revenue growth
is from new locations or increased sales at existing locations. If sales at established stores are
increasing year over year, it suggests a high quality of earnings. If, on the other hand, a retailer
reports an increase in revenue due to having more locations, but there is a decrease in samestore sales, this may signal an issue with the quality of earnings.
Ethics in Accounting
Revenue recognition issues have been at the heart of many
accounting scandals. The significance placed on reported revenues can provide an incentive for management to try to maximize
them. One of the biggest Canadian financial reporting frauds
involved a Calgary-based company, Poseidon Concepts Corp.
The company, which had a market capitalization of more than
$1.3 billion before the fraud was exposed, was in the business of
building and supplying fracking fluid storage systems to the North
American oil and gas industry. When the fraud was investigated,
it turned out that the company had been booking fictitious revenues. In fact, more than $100 million in revenues were recorded
related to contracts that were either non-existent or uncollectible!
Investors lost more than $1 billion as the value of the Poseidon
shares they owned evaporated once the fraud was exposed.2
4-4
CH A PT ER 4
Revenue Recognition and the Statement of Income
For Example
Financial Statements Canadian Tire Corporation reported
the following sales growth for the various segments of its
operations:
Canadian Tire retail stores
Felix Choo / Alamy Stock Photo
KEY POINTS
When assessing
revenues, users consider:
• quantity by measuring
growth
• quality by assessing
the source of growth
(such as same-store
sales growth) and how
closely revenue growth
corresponds with cash
flow from operating
activities
SportChek stores
Mark’s stores
2020
2019
16.5%
2.9%
(10.9)%
2.2%
(4.8)%
2.2%
From this we can see that, on a percentage basis, the company experienced significant sales
growth in Canadian Tire retail stores, which remained open during the pandemic, while experiencing decreased sales in both the SportChek and Mark’s stores, which closed for various periods
during the pandemic. The positive news for Canadian Tire was that, on a dollar basis, the gains
in the Canadian Tire sales were four times greater that the combined declines in the SportChek
and Mark’s sales.3
As we learned in Chapter 2, companies use the accrual basis of accounting. Under the
accrual basis, accounting revenues are recognized when they are earned regardless, of whether
the related cash was received by the company. However, revenues must, at some point, be collected in cash. Cash is essential to a company’s ultimate survival. Another way the quality of
earnings is assessed is to compare the cash flow from operations (from the statement of cash
flows) with net income (or net earnings). If these two amounts are moving together (both up
or both down) and if the cash flow from operating activities is greater than the net income, we
consider the earnings to be of higher quality. If the two amounts do not move together and if
the cash flow from operating activities is less than the net income, we consider the earnings to
be of lower quality. The Key Points show how users assess revenues.
Why Is Understanding How a Company
Recognizes Revenue of Significance to Users?
Users need to be aware of how companies recognize revenue so that they can make informed
judgements about reported revenues. Accounting standards outline approaches or models for
revenue recognition rather than providing specific rules, so it is possible that different companies apply them differently. The revenue recognition approach also differs depending on
whether a company is using IFRS or ASPE. Therefore, when comparing companies, a user
must understand which revenue recognition approach each company is using. Some companies have multiple business activities. For example, Rogers Communications sells Internet
services, owns a Major League Baseball team, and publishes several magazines. While Rogers
will apply a single revenue recognition model, it will have to apply it to each of its business
activities. When analyzing such companies, it is important for users to understand how this
has been done.
Financial statement users can find information about a company’s approach to revenue
recognition in the notes to its financial statements. Accounting standards require companies
to disclose this information. These standards also require companies to disclose information that enables financial statement users to understand the nature, amount, timing, and
uncertainty of revenues. Management determines the extent of the disclosure required, but it
normally includes information on the amount of revenues for each significant geographical
market and major product line and by the timing of revenue recognition (goods transferred at
a point in time or services transferred over time).
Revenue Recognition 4-5
4.2
Revenue Recognition
LEARNING OBJECTIVE 2
Identify and explain the contract-based approach to revenue recognition.
When Are Revenues Recognized?
Determining when a company has earned revenue is one of the most critical accounting decisions. We learned in Chapter 2 that, under the accrual basis of accounting, revenues are recognized when they have been earned. Determining when revenue has been earned can be
challenging. There are two revenue recognition approaches that are used in determining this:
the contract-based approach (which is also known as the asset-liability approach) and the
earnings-based approach. Companies preparing their financial statements using IFRS must
use the contract-based approach, while companies preparing their financial statements using
ASPE must use the earnings-based approach. As the focus of this text is on analyzing the
financial statements of public companies, we will concentrate on understanding the basics of
the contract-based approach so that you can determine when revenue would be recognized by
companies using this approach.
Contract-Based Approach
As the name implies, the contract-based approach focuses on the contracts a company has
with its customers. A contract is an agreement between two or more parties that creates a
combination of rights (the right to be paid by customers, which is also known as the right to
receive consideration) and performance obligations (the requirement to provide goods or
services to customers). Contracts can be written, oral, or implied by the company’s ordinary
business practices. The contract can represent either an asset (when rights exceed obligations)
or a liability (when obligations exceed rights). Whether a contract is an asset or a liability
depends on the actions that the parties to the contract have taken in terms of their responsibilities under the contract.
Under the contract-based approach, changes in a company’s net position in a contract
are required before revenues can be recognized. Changes in a company’s net position in a
contract occur when there is a change in its rights under the contract or a change in its performance obligations under the contract. Under the contract-based approach, revenues are
recognized when a company’s net position in the contract increases; that is, when a company’s
rights under the contract increase or when its performance obligations under the contract
decrease. Practically speaking, both of these scenarios occur whenever a company satisfies
its performance obligations under the contract as, by doing so, its rights under the ­contract
increase and its performance obligations under the contract decrease. The Key Points
­summarize the contract-based approach.
Exhibit 4.1 illustrates how a company’s net position in a contract can change as a result
of various actions related to the contract and when revenue would be recognized in relation to
that change. The exhibit shows the perspective of the company selling the goods or providing
the services.
KEY POINTS
• Under the contractbased approach,
revenue is recognized
whenever a company’s
net position in a
contract increases.
• A company’s net
position in a contract
increases when:
-its rights under the
contract increase;
-its performance
obligations under the
contract decrease.
• A company must
fulfill a performance
obligation in order
to increase its net
position in a contract
and recognize revenue.
4-6
CH A PT ER 4
Revenue Recognition and the Statement of Income
EXHIBIT 4.1 Illustration of When Changes in a Company’s Net Contract Position Result in the
Recognition of Revenue
Rights under the
Contract
Performance Obligations
under the Contract
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Net Contract Position &
Required Journal Entry
Company enters
into a contract with
a customer
No change (because neither
party has done anything aside
from signing the contract)
No change (because neither party
has done anything aside from
signing the contract)
No change
Company provides
goods or services to
customer
Increase (because the
company’s right to receive
consideration increases)
Decrease (because the company
has fulfilled its obligation)
Increases; therefore, recognize revenue
No journal entry to record
DR Accounts Receivable
CR Sales Revenue
If sale of goods, then also
DR Cost of Goods Sold
CR Inventory
Company invoices
customer for goods
or services
No change (because it does
not change the rights under
contract)
No change (because it does
not change the extent of
responsibilities under contract)
No change
Customer pays
Decrease (because it reduces the
company’s rights)
No change (because all
obligations were already fulfilled)
Decreases
No journal entry to record
DR Cash
CR Accounts Receivable
A five-step model, as illustrated in Exhibit 4.2, is used to determine when and how much
revenue should be recognized. This model helps to determine when a company has satisfied its performance obligations, resulting in an increase in its net position in the contract,
enabling it to recognize revenue.
EXHIBIT 4.2 Five-Step Model of Revenue Recognition
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Step 1
Step 2
Step 3
Step 4
Step 5
Identify the
contract
Identify the
performance
obligations
Determine
the
transaction
price
Allocate the
transaction
price to
performance
obligations
Recognize
revenue
when each
performance
obligation is
satisfied
We will now look at each of the steps in more detail.
Step 1.
Identify the contract. The first step is to determine whether or not there is a
contract. If there is, then it is possible to move to the next step in the model (and potentially
recognize revenue). If not, that’s it in terms of the model and no revenue can be recognized.
A contract exists when all five of the following criteria are met:
• There is a legally enforceable agreement between two or more parties.
• It has been approved and the parties are committed to their obligations.
• Each party’s rights to receive goods or services or payment for those goods and services
can be identified.
• The contract has commercial substance, meaning that the risk, timing, or amount of
the company’s future cash flows is expected to change as a result of the contract.
• Collection is considered probable.
When assessing collection, probable is defined as “more likely than not,” with consideration
given to the customer’s creditworthiness, financial resources, and intention to pay.
Revenue Recognition 4-7
If each party to the contract has the right to terminate a contract that has not been fully
performed without paying any compensation to the other party (or parties) to the contract,
then a contract does not exist.
If all of the above criteria are not met, then there is no contract. As such, no revenue can
be recognized in relation to it. Any consideration received would be recorded as a liability. If
goods or services have been transferred to the customer, no receivable would be recorded for
consideration that has not been received.
Step 2. Identify the performance obligations. The contract must be analyzed to deter-
mine the performance obligation(s) contained in it. These are the goods and/or services to be
delivered to the customer and are sometimes referred to as the contract deliverables. There
may be a single performance obligation to provide goods or services, or multiple performance
obligations in which goods or services will be delivered over a period of time.
Performance obligations relate to distinct goods or services. Goods or services are considered to be distinct if both of the following criteria are met:
• The customer can benefit from the good or service (by using, consuming, or selling it) on
its own or with other resources it possesses or can obtain from a third party.
• The promise to transfer the goods or services is separate from other promised goods or
services in the contract. That is, these goods or services are being purchased as separate
items under the contract, rather than forming part of a larger good or service.
If both of the above criteria are not met, then the goods or services are not considered to
be distinct and are bundled with other goods and services to be provided under the contract
until a distinct performance obligation is created. For example, if a building company is
contracted to construct a house, the bricks, lumber, and other building materials would not
be considered to be distinct goods. It would be the construction of the house, using these
building materials and the services of the company, that would be considered to be a distinct performance obligation. Review the Key Points regarding performance obligations.
It is important to note that a series of distinct goods or services that are substantially the same
and that have the same pattern of transfer to the customer are considered to be a single perform­
ance obligation. An example of this would be the provision of weekly landscaping services under
a three-month contract. Rather than each week’s or month’s services being considered a distinct
service, the entire three-month contract would be considered a single distinct service. This is done
so that companies can apply the five-step model once rather than having to apply it each time the
goods or services are provided. In the case of the landscaping services contract, the revenue to be
recognized each week would be consistent and would be determined based on applying the fivestep model once, at the beginning of the contract, rather than weekly as the services are provided.
Step 3.
Determine the transaction price. The transaction price is the amount of consideration the company expects to receive in exchange for providing the goods or services. This
is a core principle of the contract-based approach: the amount of revenue the seller should
recognize should reflect the consideration it expects to receive in exchange for providing the
goods or services. The consideration is normally received from the customer, but may also
be received from third parties (such as coupons that are reimbursed by manufacturers). The
transaction price excludes amounts collected on behalf of third parties (such as sales taxes).
The transaction price must reflect any variable consideration. Variable consideration
can result if there are discounts, refunds, rebates, price concessions, incentives, performance
bonuses, penalties, and so on. The transaction price must include any expected noncash consideration and is reduced by any consideration that will be paid to the customer in relation to
discounts, volume rebates, or coupons.
When a company makes sales on account, it generally gives commercial customers 30
days (or more), interest-free, to pay their account. To encourage these customers to pay their
accounts more quickly, some companies provide terms, known as sales discounts (or prompt
payment discounts) that provide the customer with a discount off the purchase price if they
pay within a shorter period of time (sales discounts are summarized in the Key Points).
A typical sales discount is “2/10, n/30,” which means that the customer could take a 2% discount if they paid within 10 days of purchase or, if this was not done, the net (or full) amount
of the account would be due within 30 days. If a customer took advantage of a sales discount, then the seller would receive only 98% of the selling price when the customer paid their
KEY POINTS
• Contracts include
performance
obligations that require
a company to provide
goods or services.
• Performance
obligations relate to the
provision of distinct
goods or services.
• Goods or services are
distinct if the customer
can benefit from them
and they are separate
from other goods and
services to be delivered
under the contract.
KEY POINTS
• Sales discounts are
used to encourage
customers to pay their
accounts earlier.
• Customers who pay
within the discount
period are entitled to
the discount.
• Expected sales
discounts reduce the
transaction price.
4-8
CH A PT ER 4
Revenue Recognition and the Statement of Income
account. Under the contract-based approach, companies offering sales discounts are required
to reduce the transaction price by management’s estimate of the expected sales discounts
because they are a form of variable consideration.
It is important to note that the customer’s credit risk is not a factor in determining the
transaction price. This is because credit risk was already assessed in evaluating the probability
of collection in Step 1 (identifying whether there was a contract or not).
The Conceptual Framework
Faithful Representation and Performance
Obligations
The objective of the conceptual framework is to provide financial
information that is useful to users. This objective is behind the need
for companies to determine whether there is a single or multiple
performance obligations in a contract. For example, if a customer
purchases a piece of custom jewellery, like a ring, it may include
several gemstones and will be manufactured according to the customer’s specifications. It is possible that the jeweller could consider
each gemstone and the ring assembly as separate performance
obligations. Given that the jeweller will fulfill each of these performance obligations at the same time (when the ring is delivered
to the customer), there would be no benefit in separating them
because it would not result in more meaningful financial reporting.
The objective of identifying separate performance obligations is
to represent faithfully the expected pattern in which goods and services will be transferred to the customer. If these will be delivered at
the same time or in the same pattern, then they should be accounted
for as a single performance obligation. If they are to be delivered at
different times and there is not a consistent transfer pattern, then
they should be accounted for as separate performance obligations.
Step 4. Allocate the transaction price to performance obligations. If, in Step 2, only a
single performance obligation was identified, then this step is not required. However, if multiple
performance obligations were identified, then a portion of the transaction price ­determined in
Step 3 must be allocated to each of them. The transaction price is allocated on the basis of the
stand-alone selling price of each performance obligation. This is the price that the company
would sell each good or service (that is, each performance obligation) for separately. ­Ideally, these
prices are determined by using the stand-alone selling price the company charges to ­customers
purchasing the goods or services separately. Once all stand-alone selling prices have been determined, a combined total can be calculated. The transaction price is then allocated to each perform­
ance obligation using its relative percentage of the combined total. If stand-alone ­selling prices
are not available, estimates are used. The use of estimates is beyond the scope of an introductory
accounting course and is something you will learn about in subsequent accounting courses.
Step 5. Recognize revenue when each performance obligation is satisfied. As each
KEY POINTS
• Revenue is recognized
when performance
obligations are
satisfied.
• Performance
obligations are
satisfied when control
of the goods has
been transferred to
the customer or the
services have been
provided.
• Performance
obligations can be
satisfied at a point in
time or over time.
performance obligation is satisfied, the company recognizes revenue equal to the portion of the
transaction price that has been allocated to it in Step 4. Performance obligations are satisfied
when control of the goods is transferred to the customer or the services have been provided
for them. Control is transferred if the customer has the ability to direct the use of the asset and
obtain substantially all of the remaining benefits from it through its use, consumption, sale,
and so on. It is possible that control is transferred at a point in time or over time. If control is
transferred over time, then the company must identify an appropriate basis upon which the
extent of transfer can be measured each period. Step 5 is summarized in the Key Points.
Indicators that control has been transferred include the customer having:
• physical possession
• legal title
• the risks and rewards of ownership
• accepted the goods or received the services
• an obligation to pay
As you can see, the five-step model of revenue recognition is fairly complex and the explanations provided above do not deal with numerous other complexities that can arise. Because these
­additional complexities are beyond the scope of an introductory financial accounting text, we will
focus on applying the essential elements of the model to common scenarios. To help with that,
Exhibit 4.3 recasts the five-step model into questions that you can answer as you apply each step.
Revenue Recognition 4-9
EXHIBIT 4.3 Questions Underlying the Five-Step Model of Revenue Recognition
Step 1
Step 2
Is there a
contract?
What
performance
obligations
are included
in the
contract?
Step 3
Step 4
Step 5
What is the
transaction
price?
How should
the transaction
price be
allocated to the
performance
obligations?
Has a
performance
obligation
been
satisfied?
Using Exhibit 4.3, let’s apply the five-step model to a few common revenue recognition
scenarios.
Scenario One: Sale of Goods. On August 5, 2024, Foot Fashions Ltd. receives an
order from Big Retail Inc., one of its regular customers, for 500 pairs of shoes at $25 per
pair. Foot Fashions accepts the order, which is to be delivered to Big Retail’s warehouse. Big
Retail agrees to pay for the order within 15 days of product delivery. The shoes cost Foot
Fashions $12 per pair. Foot Fashions delivers all of the shoes to Big Retail Inc.’s warehouse
on August 20, 2024, and an invoice for the order is mailed out that day. Big Retail pays the
invoice on September 2, 2024.
Question
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Analysis
Step 1: Is there a contract?
Yes, both parties have agreed to enter into a contract. The quantity, price, and payment
terms have been agreed to, and each party’s rights under the contract are clear. The
contract is consistent with both parties’ lines of business, meaning it has commercial
substance. There are no indications of any concerns regarding collectibility with Big
Retail.
Step 2: What performance obligations are
included in the contract?
There is a single distinct good being provided under the contract: 500 pairs of shoes.
Step 3: What is the transaction price?
The transaction price is $12,500 (500 pairs of shoes × $25).
Step 4: How should the transaction price be
allocated to the performance obligations?
There is no need to allocate the transaction price because there is a single performance
obligation.
Step 5: Has a performance obligation been
satisfied?
Revenue would be recognized by Foot Fashions once the 500 pairs of shoes have been
delivered. Upon delivery, Big Retail has control of the goods, which is indicated by
physical possession and the fact that it has the risks and rewards of ownership; it has
accepted the shoes; and it has an obligation to pay for them. As such, Foot Fashions would
recognize revenue on August 20, 2024.
Foot Fashions would record the following journal entries in relation to these transactions:
Aug. 5
No entry because neither party has performed any obligations under the contract.
Aug. 20
DR Accounts Receivable
12,500
CR Sales Revenue (500 pairs × $25)
DR Cost of Goods Sold
12,500
6,000
CR Inventory (500 pairs × $12)
Sept. 2
DR Cash
CR Accounts Receivable
6,000
12,500
12,500
Note that revenue is recognized at a point in time in this case and is not tied to the receipt of cash.
4-10
C H A PTE R 4
Revenue Recognition and the Statement of Income
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 4-1
• Demonstration Problem 4-1 in Wiley’s course resources
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Scenario Two: Provision of Services.
On June 14, 2024, Green Clean Ltd. enters
into a contract with Bestwick Inc. to provide cleaning services at Bestwick’s office building
for a 12-month period beginning on July 1, 2024. Green Clean will provide cleaning services twice each week throughout the period to Bestwick, which operates a successful IT
advisory business. The contract is for $9,600, and Bestwick agrees to pay one-twelfth of the
contract amount on the first of each month. Green Clean prepares its financial statements
on a monthly basis.
Question
Analysis
Step 1: Is there a contract?
Yes, both parties have agreed to enter into a contract. The service to be provided, price, and
payment terms have been agreed to, and each party’s rights under the contract are clear.
The contract is consistent with both parties’ lines of business, meaning it has commercial
substance. There are no indications of any concerns regarding collectibility with Bestwick
because it is a successful company.
Step 2: What performance obligations
are included in the contract?
In this case, there is a series of distinct services that are substantially the same and have the
same pattern of transfer to the customer. The cleaning services are the same each time and
will be provided 104 times (twice a week for one year) over the contract. Therefore, they are
considered to be a single performance obligation.
Step 3: What is the transaction price?
The transaction price is $9,600.
Step 4: How should the transaction
price be allocated to the performance
obligations?
The transaction price will be allocated to the performance obligation on a monthly basis
(because Green Clean prepares its financial statements monthly). $800 ($9,600 ÷ 12) will be
allocated to each month.
Step 5: Has a performance obligation
been satisfied?
Revenue would be recognized by Green Clean after it has performed the cleaning services
for the month. Once the cleaning services have been provided, that portion (1/12) of the
performance obligation has been satisfied.
Green Clean would record the following journal entries in relation to these transactions:
Jun. 14
No entry because neither party has performed any obligations under the contract.
Even though Green Clean receives payment on July 1, the company cannot recognize any
revenue because it has yet to satisfy any of its performance obligations under the contract.
Therefore, the payment received represents a liability under the contract. The entry below
would be made at the beginning of each month of the contract.
Jul. 1
DR Cash
800
CR Deferred Revenue
800
At the end of each month, as Green Clean provides the cleaning services and satisfies its performance obligations under the contract, the company would be able to recognize the related
revenue. The entry below would be made at the end of each month of the contract.
Jul. 31
DR Deferred Revenue
CR Service Revenue
Note that revenue is recognized over time in this case.
800
800
Revenue Recognition 4-11
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 4-2
• Demonstration Problem 4-2 in Wiley’s course resources
Scenario Three: Sale Involving Multiple Performance Obligations. On September
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5, 2024, WorkScape Ltd. enters into a contract with Telcom Co. to provide office furniture and
wall products, which will be used to create 100 office workstations for Telcom’s new open office
configuration. As part of the contract, Telcom also hires WorkScape to install the office furniture
and wall products. Details of the contract are as follows:
• The total price of the contract is $148,000.
• The office furniture would normally retail for $98,000, and wall products would normally
retail for $48,000. WorkScape would normally charge $9,000 for installation of this scale.
• The office furniture cost WorkScape $68,000, while the wall products cost $31,000.
• The contract requires WorkScape to deliver the furniture by September 30, 2024, and that
installation be completed by October 15, 2024.
• Telcom agrees to pay $125,000 upon delivery of the furniture and wall products, and the
balance once installation is complete.
WorkScape delivers the furniture and wall products on September 27, 2024, and Telcom makes
the required payment. The installation is completed on October 12, 2024, and Telcom makes
the final contract payment on October 28, 2024.
Question
Analysis
Step 1: Is there a
contract?
Yes, both parties have agreed to enter into a contract. The goods and services to be provided, price, and payment
terms have been agreed to, and each party’s rights under the contract are clear. The contract is consistent with both
parties’ lines of business, meaning it has commercial substance. There are no indications of any concerns regarding
collectibility with Telcom.
Step 2: What
performance
obligations are
included in the
contract?
The contract includes two performance obligations: the supply of office furniture and wall products and their
installation. Each of these would be considered distinct goods or services.
Step 3: What is the
transaction price?
The transaction price is $148,000.
Step 4: How should
the transaction
price be allocated
to the performance
obligations?
Because there are multiple (two) performance obligations, the transaction price must be allocated to each of them.
The allocation will be done on the basis of the stand-alone selling price of each performance obligation.
While the office furniture and wall products are distinct goods, their supply is considered to be a single performance
obligation because these items will be transferred to the customer at the same time.
Performance Obligation
Supply of office furniture
and wall products
Installation
*
Step 5: Has a
performance
obligation been
satisfied?
Stand-Alone
Selling Price
% of Total Stand-Alone
Selling Price
Contract Price
Allocation of
Contract Price
$146,000*
94.2%
× $148,000
$139,416
9,000
5.8%
× $148,000
$ 155,000
100.0%
8,584
$148,000
$98,000 + $48,000
The first performance obligation, the supply of the office furniture and wall products, is satisfied on September 27,
2024, when WorkScape delivers these goods. The revenue related to this obligation would be recognized at this point.
The second performance obligation, the installation of the office furniture and wall products, is satisfied on October
12, 2024, when these services are provided by WorkScape. The revenue related to this obligation would be recognized
at this point.
4-12
C H A PTE R 4
Revenue Recognition and the Statement of Income
WorkScape would record the following journal entries in relation to these transactions:
Sept. 5
No entry because neither party has performed any obligations under the contract.
Sept. 27
DR Cash
125,000
DR Accounts Receivable*
14,416
CR Sales Revenue
DR Cost of Goods Sold
139,416
99,000
CR Inventory†
Oct. 12
99,000
DR Accounts Receivable
8,584
CR Service Revenue
Oct. 28
DR Cash
8,584
23,000
CR Accounts Receivable
23,000
*Technically, this would be recorded as a Contract Asset, but for purposes of introductory accounting, it is acceptable to
use Accounts Receivable.
†$68,000 + $31,000
Assess Your Understanding
Attempt the following problems and review the solutions provided:
Take5 Video
• Chapter End Review Problem 4-3
• Demonstration Problem 4-3 in Wiley’s course resources
The Conceptual Framework
Faithful Representation, Comparability, and
Approaches to Revenue Recognition
Private companies that apply ASPE to prepare their financial
statements use an earnings-based approach rather than the contract-based approach to determine when revenue should be recognized. Rather than focusing on changes in the net position in
a contract to determine when revenue has been earned, the earnings-based approach focuses on the earnings process. Under the
earnings-based approach, revenue is recognized when the earnings process is substantially complete.
Accounting standard setters have developed revenue
recognition criteria that are used to help management and
other financial statement users determine when the earnings
process is complete and revenue has been earned. There are
revenue recognition criteria for the sale of goods and other revenue ­recognition criteria that can be used for the provision of
services:
Sale of Goods
Revenue from the sale of goods can be recognized when all of the
following criteria are met:
1. The risks and rewards of ownership have been transferred to
the customer.
2. The seller has no continuing involvement or control over the
goods.
3. The amount of consideration to be received can be measured
with reasonable assurance.
4. Collection is reasonably assured.
Provision of Services
Revenue from the provision of services can be recognized when
all of the following criteria are met:
1. The service has been performed.
2. The amount of consideration to be received can be measured
with reasonable assurance.
3. Collection is reasonably assured.
If we applied these criteria to the sale of goods and provision of services scenarios we worked through earlier in the chapter for the
contract-based approach, we would arrive at identical accounting treatments. This would be the case for many contracts related to common
retail transactions. For other, more complex contracts, the accounting
treatment would differ depending upon the approach that was used.
It is important to note that each approach to determining when
revenue has been earned focuses on a different financial statement.
The contract-based approach focuses on the statement of financial
position, determining if revenue has been earned by looking at the
net change in contract assets and liabilities, while the earnings-based
approach focuses on the statement of income, determining if revenue has been earned by looking at the earnings process itself.
Standard setters developed the contract-based approach with
the belief that “there will be more agreement on whether an asset
has increased or a liability has decreased than there is currently
on what an earnings process is and whether it is complete.” The
International Accounting Standards Board believes that use of the
contract-based approach will mean that companies “can recognize
revenue more consistently.” This will enhance the faithful representation of reported revenues, by improving neutrality and freedom
from error, while also improving comparability across companies.4
Other Revenue Recognition Issues 4-13
4.3
Other Revenue Recognition Issues
LEARNING OBJECTIVE 3
Explain how revenue recognition is affected by rights of return, warranties, consignment, and third-party sale arrangements.
How Do Rights of Return, Warranties,
Consignment, and Third-Party Sale Arrangements
Affect Revenue Recognition?
There are a variety of contractual arrangements that can affect the timing and amount of
revenue a company recognizes. We will explore four common arrangements: rights of return,
warranties, consignment sales, and third-party sales.
Rights of Return
Many companies provide a period in which customers can return goods for a variety of reasons
(such as they were the wrong goods or they arrived damaged). When a customer returns goods,
the seller may offer a refund (either in cash or as a reduction of accounts receivable, if the
customer’s payment is still outstanding). It may also replace the product or offer the customer
a reduction in the sales price, which is known as an allowance, if they are willing to keep the
goods. Being able to assess the extent of sales returns and allowances is important information
for management because it helps them evaluate product quality, either the quality of goods
purchased from suppliers or the quality of the company’s own manufacturing process.
If a company makes sales with a right of return, management must estimate the extent
of expected returns because they affect the estimated transaction price (Step 3 of the five-step
model). The amount of expected returns is another form of variable consideration. A refund
liability is established for the amount of expected returns because management expects the
company will have to return (as a refund or credit) this portion of the consideration received
from the customer.
Let’s return to the sale of goods scenario used earlier in the chapter and add a return estimate.
On August 5, 2024, Foot Fashions Ltd. receives an order from Big Retail Inc., one of its
regular customers, for 500 pairs of shoes at $25 per pair. Foot Fashions accepts the order,
which is to be delivered to Big Retail’s warehouse. Big Retail agrees to pay for the order within
15 days of product delivery. The shoes cost Foot Fashions $12 per pair. Foot Fashions delivers
all of the shoes to Big Retail Inc.’s warehouse on August 20, and Foot Fashions’ management
estimates a return rate of 4%. It expects the returned goods to be scrapped, as they cannot be
resold. On September 2, Big Retail pays for the order. On September 12, Big Retail returns 15
pairs of shoes and receives a cash refund.
Foot Fashions would record the following journal entries in relation to these transactions:
Aug. 20
DR Accounts Receivable (500 × $25)
12,500
CR Refund Liability ($12,500 × 4%)
500
CR Sales Revenue ($12,500 × 96%)
DR Cost of Goods Sold
12,000
6,000
CR Inventory (500 pairs × $12)
Sept. 2
DR Cash
6,000
12,500
CR Accounts Receivable
Sept. 12
DR Refund Liability
CR Cash
12,500
375
375
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4-14
C H A PTE R 4
Revenue Recognition and the Statement of Income
If Foot Fashions had expected to be able to resell the returned goods, then the company
would have recorded the following journal entries in relation to these transactions (note that
the entries that differ because the returned goods can be resold have been highlighted in red):
Aug. 20
DR Accounts Receivable (500 × $25)
12,500
CR Refund Liability ($12,500 × 4%)
500
CR Sales Revenue ($12,500 × 96%)
DR Cost of Goods Sold
DR Estimated Inventory Returns (500 pairs × 4% × $12)
12,000
5,760
240
CR Inventory (500 pairs × $12)
Sept. 2
DR Cash
Sept. 12
DR Refund Liability
6,000
12,500
CR Accounts Receivable
12,500
375
CR Cash
DR Inventory (15 pairs × $12)
CR Estimated Inventory Returns
375
180
180
For Example
Financial Statements Canadian Tire’s return policy for consumers, which is detailed on the
company’s website, is as follows:
“Unopened items in original packaging returned with a receipt within 90 days of purchase will
receive a refund to the original method of payment or will receive an exchange. Items that are
opened, damaged and/or not in resalable condition may not be eligible for a refund or exchange.”5
KEY POINTS
• Assurance warranties
are not considered
to be a separate
performance
obligation.
• Service warranties
are considered to be a
separate performance
obligation.
• Service warranties are
purchased separately,
they generally have
a long term, and the
seller is not legally
required to provide
them.
Warranties
It is common for companies to offer warranties on their products (see the Key Points for a
brief explanation of warranties). Sometimes warranty coverage is included in the price of the
product, which is called an assurance warranty (or standard warranty). Customers may
also be given the option to purchase separate warranty coverage, which is called a service
warranty (or extended warranty).
A service warranty is considered to be a separate performance obligation (Step 2 of the
five-step model) and, as such, a portion of the transaction price must be allocated to it. Assurance warranties are not considered to be separate performance obligations, so there is no need
to allocate the transaction price. We will discuss assurance warranties further in Chapter 9.
Factors that indicate that the warranty is a service warranty include:
• The warranty is priced or negotiated separately.
• The warranty coverage period is longer. The longer it is, the more likely the warranty is a
service warranty.
• The warranty is not required by law.
Consignment Sales
Consignment arrangements are another common situation to be considered in determining
when revenue can be recognized. You may be familiar with consignment stores and may have
used one either as a seller or buyer. For example, some student unions operate consignment
arrangements for used textbooks. The student (the owner or consignor) leaves their used textbook with the student union office (the consignee). When the book sells, the student union
collects the full payment. It keeps its commission and pays the balance to the student who was
selling the book. If the book does not sell within a specified time, it is returned to the student.
Other Revenue Recognition Issues 4-15
In terms of recognizing revenue when there is a consignment arrangement, the consignor
would not recognize any revenue when they transfer goods to the consignee (because they
retain control of them). At the time the goods are sold, both the consignor and the consignee
would recognize revenue. The consignor’s transaction price (Step 3 of the five-step model)
would be the net amount (the selling price less consignee’s commission), while the consignee’s transaction price (Step 3 of the five-step model) would be the amount of the commission.
Factors that would indicate a consignment arrangement include:
• The company transferring the goods continues to control them until a future sale occurs.
• The company transferring the goods is able to require them to be returned.
• The company receiving the goods does not have an obligation to pay for them until they
are sold.
Let’s look at a scenario involving a children’s clothing consignment store. The store’s consignment agreement states that the person bringing in the clothing to be sold (that is, the
consignor) will receive 35% of the selling price when the clothing is sold. The store (that is,
the consignee) will receive 65% of the selling price as its fee for making the sale. If a child’s
snowsuit was sold for $180, the consignment store would recognize revenue of $117 ($180 ×
65%), not $180. The difference of $63 is the balance due to the consignor.
For Example
Vancouver-based Ritchie Bros. Auctioneers Incorporated is the
world’s largest auctioneer of used industrial equipment. During the
year ended December 31, 2020, the company sold equipment that generated gross auction proceeds of U.S. $5.4 billion. From this, the company earned auction revenues of U.S. $871 million. The vast majority
Bloomberg/Getty Images
of the equipment the company auctions is held on consignment by the
Bloomberg/Getty Images
company pending the auction. While Ritchie Bros. takes possession of
the used equipment prior to auctioning it off, it is on a consignment basis and is not recorded as
inventory by the company. In other words, Ritchie Bros. is the consignee. As such, when the equipment is sold, there is no cost of goods sold. The difference between the gross auction proceeds of
U.S. $5.4 billion and the auction revenues of U.S. $871 million is the amount due to the owners of
the used equipment (the consignors) from the sales.6
Third-Party Sales
Sometimes a company is involved in third-party sales, either selling goods on behalf of a third
party or using a third party to sell its goods. Travel sites like Expedia Inc. are an example of
this. Customers purchase flights, hotel rooms, car rentals, and other travel services on the
site and make payments to Expedia for them. Expedia keeps a portion of these payments (its
commission or ticketing fee), but pays the balance to the companies that will be providing the
services (airlines, hotels, car rental companies, and so on). The revenue recognition question
is whether the full amount (or gross amount) of the payment would be considered to be revenue or just the commission or ticketing fee (or net amount) the company retains for providing
the booking service.
The answer to this question depends on whether the company’s performance obligation
is to provide the goods or services (in which case it is considered to be a principal) or to
arrange for a third party to provide the goods or services (in which case it is considered to be
an agent). If the company is considered to be a principal, then the transaction price (Step 3 of
the five-step model) would be the gross amount. If the company is considered to be an agent,
then the transaction price (Step 3 of the five-step model) would be the net amount. Information about agents is summarized in the Key Points.
Factors that would indicate that a company is serving as agent rather than principal include:
• A third party is responsible for providing the goods or services.
• The company receives consideration in the form of a commission.
KEY POINTS
• Companies acting as
agents only include
their commission or
fees when determining
the transaction price.
• Agents are not
responsible for
providing the goods,
they receive a
commission or fee for
arranging the sale,
they do not establish
the selling price for
the goods or services,
and they have no risks
related to holding any
inventory.
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C H A PTE R 4
Revenue Recognition and the Statement of Income
• The company does not establish the prices of the goods or services.
• The company has no risk related to holding inventory.
For Example
Expedia Inc. explains in the notes to its financial statements that it
has “determined net presentation (that is, the amount billed to a traveler less the amount paid to a supplier) is appropriate for the majority
of revenue transactions as the supplier is primarily responsible for
providing the underlying travel services and we do not control the
service provided by the supplier to the traveler.” The company goes
Bloomberg/Getty
Images
Bloomberg/Getty Images
on to explain that it acts as agent and that its business model is to
“pass reservations booked by the traveler to the relevant travel supplier,” for which the company
receives “commissions or ticketing fees from the travel supplier and/or the traveler.” In 2019, the
gross bookings on Expedia’s websites amounted to $107.87 billion, but because the company was
serving as agent rather than principal, Expedia recognized revenues of only $12.07 billion related
to these bookings.7
4.4
Statement of Income Formats
LEARNING OBJECTIVE 4
Understand the difference between a single-step statement of income and a
­multi-step statement of income.
In Chapter 1, we learned that the objective of the statement of income is to measure the
company’s performance in terms of the results of its operating activities for a month, quarter, or year. A company’s income is the difference between the revenues it earned during
the period and the expenses incurred during the same period to earn that revenue. In this
chapter, we have discussed the contract-based approach to revenue recognition to help
give us a better understanding of when revenues are earned and can be reported on the
statement of income. In this part of the chapter, we will revisit the statement of income
and discuss a couple of the different formats used to prepare it. Understanding the way in
which information is presented in these formats will help you to interpret the information
presented.
How Does a Single-Step Statement of Income
Differ from a Multi-Step Statement of Income?
There are two main formats that can be used to prepare a statement of income: the single-step
format and the multi-step format. When a company uses a single-step statement of income,
all items of revenue are presented first regardless of the source, together with a total revenue
amount. This is followed by a list of all expense items, including income taxes, together with a
total expense amount. The total expense amount is subtracted from the total revenue amount
to calculate net income or loss for the period. In other words, one arithmetic step is required
to arrive at net income (loss).
Exhibit 4.4 illustrates the format of a single-step statement of income.
Statement of Income Formats 4-17
EXHIBIT 4.4 Single-Step
Statement of Income Format
Sharpness Ltd.
Statement of Income
For the year ended December 31, 2024
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Revenues
Sales revenue
Interest revenue
Total revenues
$500,000
25,000
525,000
Expenses
Cost of goods sold
Wages expense
415,000
30,000
Rent expense
9,000
Utilities expense
7,000
Depreciation expense
6,000
Interest expense
4,000
Income tax expense
Total expenses
Net income
10,800
481,800
$ 43,200
While the single-step statement presents all of the required information, it presents it in a way
that requires users to complete their own analysis to determine important measures such as gross
profit (or gross margin) or net income from operating activities (net income without incidental revenues such as interest or dividend income). A multi-step statement of income can alleviate these
issues.
As the name suggests, the multi-step statement of income requires several steps to
reach a company’s net profit or loss. The results of each step provide the user with a key piece
of information. A typical multi-step statement includes five steps, as shown in Exhibit 4.5.
1. Sales revenue (or
revenue)
2. Gross profit (or gross
margin)
The revenues reported in this step are the revenues earned by the
company from its operating activities—what the company is in
the business of doing. Operating activities can be the sale of goods
or services.
As discussed in Chapter 1, this is the difference between sales
revenue and the cost of goods sold. This step is required for retail
companies, but not for companies selling services because they do
not have any cost of goods sold.
Gross profit is a key performance measure for retail companies.
Dividing gross profit by net sales revenue results in the gross profit
margin percentage. You can use the gross profit and gross profit
margin percentage to evaluate a company’s performance over time
or compare it with other companies in the same industry.
3. Profit from operations
(or operating income)
This is the difference between gross profit and the company’s
operating expenses. Operating expenses, such as advertising,
depreciation, rent, and wages, are subtracted from gross profit
(retail company) or from revenues (service company).
This step factors in all of the company’s non-operating activities.
4. Profit before income
tax expense (or income This includes activities that a company engaged in during the year
that are not part of its normal operating activities. This includes
before income taxes)
revenues such as interest earned on employee loans or dividends
received from short-term investments and expenses such as
interest paid on loans. Incidental revenues are added to profit
from operations, while any incidental expenses are subtracted, to
determine profit before income tax expense.
EXHIBIT 4.5 The Five Steps
of the Multi-Step Statement of
Income
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4-18
C H A PTE R 4
Revenue Recognition and the Statement of Income
EXHIBIT 4.5 The Five Steps
of the Multi-Step Statement of
Income (continued)
5. Net income (loss) (or
profit)
This is the final step in preparing a multi-step statement of
income. Income tax expense (or the provision for income taxes)
is subtracted from profit before income tax to arrive at the net
income (loss) for the accounting period.
Exhibit 4.6 illustrates the format of a multi-step statement of income.
EXHIBIT 4.6 Multi-Step
Statement of Income Format
Sharpness Ltd.
Statement of Income
For the year ended December 31, 2024
Sales revenue
$500,000
415,000
Cost of goods sold
85,000
Gross profit
Operating expenses
Wages expense
30,000
Rent expense
9,000
Utilities expense
7,000
Depreciation expense
6,000
Total operating expenses
52,000
Operating income
33,000
Other revenues and expenses
Interest revenue
25,000
(4,000)
Interest expense
Income before income tax
Income tax expense
Net income
KEY POINT
Statements of income
prepared using a multistep format present key
measures, including
gross profit and profit
from operating activities,
making analysis easier
for decision makers.
54,000
10,800
$ 43,200
As you can see from Exhibits 4.4 and 4.6, the choice of format has no effect on the revenues,
expenses, and net income amounts reported. Each presents information on the company’s performance in different ways, which can have an impact on the understanding of those results. The benefit
of a multi-step statement of income is that it allows the reader to easily identify gross profit and profits
earned from operating activities separately from other revenues and expenses related to non-operating activities. This can be important information for decision makers such as shareholders, potential
investors, and creditors. The Key Point briefly explains the benefit of a multi-step format.
Exhibits 4.4 and 4.6 illustrate the single-step and multi-step formats, but in practice, companies are free to use hybrid formats in which some parts of the statement follow a single-step
format, while other parts follow a multi-step format. There is nothing in the accounting standards that prohibits a company from using whatever model it believes presents its financial
performance in the most relevant way for the financial statement users.
Analytics in Action
Data analytics can be a powerful tool for companies when they are
analyzing sales revenues to identify their best customers or top products. These assessments could be made by analyzing data on total
sales, gross profits, etc. by customer or product. This would enable
the company to prioritize these top customers. This could mean more
frequent contacts from sales or customer service staff, preferred discounts, better payment terms, etc. Determining which of its products are most profitable is also essential for management. They may
choose to focus on these or consider changing marketing or pricing
strategies. Management could also choose to drop customers or products that are identified as being poor performers. Companies with
operations in different regions or in different countries could perform
similar analysis to assess comparative sales and gross profits when
evaluating the relative performance of each region or country.
An Analytics in Action case related to revenue analysis can
be found in Wiley’s course resources.
Statement of Comprehensive Income 4-19
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 4-4
• Demonstration Problem 4-4 in Wiley’s course resources
4.5
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Statement of Comprehensive Income
LEARNING OBJECTIVE 5
Understand the difference between comprehensive income and net income.
What Is Comprehensive Income and How Does It
Differ from Net Income?
In addition to reporting net income, public companies must report comprehensive income
in their financial statements. Comprehensive income is the total change in the shareholders’ equity (or net assets) of the enterprise from non-owner sources. It is equal to net
income plus other comprehensive income. Accounting standards require that certain
gains and losses be reported as other comprehensive income rather than being included in
net income. These gains and losses normally arise when certain financial statement items
are revalued, either to fair value or as a result of changes in foreign currency exchange
rates. As these revaluation transactions are not with third parties, they are considered
to be unrealized. They are excluded from net income, but are included in other comprehensive income. These revaluation transactions are beyond the scope of an introductory
accounting course, but it is important that you have a basic understanding of the difference between net income and total comprehensive income. Other comprehensive income
is added to net income to determine comprehensive income. Comprehensive income and
its components are an integral part of the financial statements. The items that make up
other comprehensive income can be presented either on the statement of income, immediately below net income, or in a separate statement of comprehensive income. The
starting point for this statement is net income. In either case, the final total is the comprehensive income for the period. To illustrate, Exhibit 4.7 presents Loblaw Companies
Limited’s consolidated statements of earnings, while Exhibit 4.8 presents the company’s
separate consolidated statements of comprehensive income. The Key Points also briefly
explain comprehensive income.
KEY POINTS
• Comprehensive
income = Net
income + Other
comprehensive income
• Comprehensive income
includes gains and
losses from revaluing
financial statement
items to fair value
or from changes in
foreign exchange rates.
• These transactions are
not included in net
income because they
are not transactions
with third parties, but
they are included in
comprehensive income.
EXHIBIT 4.7 Loblaw
Companies Limited’s 2020
Consolidated Statements of
Earnings
LOBLAW COMPANIES LIMITED
Consolidated Statements of Earnings
For the years ended January 2, 2021, and December 28, 2019
Financial Statements
(millions of Canadian dollars except where otherwise indicated)
Revenue
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2020
2019
$52,714
$48,037
Cost of merchandise inventories sold
36,725
33,281
Selling, general and administrative expenses
13,624
12,486
(continued)
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EXHIBIT 4.7 Loblaw
Companies Limited’s 2020
Consolidated Statements of
Earnings (continued)
2020
Operating income
Net interest expense and other financing charges (note 6)
Earnings before income taxes
Income taxes (note 7)
Net earnings
EXHIBIT 4.8 Loblaw
Companies Limited’s 2020
Consolidated Statements of
Comprehensive Income
Financial Statements
2019
2,365
2,270
742
747
1,623
1,523
431
392
$ 1,192
$ 1,131
LOBLAW COMPANIES LIMITED
Consolidated Statements of Comprehensive Income
For the years ended January 2, 2021, and December 28, 2019
(millions of Canadian dollars)
Net Earnings
2020
2019
$1,192
$1,131
2
3
Other comprehensive income (loss), net of taxes
Items that are or may be subsequently reclassified to profit or loss:
Foreign currency translation adjustment gains (losses)
Gains (losses) on cash flow hedges (note 29)
(28)
(5)
(41)
(3)
(67)
(5)
Items that will not be reclassified to profit or loss:
Net defined benefit plan actuarial gains (losses) (note 25)
Other comprehensive income (loss)
Total comprehensive income
4.6
$1,125
$1,126
Presentation of Expenses by Nature or by Function
LEARNING OBJECTIVE 6
Understand the difference between presenting expenses by function or by nature of
the item on the statement of income.
How Does a Statement of Income Presenting
Expenses by Function Differ from One
Presenting Expenses by Nature of the Items?
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Accounting standards offer companies the choice of presenting their expenses by function or by nature when preparing their statements of income. Function refers to what
functional area of the business the expenses were related to. Examples of functional areas
are cost of sales, administrative activities, and selling and distribution activities. The
nature of the expense refers to what the expense actually was, rather than the purpose
for which it was incurred. Statements of income presenting expenses by nature include
Presentation of Expenses by Nature or by Function 4-21
expense items such as employee wages, depreciation expense, cost of goods sold, advertising expenses, and rent expense. So far in the text, we have generally been preparing
statements of income by the nature of the expenses by simply listing the various expense
account balances.
The choice of presenting expenses based on their nature or function rests with management. Accounting standard setters have taken the position that management should
use whichever method they believe presents the most reliable and relevant information.
Note that preparing statements of income by function requires management to exercise
judgement in terms of which expenses are allocated to which function. For example,
wages must be allocated to the various functions. No such judgement is required when the
statement of income is prepared by nature of the expenses. For example, wages are simply
presented as “wages expense.” Standard setters stipulate that companies that prepare their
statements of income on a functional basis must also present information on the nature
of the expenses in the notes to the company’s financial statements. Specifically, companies must provide information on depreciation and amortization expenses and employee
benefits expenses.
Exhibit 4.9 is the consolidated statements of comprehensive income for Waterloo
Brewing Ltd., a brewer based in Kitchener, Ontario, that operates two production facilities
and distributes its products across Canada. It is an example of a statement of income that
presents expenses by function.
With this presentation, users can assess the expenses related to different functions. For
example, we can see that, while the company’s selling, marketing, and administration expenses
stayed constant in terms of total dollars from 2020 to 2021, increasing by only $11,081, they
decreased significantly as a percentage of sales (13.7% in 2021 and 19.6% in 2020). Similar
analysis could be done for other functional areas. However, with this presentation format, it
is not possible to determine the amount incurred for specific expenses, such as the company’s
total wage expense. For this information, we would have to look at the notes to the company’s
financial statements. (See Exhibit 4.10, which presents an extract from the notes to Waterloo Brewing Ltd.’s financial statements that discloses the company’s expense information by
nature of the expense.)
Statements of Comprehensive Income
EXHIBIT 4.9 Waterloo
Brewing Ltd.’s 2021 Statements
of Comprehensive Income
Years ended January 31, 2021 and 2020
Financial Statements
WATERLOO BREWING LTD.
Notes
Revenue
Cost of sales
20
13,21
Gross profit
Selling, marketing and administration
expenses
Other expenses
Finance costs
Loss on misappropriated funds, net
66,000,997
42,483,862
20,698,348
17,849,555
13,21
11,853,169
11,842,088
2,268,499
1,616,977
13,23
2,107,363
1,500,682
12
—
1,869,595
215,756
Income before tax
Net income and comprehensive income
for the year
2020
$60,333,417
13,21,22
Loss (gain) on disposal of property, plant
and equipment and right-of-use assets
Income tax expense
2021
$86,699,345
17
(15,168)
4,253,561
1,035,381
1,253,548
537,779
$ 3,000,013
$
497,602
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EXHIBIT 4.10 Excerpt
from Waterloo Brewing Ltd.’s
Notes to the 2021 Financial
Statements
[]Financial Statements
WATERLOO BREWING LTD.
Excerpt from Notes to Financial Statements
21. Expenses by Nature
Expenses relating to depreciation, amortization, impairment and personnel are included
within the following line items on the Statements of Comprehensive Income:
January 31,
2021
January 31,
2020
$ 5,443,908
$4,707,988
2,159,602
1,422,164
207,166
204,027
10,302,562
8,373,948
5,674,186
4,690,449
55,414
46,689
Depreciation of property, plant & equipment and
right-of-use assets
Cost of sales
Other expenses
Amortization of intangible assets
Other expenses
Salaries, benefits and other personnel-related expenses
Cost of sales
Selling, marketing and administrative expenses
Other expenses
The Conceptual Framework
Relevance, Faithful Representation, and the
Statement of Income
Relevance is a fundamental qualitative characteristic in the conceptual framework. According to this characteristic, to be useful,
financial information must matter to financial statement users.
This is one of the factors that management must consider when
deciding whether to present the statements of income by function
or by nature of the items. In some cases, it may be more meaningful to users to present the company’s expenses by function (such as
sales and marketing costs, administration costs, and distribution
expenses). In other cases, it may be more meaningful to report by
nature of the expenses (such as wage expense, advertising expense,
and rent expense). As noted previously, when companies present
their statement of income by function, they must use judgement to
4.7
allocate costs to the various functions. In doing so, they must also
ensure that these allocations are representationally faithful, meaning that the expenses are allocated to functions in a manner that
is consistent with where these expenses were actually incurred.
As an example, some universities present their expenses by
function (such as academic, student services, and administration).
When doing so, they would need to make decisions about how
to allocate costs such as the salaries of department heads, faculty
deans, and so on. They would need to consider whether these
costs were related to academic activities or if they were administrative costs. Perhaps a case could be made that a portion should
be allocated to each function. As a student, you might want to
assess how much your institution spends on academic activities
relative to administration. In doing so, these types of allocation
decisions made by management will be relevant to you.8
Financial Statement Analysis
LEARNING OBJECTIVE 7
Calculate and interpret a company’s basic earnings per share.
Now that you have an understanding of the various ways that revenue can be recognized and
the components of the statement of income, let’s use that information to have a closer look at
how we can measure performance. Most financial statement users are interested in the company’s performance. Senior management can receive bonuses based on the company meeting
earnings targets, specified as either overall amounts or percentage increases. Creditors such
Financial Statement Analysis
4-23
as banks are interested because profitable companies are able to service their debt (pay interest and repay loan principal). Common shareholders (investors) want to know how well the
company they have invested in is performing and whether there are sufficient earnings to pay
dividends. Potential investors use earnings numbers when assessing whether shares of the
company could be a good investment. In the next section, we will discuss earnings per share,
one of the primary earnings-based measures that provides users with information about a
company’s performance.
What Is Meant by Earnings per Share, and How Is
It Calculated?
Earnings per share (EPS) is a measure used by many financial statement users. The earnings per share figure expresses net income, after deducting preferred dividends, on a per-share
basis. It is one of the most frequently cited financial measures, appearing in company news
releases and the business media, as a key measure of a company’s performance. Accounting
standards require that EPS be reported either on the statement of income or in a note accompanying the financial statements.
There are a couple of variations of the earnings per share ratio. For now, we will focus on
the basic earnings per share ratio. This ratio is determined as follows.
Basic earnings per share =
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Net income − Preferred dividends
Weighted average number of
common shares outstanding*
*If the number of issued common shares changes during the year (because new shares were issued or previously issued shares were repurchased by the company), then this must be factored into the calculation.
Exhibit 4.11 illustrates the EPS calculation when there has been no change in the number of common shares during the period.
Montgomery Ltd. reported net income of $625,000 for the year ended December 31, 2024. During
the year, the company also declared and paid dividends of $30,000 on the company’s preferred
shares. At the beginning of the year, Montgomery had 250,000 common shares outstanding. No
shares were issued or repurchased during the year.
Basic earnings per share =
=
Net income − Preferred dividends
Weighted average number of
common shares outstanding
$625,000 – $30,000
250,000
= $2.38
This EPS amount could be compared with the EPS of prior periods to determine whether earnings
had improved on a per-share basis over prior periods or with the EPS results of other companies
to compare relative per-share profitability, which can be used to assess share prices. Typically, a
higher EPS will result in a higher share price.
Exhibit 4.12 illustrates the basic EPS calculation when there has been a change in the
number of common shares during the period. When this happens, a weighted average number of shares must be used. A weighted average calculation is demonstrated below using the
Montgomery example from Exhibit 4.11, except that the company issued 50,000 common
shares at the beginning of April 2024.
EXHIBIT 4.11 Basic EPS
Calculation (When No Change
in Number of Common
Shares)
4-24
C H A PTE R 4
Revenue Recognition and the Statement of Income
EXHIBIT 4.12 Basic EPS
Calculation (When Number of
Common Shares Changes)
Before we can calculate basic EPS, we must determine the weighted average number of shares
outstanding as follows:
250,000 shares × 3/12*
300,000 shares × 9/12**
Weighted average
Basic earnings per share =
=
= 62,500 shares
= 225,000 shares
= 287,500 shares
Net income−Preferred dividends
Weighted average number of
common shares outstanding
$625,000−$30,000
*January to March = 3 months
**April to December = 9 months
287,500
= $2.07
Again, this EPS amount could be compared with the EPS of prior periods to determine whether
earnings had improved on a per-share basis over prior periods or with the EPS results of other
companies to compare relative per-share profitability.
For Example
The 2020 and 2019 basic EPS results for three of Canada’s
largest food retailers were as follows:
2020*
2019*
Loblaw Companies Limited
$3.08
$2.93
Metro Inc.
$3.15
$2.79
Empire Company Limited
$2.16
$1.42
ZUMA Press,
Inc.//Alamy
AlamyStock
StockPhoto
Photo
ZUMA
Press, Inc.
These results show us that in 2020, Metro Inc. achieved
the highest basic EPS, which was a 12.9% increase over
its 2019 results. While all three companies saw increases in their basic EPS, Empire achieved the
greatest year-over-year increase, with an increase of 52.1%. This was significantly higher than
either of its competitors.9
*Note that all three companies have different year ends, so these EPS numbers cover different 12-month periods.
Loblaw’s fiscal year ends on the Saturday closest to December 31, while Metro’s fiscal year ends on the last Saturday
in September and Empire’s fiscal year ends on the first Saturday in May. The EPS figures for Loblaw and Metro are
for periods ending in 2020 and 2019, while those for Empire are for the periods ending in May 2020 and 2019.
As you learned in this chapter, the statement of income shows how much income was earned in
a period using the accrual basis of accounting. In the next chapter, we’ll look at the statement of
cash flows, which uses the cash basis of accounting to show the various inflows and outflows of
cash.
Assess Your Understanding
Take5 Video
• Demonstration Problem 4-5 in Wiley's course resources.
Summary
4-25
Review and Practice
Summary
Explain the nature of revenue and why revenue is of
significance to users.
the stand-alone selling price for each obligation and determining the percentage of each relative to the combined total.
1
• Revenues are inflows of economic benefits from a company’s
ordinary operating activities (the transactions a company normally has with its customers in relation to the sale of goods or
services).
• Revenues are not tied to the receipt of cash because other economic benefits such as accounts receivable can result.
• For a company to be successful, it must generate revenues in
excess of the expenses it incurs doing so.
• Users assess the quantity of revenues (changes in the amount of
revenues) and the quality of revenues (the source of any growth
and how closely any change in revenues corresponds with
changes in cash flows from operating activities).
Identify and explain the contract-based approach to
revenue recognition.
2
• There are two approaches to revenue recognition used in
accounting standards: a contract-based approach, which is
required under IFRS, and an earnings-based approach, which is
required under ASPE.
• Under the contract-based approach, a company recognizes
revenue whenever its net position in a contract increases. This
occurs when the company’s rights under a contract increase or
its obligations under the contract decrease.
• A five-step model is used to determine when revenue should be
recognized and what amount that should be. The steps are: (1)
identify the contract; (2) identify the performance obligations;
(3) determine the transaction price; (4) allocate the transaction
price to the performance obligations; and (5) recognize revenue
when each performance obligation is satisfied.
• A contract is a legally enforceable agreement that has been
approved by the parties and to which they are committed. It
specifies the rights and obligations of each party, it has commercial substance, and collection of payment is considered probable.
• Performance obligations relate to distinct goods or services. Goods
or services are considered to be distinct if the customer can benefit
from them through use, through consumption, or by selling them
on their own or with other resources the customer has or can access.
• The transaction price is the amount of consideration the seller
expects to receive in exchange for providing the goods or services. If the amount is variable, as a result of discounts, refunds,
rebates, incentives, and so on, then the transaction price should
reflect this, so that it reflects the amount the seller expects to
receive after these amounts have been factored in.
• If there are multiple performance obligations, then the transaction price must be allocated to each of them. This is done using
• Revenue is recognized when each performance obligation is satisfied through the transfer of goods or the provision of ­services. A
­performance obligation is deemed to have been satisfied when control of the goods or services has been transferred to the customer.
Explain how revenue recognition is affected by rights
of return, warranties, consignment, and third-party sale
arrangements.
3
• If goods are sold with a right of return, management must estimate the extent of expected refunds and reduce the estimated
transaction price by this amount. A refund liability is established
for the expected refund amount.
• There are two types of warranties: assurance warranties and
service warranties. Service warranties are sold separately from
the warrantied goods and typically have a longer warranty coverage period. Service warranties are considered to be a separate
perform­ance obligation, so a portion of the transaction price
must be allocated to them. Assurance warranties are not considered to be a separate performance obligation.
• Consignment arrangements involve the consignor transferring
their goods to a consignee who, in turn, sells them to the customer. The goods remain in the control of the consignor and the
consignee is entitled to a commission only upon sale of the goods.
The consignee recognizes only the amount of the commission,
rather than the total selling price of the goods, as revenue.
• Third-party sales involve an agent arranging sales on behalf of
a principal. The principal is responsible for providing the goods
or services to customers, and the agent receives a commission or
fee for arranging the sale. The agent recognizes as revenue only
the commission or fee, rather than the gross amount of the sale.
4 Understand the difference between a single-step
statement of income and a multi-step statement of income.
• A single-step statement of income has two parts. All revenues are reported together in one section and all expenses are
reported together in another section. The source of the revenues
and the nature of the expenses are not considered.
• On a multi-step statement of income, the revenues earned from
operations are presented separately from incidental revenues
such as interest or dividends. Some expenses, such as cost of
goods sold, are presented separately from other expenses. Multistep statements of income also provide users with key measures
such as gross profit and income from operations.
• Users of a single-step statement of income can determine meas­
ures such as gross margin and income from operations, but they
are not presented on the statement itself.
4-26
C H A PTE R 4
Revenue Recognition and the Statement of Income
area of the business (such as sales, distribution, and administration), while nature refers to the type of expense (such as wages,
rent, and insurance).
Understand the difference between comprehensive
income and net income.
5
• Companies are required to report net income and comprehensive income.
• Comprehensive income is equal to net income plus other comprehensive income.
• Other comprehensive income includes gains and losses resulting from the revaluation of certain financial statement items to
fair value or as a result of changes in foreign currency exchange
rates. Because these revaluation transactions are not transactions with third parties, they are not included in net income but
are included in other comprehensive income.
Understand the difference between presenting
expenses by function or by nature of the item on the
statement of income.
6
• Companies can present their expenses by function or by nature
on the statement of income. Function refers to the functional
• Management can choose which method to use. If they choose to
present expenses by function, then they must disclose information on the nature of the expenses in the notes to the company’s
financial statements.
Calculate and interpret a company’s basic earnings
per share.
7
• The earnings per share ratio can be determined by dividing net
income less preferred dividends by the weighted average number of common shares outstanding.
• EPS expresses net income, after preferred dividends, on a pershare basis.
• EPS is one of the most commonly cited financial measures
and companies are required to report their EPS on the statement of income or disclose it in the notes to their financial
statements.
Key Terms
Agent 4-15
Assurance warranty 4-14
Basic earnings per share 4-23
Commercial substance 4-6
Comprehensive income 4-19
Consignee 4-14
Consignment 4-14
Consignor 4-14
Contract 4-5
Control 4-8
Abbreviations Used
EPS
Earnings per share
Synonyms
Assurance warranty | Standard warranty
Gross profit | Gross margin
Net income | Net earnings
Service warranty | Extended warranty
Distinct goods or services 4-7
Earnings per share (EPS) 4-23
Function 4-20
Multi-step statement of income 4-17
Nature 4-20
Net position in a contract 4-5
Ordinary activities 4-3
Other comprehensive
income 4-19
Performance obligation 4-5
Principal 4-15
Revenue recognition criteria 4-12
Right to receive consideration 4-5
Sales discounts 4-7
Service warranty 4-14
Single-step statement of income 4-16
Stand-alone selling price 4-8
Statement of comprehensive
income 4-19
Variable consideration 4-7
Chapter End Review Problem 4-3
4-27
Chapter End Review Problem 4-1
Big T Tires Ltd. entered into a contract to sell 1,000 winter tires to
Auto Parts Ltd. on September 2, 2024. Auto Parts Ltd. is a major automotive parts chain operating in Atlantic Canada. The contract specified that the price of the tires was $60 per tire and that the tires were
to be delivered to Auto Parts’ warehouse no later than October 1, 2024.
Auto Parts agreed to pay for the tires within 15 days of delivery. Big T
Tires delivered all of the tires to Auto Parts’ warehouse on September
26, 2024, and mailed an invoice for the order that day. Auto Parts paid
the invoice on October 10, 2024. The tires cost Big T Tires $46 each.
Required
a. Determine how much revenue Big T Tires would be able to recognize in September 2024. Use the five-step model for revenue
recognition in preparing your response.
b. Prepare all of the required journal entries for the above transactions based on your analysis in part (a).
STRATEGIES FOR SUCCESS
• Be sure to apply facts from the problem to answer the
question related to each step in the five-step model.
• Remember that identifying performance obligations
is key and that performance obligations are met when
control of the goods or services is transferred to the
buyer.
Chapter End Review Problem 4-2
On August 10, 2024, Confitech Ltd. enters into a contract with Legal
Co. to provide mobile shredding services at Legal Co.’s offices for a
three-month period beginning on September 1, 2024. The contract
requires Confitech to bring one of its unmarked mobile shredding
trucks to Legal Co.’s office every Friday morning throughout the contract period. The contract is for $6,000, and Confitech agrees to shred
up to 80 copier paper boxes of confidential documents each month
and take the contents to the local landfill. Any additional boxes will
be shredded at a cost of $30 per box, with Confitech invoicing these
amounts at the end of each month. Legal Co. agreed to pay one-third
of the contract on the first day of each month. Confitech prepares its
financial statements on a monthly basis.
The actual number of boxes shredded was as follows:
September
October
November
95 boxes
72 boxes
90 boxes
All payments required under the contract were made by Legal Co.,
including the charges for excess shredding, which were paid on October 10 and December 8.
Required
a. Determine how much revenue Confitech would be able to recognize in each month of the contract. Use the five-step model for
revenue recognition in preparing your response.
b. Prepare all of the required journal entries for the above transactions based on your analysis in part (a).
STRATEGIES FOR SUCCESS
• Be sure to apply facts from the problem to answer the
question related to each step in the five-step model.
• Remember that identifying performance obligations
is key and that performance obligations are met when
control of the goods or services is transferred to the buyer.
Chapter End Review Problem 4-3
On October 1, 2024, Image Ltd. enters into a contract with Health
Co. to sell it two MRI machines, install the machines, and provide
training for 50 of Health Co.’s employees on how to use the machines.
Details of the contract are as follows:
• The total price of the contract is $6.1 million.
• The MRI machines can be purchased for $3.1 million each
and installed by independent contractors. These machines cost
Image Ltd. $2.7 million each.
• Image Ltd. does installation work when its customers change locations or move their MRI machines as part of hospital redevelopments.
Image Ltd. normally charges $100,000 per machine for installation.
• Image Ltd. normally charges $1,000 per employee for training.
• The contract requires Image to deliver the MRI machines
by October 25, 2024, and that installation be completed by
November 15, 2024. Training is to be completed by November
30, 2024.
• Health Co. agreed to pay $3 million upon delivery of the MRI
machines and the balance once installation and training are
complete.
Image Ltd. delivered the MRI machines on October 22, 2024, and
Health Co. made the required payment two days later. The installation of the machines was completed on November 13, 2024, and staff
training was completed on November 28, 2024. Health Co. made the
final contract payment on December 18, 2024.
4-28
C H A PTE R 4
Revenue Recognition and the Statement of Income
STRATEGIES FOR SUCCESS
Required
a. Determine how much revenue Image Ltd. would be able to recognize in each month of the contract. Use the five-step model for
revenue recognition in preparing your response.
b. Prepare all of the required journal entries for the above transactions based on your analysis in part (a).
• Be sure to apply facts from the problem to answer the
question related to each step in the five-step model.
• Remember that identifying performance obligations
is key and that performance obligations are met when
control of the goods or services is transferred to the buyer.
Chapter End Review Problem 4-4
The following information was taken from Ngo Inc.’s financial records
at October 31, 2024:
2024
2023
$ 152,000
$ 134,000
1,042,000
972,000
227,000
198,000
Financing expenses
27,000
18,000
Income tax expense
Administrative expenses
Cost of goods sold
Depreciation expense
52,000
37,000
Interest income
2,000
1,000
Utilities expense
22,000
19,000
2,095,000
1,876,000
205,000
178,000
Sales revenue
Selling expenses
Required
STRATEGIES FOR SUCCESS
• As the name implies, preparing a multi-step statement of
income is a matter of following steps. Start by identifying
revenues from ordinary activities, which are normally
referred to as sales. If the company is a retailer, subtract
cost of goods sold from sales revenue to determine gross
profit. The next step is to subtract all of the ordinary
expenses incurred to generate income from gross profit
to determine profit from operations. Other revenues and
expenses are then subtracted from profit from operations
to determine profit before tax. Income tax expense is
subtracted from this to arrive at net income.
• Gross margin percentage is determined by dividing
gross profit by sales revenue. A higher gross margin
percentage is better than a lower one, as this indicates
that a larger portion of the selling price of goods is
available to cover the company’s other expenses.
a. Prepare a comparative multi-step statement of income for Ngo Inc.
b. Determine Ngo’s gross margin percentage for 2023 and 2024. Did
this improve or worsen?
Solutions to Chapter End Review Problems
Suggested Solution to Chapter End Review Problem 4-1
a.
Question
Analysis
Step 1: Is there a
contract?
Yes, both parties have agreed to enter into a contract. The quantity, price,
and payment terms have been agreed to, and each party’s rights under
the contract are clear. The contract is consistent with both parties’ lines of
business, meaning it has commercial substance. There are no indications of
any concerns regarding collectibility with Auto Parts Ltd., which is a major
chain in Atlantic Canada.
Step 2: What
performance
obligations are
included in the
contract?
There is a single distinct good being provided under the contract: 1,000
tires.
Step 3: What is the
transaction price?
The transaction price is $60,000 (1,000 tires × $60).
Step 4: How should
the transaction
price be allocated
to the performance
obligations?
There is no need to allocate the transaction price because there is a single
performance obligation.
(continued)
Solutions to Chapter End Review Problems
Question
Step 5: Has a
performance
obligation been
satisfied?
Analysis
Revenue would be recognized by Big T Tires once it delivered the 1,000
tires. Upon delivery, Auto Parts has control of the goods, which is indicated
by physical possession; it has the risks and rewards of ownership; it has
accepted the tires; and it has an obligation to pay for them. As such, Big T
Tires would recognize revenue on September 26, 2024.
b.
Sept. 26
DR Accounts Receivable
60,000
CR Sales Revenue
DR Cost of Goods Sold
60,000
46,000
CR Inventory (1,000 tires × $46)
Oct. 10
DR Cash
46,000
60,000
CR Accounts Receivable
60,000
Suggested Solution to Chapter End Review Problem 4-2
a.
Question
Analysis
Step 1: Is there a
contract?
Yes, both parties have agreed to enter into a contract. The service to be
provided, price, and payment terms have been agreed to, and each party’s
rights under the contract are clear. The contract is consistent with both
parties’ lines of business, meaning it has commercial substance. There are
no indications of any concerns regarding collectibility with Legal Co.
Step 2: What
performance
obligations are
included in the
contract?
In this case, there is a series of distinct services that are substantially the
same and have the same pattern of transfer to the customer (the shredding
services are the same each time and will be provided 12 times (once a week
for three months) over the contract). Therefore they are considered to be a
single performance obligation.
Step 3: What is the
transaction price?
The transaction price is $6,000.
Step 4: How should
the transaction
price be allocated
to the performance
obligations?
The transaction price will be allocated to the performance obligation on
a monthly basis (as Confitech prepares its financial statements monthly).
$2,000 ($6,000 ÷ 3) will be allocated to each month. Confitech will also need
to record revenue for any additional shredding services performed.
Step 5: Has a
performance
obligation been
satisfied?
Revenue would be recognized by Confitech after it has performed the
shredding services for the month. Once the monthly shredding services
have been provided, that portion (⅓) of the performance obligation has
been satisfied.
b.
Sept. 1
DR Cash
Sept. 30
DR Deferred Revenue
2,000
CR Deferred Revenue
2,000
2,000
CR Service Revenue
Sept. 30
DR Accounts Receivable
2,000
450
CR Service Revenue (15 boxes × $30)
Oct. 1
DR Cash
CR Deferred Revenue
450
2,000
2,000
(continued)
Month
Revenue
Recognized
Sept.
$2,450
Oct.
2,000
Nov.
2,300
Total
$6,750
4-29
4-30
C H A PTE R 4
Revenue Recognition and the Statement of Income
Oct. 10
DR Cash
450
CR Accounts Receivable
Oct. 31
450
DR Deferred Revenue
2,000
CR Service Revenue
Nov. 1
DR Cash
Nov. 30
DR Deferred Revenue
2,000
2,000
CR Deferred Revenue
2,000
2,000
CR Service Revenue
Nov. 30
2,000
DR Accounts Receivable
300
CR Service Revenue (10 boxes × $30)
Dec. 8
300
DR Cash
300
CR Accounts Receivable
300
Suggested Solution to Chapter End Review Problem 4-3
a.
Question
Analysis
Step 1: Is there a
contract?
Yes, both parties have agreed to enter into a contract. The goods and
services to be provided, price, and payment terms have been agreed to, and
each party’s rights under the contract are clear. The contract is consistent
with both parties’ lines of business, meaning it has commercial substance.
There are no indications of any concerns regarding collectibility with
Health Co.
Step 2: What
performance
obligations are
included in the
contract?
The contract includes three distinct performance obligations: the supply of the
MRI machines, installation of the machines, and training of the employees.
Each of these would be considered distinct goods or services.
Step 3: What is
the transaction
price?
The transaction price is $6,100,000.
Step 4: How
should the
transaction price
be allocated to
the performance
obligations?
As there are multiple performance obligations, the transaction price must
be allocated to each of them. The allocation will be done on the basis of the
stand-alone selling price of each performance obligation.
Step 5: Has a
performance
obligation
been satisfied?
Performance
Obligation
% of Total
Stand-Alone Stand-Alone
Selling Price Selling Price
Contract
Price
Allocation of
Contract Price
Supply of MRI
machines
$6,200,000
96.1%
× $6,100,000
$5,862,100
Installation
$ 200,000
3.1%
× $6,100,000
$ 189,100
Training
$
50,000
0.8%
× $6,100,000
$
$6,450,000
100.0%
48,800
$6,100,000
The first performance obligation, the supply of the MRI machines, is
satisfied on October 22, 2024, when Image Ltd. delivers these goods.
The revenue related to this obligation would be recognized at this
point.The second performance obligation, the installation of the MRI
machines, is satisfied on November 13, 2024, when these services
are provided by Image Ltd. The revenue related to this obligation
would be recognized at this point.The third performance obligation,
the employee training, is satisfied on November 28, 2024, when the
training was completed.
Solutions to Chapter End Review Problems
b.
Oct. 22
DR Accounts Receivable
5,862,100
CR Sales Revenue
DR Cost of Goods Sold
DR Cash
DR Accounts Receivable
5,400,000
Nov.
237,900
Dec.
—
3,000,000
Total
$6,100,000
189,100
CR Service Revenue
Nov. 28
$5,862,100
3,000,000
CR Accounts Receivable
Nov. 13
189,100
DR Accounts Receivable
48,800
CR Service Revenue
Dec. 18
DR Cash
48,800
3,100,000
CR Accounts Receivable
3,100,000
Suggested Solution to Chapter End Review Problem 4-4
a.
NGO INC.
Statement of Income
For the year ended October 31
Sales revenue
2024
2023
$2,095,000
$1,876,000
Cost of goods sold
1,042,000
972,000
Gross profit
1,053,000
904,000
Selling expenses
205,000
178,000
Depreciation expense
227,000
198,000
Administrative expenses
152,000
134,000
22,000
19,000
Total operating expenses
606,000
529,000
Profit from operations
447,000
375,000
Operating expenses
Utilities expense
Other revenues and expenses
Interest income
2,000
1,000
Financing expenses
(27,000)
(18,000)
Profit before income tax
422,000
358,000
52,000
37,000
$ 370,000
$ 321,000
Income tax expense
Net income
b.
2024
Gross profit percentage
Revenue
Recognized
Oct.
5,400,000
CR Inventory
Oct. 24
Month
5,862,100
2023
$1,053,000 = 0.503 or 50.3%
$ 904,000 = 0.482 or 48.2%
$2,095,000
$1,876,000
Ngo’s gross profit percentage improved in 2024 because it was 2.1 percentage points higher, meaning that a higher percentage of the company’s sales revenue was available to cover the company’s
expenses.
4-31
4-32
C H A PTE R 4
Revenue Recognition and the Statement of Income
Assignment Material
Discussion Questions
DQ4-1 Identify and explain the difference between the contract-based and earnings-based approaches to revenue recognition.
DQ4-2 Explain, in your own words, each of the five steps used to
determine when and how much revenue should be recognized under
the contract-based approach.
DQ4-3 Explain what is meant if a company’s net contract position
has increased.
DQ4-4
Explain the meaning of “performance obligation.”
DQ4-5 What is the most common point at which revenue is recognized for the sale of goods? Why is this the case?
DQ4-6 Explain when revenue should be recognized from the provision of services under the contract-based approach.
DQ4-7 Describe the accounting treatment for a deposit made by a
customer for the future delivery of goods. Refer to the five-step model
in your explanation.
DQ4-8 Explain what is meant by stand-alone selling price and how
it is determined.
DQ4-9 Explain what sales discounts are and how they are accounted
for under the contract-based approach to revenue recognition.
DQ4-10 If a company provides customers with the right to return
goods, explain how this impacts the recognition of revenue under the
contract-based approach.
DQ4-11 Explain the difference between assurance and service warranties, and how they affect the recognition of revenue under the contract-based approach.
DQ4-12 Explain the difference between the consignor and consignee in a consignment arrangement. When would each recognize
revenue?
DQ4-13 Explain why a multi-step statement of income provides
users with better information than a single-step statement of income
does. Identify some of this information.
DQ4-14 Identify and briefly describe the major sections of a multi-­
step statement of income.
DQ4-15 How does the single-step statement of income differ from
the multi-step statement of income? Do they produce different net
income amounts? Explain.
DQ4-16 What kinds of items are included on the statement of comprehensive income?
DQ4-17 Explain the difference between a statement of income with
expenses presented by nature and one with expenses presented by
function. Does one require more judgement on the part of management? Why or why not?
DQ4-18 Explain what the basic earnings per share ratio tells users,
including why net income is reduced by preferred dividends as part of
the ratio calculation.
Application Problems Series A
AP4-1A (Revenue recognition criteria) The following are independent situations.
1. The insurance policy on your car starts February 1, 2024, and covers one year. You paid the insurance company $1,800 on January 28, 2024.
2. Porter Airlines sold you a non-refundable one-way ticket in October 2024 for your flight home at
Christmas. The cost of the ticket was $398.
3. You went for your annual dental checkup on April 5, 2024. The fees were $125, and the dentist’s
office requires payment within 30 days of the visit. You paid the bill on April 30, 2024.
4. The Winnipeg Jets sell season tickets in one section of the arena for $6,087 per seat. The season
begins in September, ends in March, and covers 41 games. You bought one season’s ticket and paid
for it in July 2024 for the 2024–25 season.
Required
For each of the above situations, from the perspective of the company you purchased the goods or services from, determine:
a. the performance obligation(s) included in the contract,
b. the transaction price, and
c. when the performance obligation(s) would be satisfied, resulting in revenue recognition.
AP4-2A (Revenue recognition) TreeHold Corp. designs and builds custom harvesting equipment
for logging companies across Canada. The company, which is publicly traded, has a May 31 year end.
Application Problems Series A 4-33
On February 18, 2024, TreeHold signed a contract with Coastal Harvesting Ltd. to design and build 25
custom harvesters that can harvest wood at the steep grades found along many of the Pacific Coast timber
stands included in Coastal’s harvesting leases. The following events took place in 2024 in relation to the
contract:
1. February 18: Officials from TreeHold and Coastal sign the contract. The contract was for $4.1 million. TreeHold is to design, manufacture, and deliver the 25 machines to Coastal’s operations centre
in Duncan, British Columbia. TreeHold’s management estimates that the design component of the
contract would be valued at $510,000 if contracted for separately, while the machine construction
component of the contract would be valued at $4 million if the machines were purchased separately.
TreeHold agrees to provide a three-year assurance-type warranty for the machines, and the company’s management estimates that the warranty claims would total $230,000 based on past experience.
Coastal agrees to pay a $1,250,000 deposit within 10 days of signing the contract and to pay the balance within 15 days of the equipment being delivered.
2. February 25: Coastal pays the deposit specified in the contract.
3. March 28: TreeHold’s engineering staff complete the equipment design and it is approved by officials from Coastal.
4. May 18: TreeHold completes construction of the 25 harvesters.
5. May 20: The 25 harvesters are loaded onto TreeHold’s trucks and are delivered to Coastal’s operation
centre in Duncan later that day.
6. June 2: Coastal pays the balance owing on the contract.
Required
a. Using the five-step model for revenue recognition, determine when and how much revenue TreeHold would be able to recognize for the year ended May 31, 2024. Round percentages to two decimal
places.
b. Prepare TreeHold’s required journal entries for all of the dates appearing above along with any other
necessary journal entries for the contract based on your analysis in part (a).
AP4-3A (Revenue recognition) Best Snacks Inc. is a publicly traded snack food company
focused on snacks and candies from around the world. On a monthly basis, the company boxes
snacks and candies from a different country, along with facts about each and a scorecard for
tracking favourites. The boxes can be purchased at specialty shops and are available for annual
subscription.
The consumer can choose between two annual subscriptions, the Good Box for $144 annually
and the Oh So Good Box for $240 annually. Subscriptions are paid in advance and are non-cancellable.
Best Snacks sold for cash 10,000 subscriptions on October 1, 2024, of which 20% were Oh So Good Box
subscriptions.
Single Good Boxes can be purchased at specialty shops. Best Snacks charges the shops $8 per box.
Normally, 2,400 boxes are delivered to specialty shops each month, with 20% of these being returned
unsold. Of the 2,400 boxes sent out in October 2024, all were sold on account, and none of the returned
boxes are expected to be resold and are scrapped. Unsold boxes are returned by shops in the following
month.
The products in the Good Boxes cost Best Snacks $5 per box, while the products in the Oh So Good
Box cost Best Snacks $9 per box.
Required
a. Determine how much revenue Best Snacks would be able to recognize in October 2024. Use the fivestep model for revenue recognition in preparing your response.
b. Prepare the required summary journal entries for the contract based on your analysis in part (a).
AP4-4A (Revenue recognition) GoWeb IT Inc. is a public company that manufactures and
sells IT systems and also provides IT training and support. GoWeb’s customers can purchase IT
system hardware or support services separately, but the company also offers hardware and support
services as a package. On June 14, 2024, Western Power Ltd., one of GoWeb’s customers, purchased
an equipment and support package. The contract with Western is for $4.2 million and includes hardware and three years of support services. The hardware that was purchased would normally sell for
$3.2 million, and support services would be valued at $1.3 million if purchased separately. The hardware cost GoWeb $2.6 million and was delivered on June 30, 2024. GoWeb’s management expects
that about half of the support services will be provided in July 2024 as the new hardware is installed.
The balance of the support is expected to be provided evenly over the remainder of the contract. The
contract also calls for Western to make a $1.2-million payment to GoWeb within 30 days of signing
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the contract and then $1 million on January 1, 2025, 2026, and 2027. Western is a successful company
and GoWeb’s management has no concerns about collectibility.
Required
a. Assuming that GoWeb provides the goods and services as expected under the contract and Western
makes its payments as required, determine when and how much revenue GoWeb would be able to
recognize in each year of the contract. Use the five-step model for revenue recognition in preparing
your response. Round percentages to two decimal places.
b. Prepare the required summary journal entries and any required adjusting journal entries for the
contract based on your analysis in part (a). GoWeb has a calendar year end and records adjusting
journal entries monthly.
AP4-5A (Revenue recognition) DC Systems Ltd. manufactures and sells security screening systems to government agencies across North America. The company’s parcel and small cargo X-ray systems are used to inspect freight and small cargo at customs facilities. In 2024, DC signed a two-year
contract with NCC, a Canadian Crown corporation, to supply it with 100 vehicles at a price of $50,000
per vehicle. DC’s cost to manufacture each vehicle is $28,500. The following schedule summarizes
the production, delivery, and payments in relation to the contract. Production costs are recorded to
inventory:
2024
Systems delivered
2025
Total
80
20
100
Production costs incurred
$2,280,000
$ 570,000
$2,850,000
Cash payments received
$3,200,000
$1,500,000
$4,700,000
Required
a. Determine how much revenue DC Systems would be able to recognize in 2024 and 2025. Use the
five-step model for revenue recognition in preparing your response.
b. Prepare the required summary journal entries for the contract based on your analysis in part (a).
c. How would your answer to part (a) change if DC allowed NCC to return any systems that were
defective? Based on past experience, DC’s management estimated a return rate of 1% and that the
systems being returned would need to be scrapped.
AP4-6A (Revenue recognition) Beach Life Ltd. operates an online booking service restricted to
beachfront properties around the world. Users of the company’s website booked beach rentals totalling
$7.8 million in 2024. Bookings are fully paid for at the time of reservation and are 50% refundable if the
reservation is cancelled anytime up to 21 days before the reservation date. After that date, the reservations
are non-cancellable.
Under the terms of the company’s listing agreements with property owners, Beach Life charges a fee
of 12% of the total reservation and electronically transfers the balance of the cash collected directly to the
property owner’s bank five days before the reservation date.
Of the 2024 bookings, 90% had been completed before Beach Life’s December 31 year end. The balance was still within the cancellation period.
Required
Determine how much revenue Beach Life would be able to recognize in 2024. Use the five-step model for
revenue recognition in preparing your response.
AP4-7A (Revenue recognition and statement of income) Kabili Bites Ltd. operates a chain of
restaurants across Canada. Most of the company’s business is from customers who enjoy in-restaurant
lunches and dinners and pay before they leave. The company also provides catered food for functions
outside of the restaurant. Catering customers are required to pay a 40% deposit at the time of booking the
event. The remaining 60% is due on the day of the function.
During 2024, the restaurant chain collected $7,036,000 from restaurant and catered sales. At
year end, December 31, 2024, the catered sales amount included $121,000 for a convention scheduled for January 12, 2025. Kabili Bites Ltd. paid $3,298,000 for food supplies during the year and
$1,248,000 for wages for the chefs and other restaurant staff. The restaurant owed $62,000 in wages
to its staff at year end, which will be paid on January 4, 2025, as part of the normal weekly pay
schedule.
Application Problems Series A
Required
a. Prepare as much of the multi-step statement of income for Kabili Bites Ltd. as you can, showing the
amount of sales and any other amounts that should be included. Show all calculations.
b. Using the five-step revenue recognition method, explain when Kabili Bites can recognize revenues
from its various revenue streams.
c. Did Kabili Bites have a cost of goods sold? Why or why not?
d. What other expenses do you think the company probably has?
AP4-8A (Statement of income presentation) The statement of income for DiTuri Manufacturing
Inc. for the years 2022 to 2024 is presented below.
DITURI MANUFACTURING INC.
Statement of Income
For the year ended October 31
(in thousands of dollars)
2024
2023
2022
$ ?
$1,364
$1,118
Cost of goods sold
949
?
?
Gross margin
687
?
448
?
136
112
Administrative expenses
131
109
89
Depreciation expense
110
98
?
Operating income
283
270
145
Investment income
10
?
12
Financing expenses
24
18
?
269
?
142
?
52
28
$215
$ 208
$ ?
Sales revenue
Operating expenses
Store expenses
Earnings before income taxes
Income tax expense
Net earnings
Required
Calculate the missing amounts on the statement of income.
AP4-9A (Statement of income presentation) You have been provided with the following account
balances for Webber Ltd. for the years ended November 30, 2024 and 2025:
2025
2024
$ 310,000
$ 320,000
1,764,000
1,456,000
112,000
105,000
82,000
102,000
5,200
6,100
Rent expense
36,000
27,000
Sales revenue
3,150,000
2,800,000
88,000
76,000
504,000
492,000
Advertising expense
Cost of goods sold
General and administrative expenses
Income tax expense
Interest revenue
Utilities expense
Wages expense
Required
a. Prepare a multi-step, comparative statement of income for Webber for 2024 and 2025.
b. Determine Webber’s gross margin percentage for each year. In which year was Webber more successful in this area?
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c. Did the year with the superior gross margin percentage also have the largest net income? Explain
why this may or may not be the case.
AP4-10A (Statement of income presentation) The following account balances are taken from
Sherwood Ltd.’s adjusted trial balance at June 30, 2024:
Debit
Sales revenue
Credit
$1,250,000
Advertising expense
$125,000
Cost of goods sold
596,000
General and administrative expenses
40,000
Selling expenses
75,000
Depreciation expense
70,000
Interest expense
37,000
Interest revenue
44,000
Income tax expense
10,700
Wages expense
165,000
Utilities expense
106,000
Required
a. Prepare a single-step statement of income for the year ended June 30, 2024.
b. Prepare a multi-step statement of income for the year ended June 30, 2024.
c. Compare the two statements and comment on the usefulness of each one.
AP4-11A (Statement of income presentation: nature vs. function) Navaria Inc. manufactures
and sells chairlift mobility aids. These are chairlift systems designed for in-home use to aid persons
with mobility challenges. The company sells its systems online and through a network of independent
sales agents. Installation of the systems is done by independent contractors hired directly by Navaria’s
customers.
The following information was taken from Navaria’s financial records for the year ended June 30,
2024:
(in thousands of dollars)
Administrative expense
$
Cost of goods sold
9,550
79,159
Other expenses
641
Financing expenses
825
Interest revenue
630
Income tax expense
4,953
Sales revenue
Engineering activities
Research and development activities
Sales and marketing activities
119,728
Wages
Rental of
Equipment
Advertising
Depreciation
$1,927
$65
$ 0
$524
774
33
0
128
3,586
0
5,866
26
Required
a. Prepare a multi-step statement of income for the year ended June 30, 2024, that reports expenses by
nature.
b. Prepare a multi-step statement of income for the year ended June 30, 2024, that reports expenses by
function.
Application Problems Series B
AP4-12A (Statement of income presentation: basic EPS) The following information was taken
from Thor Ltd.’s adjusted trial balance as at July 31, 2024:
Sales revenue
$1,205,700
Investment revenue
Administration expense
Wages expense
1,900
85,000
25,000
Cost of goods sold
543,000
Selling expense
250,000
Utilities expense
60,700
Depreciation expense
75,000
Financing expense
18,500
Income tax expense
75,000
Dividends declared—Common shares
25,000
Required
a. Prepare a single-step statement of income for the year ended July 31, 2024.
b. Prepare a multi-step statement of income for the year ended July 31, 2024.
c. If Thor had 60,000 common shares outstanding throughout the year, determine the company’s basic
earnings per share.
d. Determine Thor’s gross margin percentage for the year.
Application Problems Series B
AP4-1B (Revenue recognition criteria) The following are independent situations.
1. You bought a printer from Best Buy’s online site and paid with your credit card on June 14, 2024.
The printer was delivered on June 18. You paid the credit card balance on July 15.
2. You bought furniture from Leon’s on December 19, 2024, during a promotion and took it home that
day. The selling price of the furniture was $1,100 and payment is due January 2, 2026.
3. On March 14, 2024, you purchased a travel pass on VIA Rail for $500 that entitles you to unlimited
rail travel for the months of April, May, and June 2024. The pass is non-refundable.
4. You decide you need a new smart phone. You can purchase an iPhone from Rogers Communications. The current promotion indicates there is no cost for the phone if you sign up for a two-year
phone and data plan at $50 per month.
Required
For each of the above situations, determine:
a. the performance obligation(s) included in the contract,
b. the transaction price, and
c. when the performance obligation(s) would be satisfied, resulting in revenue recognition.
AP4-2B (Revenue recognition) Derby Transportation Inc. designs and builds trains for rail networks across Canada. The company, which is publicly traded, has an October 31 year end. On March 15,
2024, Derby Transportation signed a contract with OM Corridor Corp. to design and build 10 high-speed
trains, with each train consisting of seven passenger cars. The high-speed trains will operate between
Ottawa and Montreal. The following events took place in 2024 in relation to the contract:
1. March 15: At the signing ceremony, officials from Derby and OM sign a contract, which is for $11
million. Derby is to design, manufacture, and deliver the 10 trains to OM’s train yards in Montreal. Derby’s management estimates that the design component of the contract would be valued
at $2 million if contracted for separately, while the manufacturing of the 10 trains would be valued at a total of $10 million if they were purchased separately. Derby agreed to provide a two-year
assurance-type warranty for the trains, and the company’s management estimates that the warranty
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Revenue Recognition and the Statement of Income
claims would total $500,000 based on experience. OM agrees to pay a $5.1 million deposit within
14 days of signing the contract and to pay the balance within 45 days of the trains receiving final
approval and certification from the Transportation Safety Board.
2. March 29: OM pays the deposit specified in the contract.
3. May 9: Derby’s engineering staff complete the train design and it is approved by officials from OM
as well as the Transportation Safety Board.
4. August 1: Derby completes construction of the 10 trains.
5. September 1: The 10 trains are delivered according to the contract to OM’s Montreal train yards.
6. September 30: After testing for safety compliance, the trains receive final approval from OM and the
Transportation Safety Board and are certified to carry passengers.
7. November 15: OM pays the balance owing on the contract.
Required
a. Using the five-step model for revenue recognition, determine when and how much revenue Derby
would be able to recognize for the year ended October 31, 2024. Round percentages to two decimal
places.
b. Based on your analysis in part (a), prepare all of the journal entries required by Derby in relation to
the contract. If no journal entry is required, explain why that is the case.
AP4-3B (Revenue recognition) Gourmand Dinner Box Inc. is a catering company that sells meal
kits that its customers can take home and quickly prepare. The company sells its meal kits at local grocery
stores and has recently begun to offer a monthly subscription service, which delivers meal kits to the
customer’s home.
Single meal kits can be purchased at grocery stores. Approximately 10% of the kits shipped
to grocery stores each month are returned unsold and are then discarded. Gourmand charges the
grocery stores $15 for each meal kit. In December 2024, Gourmand began selling three-month subscriptions for $900. Subscriptions are paid in advance and are non-cancellable. Gourmand sold 800
subscriptions on December 1, 2024, which entitle the subscriber to 15 meal kits each month beginning in December 2024. During December, 4,500 meal kits were sold, on account, to grocery stores
and all required subscriber meals were delivered. Grocery stores have 30-day terms of payment with
Gourmand.
Required
a. Determine how much revenue Gourmand Dinner Box would be able to recognize in December
2024. Use the five-step model for revenue recognition in preparing your response.
b. Based on your analysis in part (a), prepare the required journal entries for the contract. Gourmand
records adjusting journal entries monthly. Ignore any related costs to prepare the meal kits.
AP4-4B (Revenue recognition) ADM Ltd. is a public company that manufactures and sells satellite systems and provides support services. ADM’s customers can purchase satellites or support services
separately, but the company also offers satellite systems that include training and support as a package.
On October 1, 2024, First Web Ltd. purchased a satellite and support package from ADM. The contract is
for $100 million and includes the satellite and 10 years of support services once the satellite is delivered
in orbit. The satellite that was purchased by First Web would normally sell for $95 million and 10 years
of support services would be valued at $15 million if purchased separately. ADM’s management expects
the satellite to be delivered in orbit by October 1, 2025. The support is expected to be provided evenly for
10 years after delivery of the satellite. The contract requires First Web to make a $15-million payment to
ADM within 30 days of signing the contract and then $35 million on October 1, 2025, with the balance
to be paid annually over 10 years once the satellite is delivered in orbit on October 1, 2025. First Web has
secured financing to pay for the satellite system and so ADM’s management has no concerns related to
collectability.
Required
a. Assuming that ADM provides the goods and services as and when expected under the contract and
First Web makes its payments as required, determine when and how much revenue ADM would
be able to recognize in each of the first three fiscal years ending December 31 (2024, 2025, 2026) of
the contract. Use the five-step model for revenue recognition in preparing your response. Round
percentages to two decimal places.
b. Based on your analysis in part (a), prepare the required journal entries for 2024, 2025, and 2026.
Assume ADM records adjusting journal entries at December 31 each year.
Application Problems Series B
AP4-5B (Revenue recognition) Sound Sleeper Ltd. manufactures and sells mattresses to retailers
across Canada. In 2024, Sound Sleeper signed a two-year contract with Zzz Ltd. to supply it with 40,000
mattresses at a price of $100 per unit. Sound Sleeper’s cost to manufacture a mattress is $25. Sound
Sleeper provides Zzz with 30-day credit terms from the date of delivery. The following schedule summarizes the production, delivery, and payments in relation to the contract:
2024
Mattresses delivered
2025
Total
15,000
25,000
40,000
Manufacturing costs incurred
$ 375,000
$ 625,000
$1,000,000
Cash payments received
$1,400,000
$2,450,000
$3,850,000
Required
a. Determine how much revenue Sound Sleeper would be able to recognize in 2024 and 2025. Use the
five-step model for revenue recognition in preparing your response.
b. Prepare the required summary journal entries for the contract based on your analysis in part (a),
c. How would your answer to part (a), change if Sound Sleeper allowed Zzz to return any mattresses
that were returned by customers who found them uncomfortable? Based on experience, Sound
Sleeper’s management estimated a return rate of 1% and that the mattresses being returned would
be donated to local shelters.
AP4-6B (Revenue recognition) Millionaire Ride Ltd. operates an online booking service for luxury
car rentals around the world. Users of the company’s website booked luxury cars totalling $8.4 million
in 2024. Bookings are fully paid for at the time of reservation and are fully refundable if the reservation is cancelled anytime up to 20 days before the reservation date. After that date, the reservations are
non-cancellable.
Under the terms of the company’s listing agreements with luxury car owners, Millionaire Ride
charges a fee of 10% of the total reservation and electronically transfers the balance of the cash collected
directly to the car owner’s bank five days before the reservation date.
Of the 2024 bookings, 75% had been completed before Millionaire Ride’s December 31 year end. The
balance of the bookings were still within the cancellation period.
Required
Determine how much revenue Millionaire Ride would be able to recognize in 2024. Use the five-step
model for revenue recognition in preparing your response.
AP4-7B (Revenue recognition and statement of income) Kohlrabi Electronics Ltd. operates an
online electronics business selling hardware and software. Customers confirm the goods ordered and pay
for their purchase before Kohlrabi ships the merchandise they have ordered. The company also provides
IT consulting services to larger customers. Customers who require consulting services sign a contract
and are required to pay a 20% deposit at the time of signing. The remaining 80% is due on delivery of the
final consulting report.
During 2024, the online business collected $6,097,000 from hardware and software sales. At year
end, August 31, 2024, the company had collected $897,000 cash for IT consulting services which included
$260,000 for services scheduled to be completed by December 31, 2024. Kohlrabi paid $2,199,000 for the
hardware and software inventory sold during the year and $1,447,000 for wages to technical and warehouse staff. The company owed $56,000 in wages to its staff at year end, which will be paid on September
11, 2024, as part of the normal weekly pay schedule.
Required
a. Prepare as much of the single-step statement of income for Kohlrabi Electronics Ltd. as you can,
presenting the amount of sales revenue for each revenue stream and any other amounts that should
be included. Show all calculations.
b. Using the five-step revenue recognition method, explain when Kohlrabi Electronics can recognize
revenues from its various revenue streams.
c. Did Kohlrabi have a cost of goods sold? Why or why not?
d. What other expenses do you think the company probably has?
AP4-8B (Statement of income presentation) The statement of income for Primitivo Winery Inc.
for the years 2022 to 2024 is presented below.
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PRIMITIVO WINERY INC.
Statement of Income
For the year ended April 30
(in thousands of dollars)
Sales revenue
2024
2023
2022
$ 2,000
$ 1,654
$ ?
1,200
?
837
?
?
608
100
57
45
45
35
15
Cost of goods sold
Gross margin
Operating expenses
Insurance expense
Utility expense
Travel expenses
?
100
105
50
50
50
Operating income
506
426
?
Rental income
350
?
200
?
60
65
811
591
?
Depreciation expense
Interest expenses
Earnings before income taxes
Income tax expense
Net earnings
20
$ ?
$
?
14
576
$ ?
Required
Calculate the missing amounts on the statement of income.
AP4-9B (Statement of income presentation) You have been provided with the following account
balances for Broiler Ltd. for the years ended September 30, 2024, and 2025:
2025
2024
$ 220,000
$ 300,000
1,546,000
1,366,000
General and administrative expenses
222,000
155,000
Income tax expense
500,000
75,000
Advertising expense
Cost of goods sold
Interest revenue
3,200
4,000
Rent expense
15,000
12,000
Sales revenue
3,750,400
2,450,000
Utilities expense
Wages expense
90,000
66,000
403,000
376,000
Required
a. Prepare a multi-step comparative statement of income for Broiler Ltd. for 2024 and 2025.
b. Determine Broiler’s gross margin percentage for each year. In which year was Broiler more successful in this area?
c. Did the year with the superior gross margin percentage also have the largest net income? Explain
why or why not.
AP4-10B (Statement of income presentation) The following account balances are taken from Ballistik Ltd.’s adjusted trial balance at January 31, 2024:
Debit
Sales revenue
Credit
$5,275,000
Wages expense
$ 175,000
Cost of goods sold
3,645,000
(continued)
Application Problems Series B
Debit
General and administrative expenses
Credit
66,000
Utilities expenses
105,000
Depreciation expense
95,000
Interest expense
33,000
Interest revenue
50,000
Income tax expense
150,700
Advertising expense
125,000
Selling expenses
196,000
Required
a. Prepare a single-step statement of income for the year ended January 31, 2024.
b. Prepare a multi-step statement of income for the year ended January 31, 2024.
c. Compare the two statements and comment on the usefulness of each one.
AP4-11B (Statement of income presentation: nature vs. function) Cartier Custom Homes Inc.
manufactures and sells pre-fab homes. These homes are manufactured in a controlled environment to
ensure a consistent high quality, which results in greater customer satisfaction. The company sells its
homes online and through a network of independent sales agents. On-site installation of the homes is
done by independent contractors hired directly by Cartier’s customers.
The following information was taken from Cartier’s financial records for the year ended March
31, 2024:
(in thousands of dollars)
Administrative expenses
Cost of goods sold
Other expenses
Financing expenses
Dividend revenue
Income tax expense
Sales revenue
$
10,645
1,650,159
1,761
65,125
2,730
167,753
2,671,928
Wages
Rental of
Equipment
$107,000
$1,765
Research and development activities
5,764
Sales and marketing activities
2,596
Architectural activities
Advertising
$
Depreciation
0
$7,252
6,300
0
1,118
0
3,678
500
Required
a. Prepare a multi-step statement of income for the year ended March 31, 2024, that reports expenses
by nature.
b. Prepare a multi-step statement of income for the year ended March 31, 2024, that reports expenses
by function.
AP4-12B (Statement of income presentation: basic EPS) The following information was taken
from Egeland Ltd.’s adjusted trial balance as at July 31, 2024:
Sales revenue
Interest expense
Cost of goods sold
Utilities expense
$2,788,800
44,000
1,556,000
16,000
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C H A PTE R 4
Revenue Recognition and the Statement of Income
Depreciation expense
216,000
Distribution expenses
414,000
Administration expenses
279,000
Advertising expense
64,000
Interest revenue
19,200
Income tax expense
77,000
Dividends declared—Common shares
30,000
Dividends declared—Preferred shares
15,000
Required
a. Prepare a single-step statement of income for the year ended July 31, 2024.
b. Prepare a multi-step statement of income for the year ended July 31, 2024.
c. Determine Egeland’s gross margin percentage for the year.
d. If Egeland had 80,000 common shares outstanding throughout the year, determine the company’s
basic earnings per share.
User Perspective Problems
UP4-1 (Revenue recognition and earnings) Financial analysts frequently refer to the quality of a
company’s earnings. By quality, they mean that the earnings are showing growth and are good predictors
of future earnings.
Required
If you were looking for evidence of a company’s quality of earnings, what would you look for on the
financial statements?
UP4-2 (Revenue recognition) Suppose that your company sells appliances to customers under
sales contracts that allow them to pay for the appliance in monthly payments over one year. Credit checks
are performed at the time of sale.
Required
Using the contract-based approach, describe when revenue would be recognized for this type of sale.
UP4-3 (Revenue recognition) Chargeit Inc. imports and distributes cellphone chargers and fully
charged portable backup power stations to gas stations and other small retailers. Chargeit has a standard
contract that it enters into with each gas station or retailer, which stipulates the following:
1. The gas stations and retailers are required to place Chargeit’s product display unit on or adjacent to
the cash counter.
2. Chargeit is responsible for servicing the display unit, in terms of restocking it, and its employees will
visit each gas station or retailer at least twice each month to count the number of products in the
display unit, determine the number of products sold, and restock the display units.
3. The gas stations or retailers are required to pay only for the products sold to customers, receive 20%
of each sale, and remit the balance to Chargeit at the end of each month.
4. The gas stations and retailers are responsible for any products stolen from the Chargeit display
station.
5. The contract is cancellable by either party with 30 days’ notice, and all unsold product and the display unit must be returned to Chargeit.
Required
Explain when Chargeit would recognize revenue under the contract-based approach. Also explain how
the gas stations and retailers would recognize revenue under the contract-based approach.
UP4-4 (Revenue recognition) Kidlet Toys Ltd. designs and manufactures toys for the early childhood education market. The company sells its products to national toy retailers as well as to independent
User Perspective Problems
toy stores across North America. The company allows its customers to return any unsold products within
90 days of receiving the products from Kidlet. The rationale for this policy is to stimulate sales, especially
among the independent toy stores. Returned toys are discarded.
Required
Explain when Kidlet would recognize revenue under the contract-based approach. Also explain what the
company would have to do to determine the amount of revenue that could be recognized.
UP4-5 (Revenue recognition policy and sales targets) Suppose that you are the vice-president
in charge of marketing and sales in a large company. You want to boost sales, so you have developed an
incentive plan that will provide a bonus to the salespeople based on the revenue they generate.
Required
At what point would you recommend that the company count a sale toward the bonus plan: when the
salesperson generates a purchase order, when the company ships the goods, or when the company
receives payment for the goods? Explain.
UP4-6 (Revenue recognition) Sound Co. sells memberships to an online music streaming service. Memberships are available for 1-month, 6-month, and 12-month periods. The memberships are
non-refundable.
Required
Using the five-step model, explain when Sound Co. would recognize revenue from the membership sales.
UP4-7 (Advertising revenue recognition) Suppose the sports channel on television sells $10 million in advertising slots to be aired during the games that it broadcasts during the FIFA World Cup.
Suppose also that these slots are contracted out during the month of October with a down payment of $2
million. The ads will be aired in June and July of the following year, with 40% of the ads airing in June
and the balance in July.
Required
If the sports channel’s fiscal year end is December 31 and the company uses the contract-based approach,
how should it recognize this revenue in its financial statements?
UP4-8 (Revenue recognition for gift cards) Suppose that a national clothing retailer sells gift
cards for merchandise. During the Christmas holiday period, it issues $500,000 in gift cards.
Required
If the company’s fiscal year end is December 31, how should it recognize the issuance of these gift cards
in its financial statements at year end? Explain your answer in relation to the contract-based approach to
revenue recognition.
UP4-9 (Revenue recognition on software sales) Suppose that Solution Software Company produces inventory-tracking software that it sells to retail companies. The software keeps track of what
inventory is on hand and where it is located. It automatically adjusts the information when items are sold
and alerts the company when new inventory needs to be ordered. The software package sells for $100,000
and the company agrees to customize it to the buyer’s operations, which normally takes several months.
Required
If the fiscal year end is September 30 and the company sells 10 software units in August, how should it
recognize these sales in the financial statements at year end? Use the contract-based approach to revenue
recognition to support your answer.
UP4-10 (Statement of income: expense presentation) You are a member of the executive of the
students’ union at your university. As one of the few executive members with some knowledge of financial accounting, you have been tasked with responding to a request from the office of the university’s
vice-president of finance. She has asked the student union to provide its thoughts on the university’s
move to present the expenses on its statement of operations (statement of income) by function rather
than by nature. The VP is proposing two functions: (1) instruction/student support and (2) ancillary.
Required
a. What concerns might the student union have with this proposal?
b. What recommendation(s) would you suggest the student union make in relation to the proposal?
4-43
4-44
C H A PTE R 4
Revenue Recognition and the Statement of Income
Work in Progress
WIP4-1 (Revenue recognition) You are studying with your study group when one of your group
members makes the following statement:
“Under the contract approach, companies recognize revenue whenever their net position in a contract improves. As such, when a customer places an order and makes a deposit, the seller can recognize revenue as their net position has improved as they have received cash, which increases contract
assets.”
Required
Explain whether or not your group member’s rationale is correct.
WIP4-2 (Sales discounts) You are studying with some classmates and are reviewing each other’s
responses to the following questions:
Why do companies offer sales discounts to customers? How would a sales discount of 1/10, n/45 be
interpreted?
Your classmate responds as follows:
“Companies offer sales discounts so that they can earn revenue quicker or sell inventory quicker.
A sales discount of 1/10, n/45 means that the buyer has to pay one-tenth of the invoice amount
within 45 days.”
Required
Identify how your classmate’s answer could be substantively improved.
WIP4-3 (Sales discounts) You are studying with some classmates and are reviewing each other’s
responses to the following questions:
Why do companies offer sales discounts to customers? How would a sales discount of 1/10, n/45 on
a $2,000 purchase be interpreted?
Your classmate responds as follows:
“Companies offer sales discounts in order to increase the amount of revenue they earn and to
speed up the collection of cash from customers. If you are offered a sales discount of 1/10, n/45 on
a $2,000 purchase, it means that you must pay before 10 days and, if you do, you will get 10% off,
so you will only have to pay $1,800 to settle the account.”
Required
Identify how your classmate’s answer could be substantively improved.
WIP4-4 (Consignment arrangements)
following:
During a study session, one of your classmates states the
“Companies that are consignors in a consignment arrangement are essentially in the same position
as agents in third-party sale arrangements. They receive a commission whenever the consigned
goods are sold.”
Required
Evaluate your classmate’s response. Identify the elements that are correct and incorrect.
Reading and Interpreting Published Financial Statements
RI4-1 (Revenue recognition and statement of income presentation) Spin Master Corp. is a
Toronto-based children’s entertainment company. The company designs, manufactures, and markets
toys and digital games, as well as creating and producing entertainment content. Exhibit 4.13 contains
an excerpt from Spin Master’s 2020 annual report.
Reading and Interpreting Published Financial Statements
4-45
EXHIBIT 4.13 Spin Master
Corp.’s 2020 Consolidated
Statements of Earnings
SPIN MASTER CORP.
Consolidated Statements of Earnings and Comprehensive Income
(US$ millions, except earnings per share)
Year Ended December 31
Notes
Revenue
4
2020
$1,570.6
2019
$1,581.6
Cost of sales
842.7
796.6
Gross profit
727.9
785.0
7
367.8
395.4
Administrative expenses
7
264.6
247.9
Depreciation and amortization expenses
7
37.7
32.6
Other expenses
5
8.7
6.6
Foreign exchange loss
8
27.6
5.8
Finance costs
6
12.1
11.7
9.4
85.0
(36.1)
20.7
Expenses
Selling, marketing, distribution and
product development
Income before income tax (recovery)
expense
Income tax (recovery) expense
9
Net income
$
45.5
$
64.3
Required
a. Calculate Spin Master’s gross profit percentage for 2020 and 2019. Has it improved?
b. Does Spin Master prepare its consolidated statement of earnings using a single-step or a multi-step
approach?
c. Does Spin Master present its expenses by function or by nature? Does this approach require a higher
level of management judgement when preparing the statement?
RI4-2 (Revenue recognition and statement of income presentation) Gildan Activewear Inc. is a
Montreal-based company that manufactures and sells activewear, socks, and underwear. The company’s brands
include Gildan, Gold Toe, and Anvil. The company also manufactures products through licensing arrangements with Under Armour and New Balance brands. Exhibit 4.14 presents the company’s consolidated statements of earnings and comprehensive income for the years ended January 3, 2021, and December 29, 2019.
EXHIBIT 4.14 Gildan
Activewear Inc.’s 2020
Consolidated Statements of
Earnings and Comprehensive
Income
GILDAN ACTIVEWEAR INC.
Consolidated Statements of Earnings and Comprehensive Income
Fiscal years ended January 3, 2021, and December 29, 2019
(in thousands of U.S. dollars, except per share data)
Net sales (note 25)
Cost of sales (note 16(c))
2020
2019
$1,981,276
$2,823,901
1,732,217
2,119,440
Gross profit
249,059
704,461
Selling, general and administrative expenses (note 16(a))
272,306
340,487
15,453
27,652
Restructuring and acquisition-related costs (note 17)
48,154
47,329
Impairment of goodwill and intangible assets
93,989
—
Impairment of trade accounts receivable (note 6)
(continued)
4-46
C H A PTE R 4
Revenue Recognition and the Statement of Income
EXHIBIT 4.14 Gildan
Activewear Inc.’s 2020
Consolidated Statements of
Earnings and Comprehensive
Income (continued)
(180,843)
288,993
Financial expenses, net (note 14(c))
48,530
39,168
Earnings (loss) before income taxes
(229,373)
249,825
Operating income (loss)
(4,091)
Income tax recovery (note 18)
(225,282)
Net earnings (loss)
(9,984)
259,809
Other comprehensive income (loss), net of related
income taxes:
Cash flow hedges (note 14(d))
Actuarial gain (loss) on employee benefit obligations
(note 12(a))
(8,503)
(3,917)
12,142
(1,296)
3,639
(5,213)
$ (221,643)
Comprehensive income (loss)
$ 254,596
Required
a. Gildan reports “net sales” on its consolidated statements of earnings. Explain what this means.
b. Calculate the amount of Gildan’s gross profit percentage for 2020 and 2019. Has it improved?
c. Using the financial statements in Appendix A, calculate Dollarama’s gross profit percentages for the
same periods. How do they compare with Gildan’s percentages?
d. Does Gildan prepare its consolidated statements of earnings using a single-step or a multi-step
approach?
e. Does Gildan present its expenses by function or by nature? Does this approach require a higher level
of management judgement when preparing the statement?
RI4-3 (Revenue recognition and statement of income presentation) Maple Leaf Foods Inc.
produces value-added meat products for customers across North America, the United Kingdom, and
Japan. Exhibit 4.15 presents the company’s consolidated statements of earnings for the years ended
December 31, 2020 and 2019.
EXHIBIT 4.15
Maple Leaf
Foods Inc.’s 2020 Consolidated
Statements of Net Earnings
MAPLE LEAF FOODS INC.
Consolidated Statements of Net Earnings
Fiscal years ended December 31
(in thousands of Canadian dollars, except per share data)
Notes
2020
2019
$4,303,722
$3,941,545
Cost of goods sold
3,600,669
3,350,566
Gross margin
703,053
590,979
Sales
Selling, general and administrative expenses
Earnings before the following:
Restructuring and other related costs
Other expense
Earnings before interest and income taxes
Income expenses and other financing costs
13
490,659
457,681
212,394
133,298
4,284
11,004
16,757
3,268
191,353
119,026
31,480
32,031
(continued)
Reading and Interpreting Published Financial Statements 4-47
Earnings before income taxes
20
159,873
86,995
46,596
12,367
7
$ 113,277
$ 74,628
21
$ 0.92
$ 0.60
$ 0.91
$ 0.60
Income taxes expense
Net earnings
EXHIBIT 4.15 Maple Leaf
Foods Inc.’s 2020 Consolidated
Statements of Net Earnings
(continued)
Earnings per share attributable to common
shareholders:
Basic earnings per share
Diluted earnings per share
Weighted average number of shares (millions)
Basic
21
Diluted
123.1
123.6
124.3
125.2
Required
a. Calculate the percentage changes in Maple Leaf’s sales revenue and cost of goods sold between 2019
and 2020. Comment on what you expect the impact of these changes to be on the company’s gross
profit percentage for the same period.
b. Calculate Maple Leaf’s gross profit percentage for 2020 and 2019. Has it improved?
c. Does Maple Leaf present its expenses by function or by nature? Does this approach require a higher
level of management judgement when preparing the statement?
RI4-4 (Revenue recognition and statement of income presentation) High Liner Foods Inc.
processes and markets seafood products throughout Canada, the United States, and Mexico under the
High Liner and Fisher Boy brands. It also produces private label products and supplies restaurants and
institutions. Exhibit 4.16 presents High Liner Foods’ consolidated statement of income for 2020 and 2019.
EXHIBIT 4.16 High Liner
Foods Inc.’s 2020 Consolidated
Statements of Income
HIGH LINER FOODS INC.
Consolidated Statements of Income
(in thousands of United States dollars, except per share amounts)
Fifty-three
Fifty-three
weeks ended weeks ended
December
January
28, 2019
2, 2021
Notes
Sales
$ 827,453
$ 942,224
Cost of sales
649,529
756,364
Gross profit
177,924
185,860
45,076
45,759
73,736
90,019
—
974
2,957
1,572
56,155
47,536
19,483
33,012
36,672
14,524
24
Distribution expenses
Selling, general and administrative expenses
Impairment of property, plant and equipment
8
Business acquisition, integration and other expenses
Results from operating activities
Finance costs
28
Income before income taxes
Income taxes
Current
18
6,535
3,356
Deferred
18
1,335
879
18
7,870
4,235
Income tax expense
(continued)
4-48
C H A PTE R 4
Revenue Recognition and the Statement of Income
Net income
$ 28,802
$ 10,289
Earnings per common share
Basic
20
$ 0.85
$ 0.31
Diluted
20
$ 0.83
$ 0.30
Basic
20
33,853,881
33,801,217
Diluted
20
34,519,305
34,195,365
Weighted average number of shares outstanding
Required
a. Has High Liner Foods used a single-step or a multi-step income statement? What aspects of the
statement influenced your answer?
b. Calculate High Liner Foods’ gross profit percentage for 2020 and 2019. Did the company’s gross
profit, as a percentage of its revenue, increase or decrease?
c. Calculate High Liner Foods’ net profit rate (net earnings divided by net sales) for 2020 and 2019. Did
the company’s net profit, as a percentage of its revenue, increase or decrease?
Cases
C4-1 Quebec Supercheese Company
Quebec Supercheese Company (QSC) produces many varieties of cheese that are sold in every province
in Canada, mainly through large grocery stores and specialty cheese shops. The cheese is produced at its
factory in Montreal and shipped across Canada using commercial refrigerated trucks that pick up the
cheese at the factory loading dock. The purchasers pay for the trucking and assume responsibility for the
cheese as soon as the trucks pick it up at the factory. In accordance with the contract-based approach to
revenue recognition, QSC recognizes the sale as soon as the trucks load the cheese, because control is
transferred to the purchasers at this point.
QSC is not happy with these arrangements because it has received many complaints from purchasers about spoilage. Even though the purchasers and their truckers have full responsibility for this spoilage, many disputes have occurred because the truckers insist the cheese is spoiled when they pick it up.
QSC is considering setting up its own fleet of trucks to deliver its cheese across Canada. It estimates
that the additional freight costs can be regained through the higher prices it would charge for including
shipping in the price.
If the company makes the deliveries, the control over the cheese will not transfer until the cheese is delivered. QSC’s president was not happy when she learned that sales would be recognized and recorded only upon
delivery to the customer, since she knew that an average of five days’ sales are in transit at all times because
of the distances involved. One day’s sales total approximately $100,000 on average. The effect of this change
would be an apparent drop in sales of $500,000 and a $50,000 decrease in net income in the year of the change.
Required
Respond to the president’s concerns about the impact of changing the point at which the company recognizes revenue.
C4-2 Mountainside Appliances
Danielle Madison owns a store called Mountainside Appliances Ltd. that sells several different brands
of refrigerators, stoves, dishwashers, washers, and dryers. Each of the appliances comes with a factory
warranty on parts and labour that is usually one to three years. For an additional charge, Danielle offers
customers more extended warranties. These extended warranties come into effect after the manufacturers’ warranties end.
Required
Using the contract-based approach to revenue recognition, discuss how Danielle should account for the
revenue from the extended warranties.
Endnotes 4-49
C4-3 Furniture Land Inc.
Furniture Land Inc. is a producer and retailer of high-end custom-designed furniture and uses the contract-based approach to revenue recognition. The company produces only to special order and requires a
one-third down payment before any work begins. The customer is then required to pay one-third at the
time of delivery and the balance within 30 days after delivery.
It is now February 1, 2024, and Furniture Land has just accepted $3,000 as a down payment from
H. Gooding, a wealthy stockbroker. Per the contract, Furniture Land is to deliver the custom furniture
to Gooding’s residence by June 15, 2024. Gooding is an excellent customer and has always abided by the
contract terms in the past. If Furniture Land cannot make the delivery by June 15, the contract terms
state that Gooding has the option of cancelling the sale and receiving a full reimbursement of any down
payment. It is estimated that Furniture Land’s cost to design and manufacture the furniture ordered by
Gooding will be $6,300.
Required
As Furniture Land’s accountant, describe when the company should be recognizing revenue. Prepare all
journal entries related to the sale.
Endnotes
1
Joanna Pachner, “Why Online Gaming Is the New Social Media: Enthusiast Gaming CEO Adrian Montgomery Explains,” Toronto Star, May 7, 2021; Jaren Kerr, “Toronto Video Game Platform Enthusiast
Gaming to List Shares on Nasdaq in Bid to Attract U.S. Investors,” The Globe and Mail, April 13, 2021; Joe
O’Connor, “This Canadian Company Is Taking Aim at the $150-Billion-Plus Global Video-Game Industry,” Financial Post, March 15, 2021; Joe Castaldo, “Power-up Mode: Enthusiast Gaming Is Racing Ahead
of E-sports Rivals, But Can It Make Money?” The Globe and Mail, January 8, 2021; Enthusiast Gaming
Holdings Inc., 2020 Annual Report; Enthusiast corporate website, https://www.enthusiastgaming.com.
2
The Canadian Press, “Former Poseidon Concepts Executive Pays US$75K to Settle SEC Fraud Charges,”
Canadian Business, February 6, 2015; Tim Kiladze, “The Poseidon Misadventure,” Report on Business,
November 2016.
3
Canadian Tire Corporation, Limited, 2020 Annual Report.
4
CPA Canada, “Section 3400, Revenue,” in Accounting Standards for Private Enterprises (ASPE); International Accounting Standards Board, Discussion Paper: Preliminary Views on Revenue Recognition in
Contracts with Customers, December 2008.
5
“Returns,” Canadian Tire Corporation, Limited, accessed July 15, 2021, www.canadiantire.ca/en/customer-service/returns.html.
6
Ritchie Bros. Auctioneers Incorporated, 2020 Annual Report.
7
Expedia Inc., 2019 Annual Report.
8
CPA Canada, “Conceptual Framework,” in The Standards and Guidance Collection, part 1, International
Financial Reporting Standards.
9
Loblaw Companies Limited, 2020 Annual Report; Metro Inc., 2020 Annual Report; Empire Company
Limited, 2020 Annual Report.
WR studio/Shutterstock
CHAPTER 5
The Statement of Cash Flows
The Dash for Cash
When Joseph-Armand Bombardier created a gas-powered
“snow vehicle” in 1937, he probably never imagined that one
day, these Ski-Doos would be joined by a whole family of recreational vehicles and be sold in 130 countries.
Quebec-based Bombardier Recreational Products, or BRP,
was spun off from parent company Bombardier Inc. in 2003
and became a publicly traded company in 2013. BRP had $5.9
billion in revenues in its year ended January 31, 2021, from
products such as the iconic Ski-Doo snowmobiles and Sea-Doo
personal watercraft, Can-Am all-terrain vehicles, and Alumacraft jet boats.
As you would expect of a company that develops and
manufactures powersports vehicles and marine products,
BRP’s sales are seasonal, and they are highest during and just
before the season in which the items are used. For example,
retail sales of snowmobiles are highest in the fall and winter,
sales of boats are highest in the winter and spring, and sales
of personal watercraft are highest in the spring and summer.
BRP’s revenues tend to be higher in the second half of the fiscal year than in the first half.
BRP relies on net cash from operating activities such
as sales as its main source of liquidity—its ability to meet
its short-term obligations, including paying its more than
14,500 employees worldwide, investing in infrastructure and
facilities, and spending on research and development of new
products. Cash flows from operating activities are affected by
the seasonal nature of BRP’s sales—which the company says
can fluctuate substantially from quarter to quarter and from
year to year.
One way BRP helps manage its cash flows is to use a
form of “just-in-time” production so it doesn’t tie up too much
cash in raw materials or inventory. “The Company operates a
build-to-order process under which it manufactures products
based on dealer and distributor orders. It also manages a sales
and operations process through which it adjusts production
schedules on a weekly or monthly basis to precisely tailor production to incoming orders and market conditions,” BRP says
in its fiscal 2021 annual report. “Dealers and distributors also
have the opportunity to modify their orders during the season,
either quarterly, monthly or on an ongoing basis, depending
on the product line and the geography.”
BRP was also able to weather the impacts of the COVID19 pandemic. The lockdowns caused an economic slowdown
in many sectors but did not dampen sales of recreational vehicles, which remained popular with people seeking something
to do outdoors. BRP’s consolidated statement of cash flows for
the year ended January 31, 2021, shows that the company’s
cash position increased by almost $1.3 billion during the year,
including $954 million in cash generated from the company’s
operating activities.1
5-1
5-2
CH A PT ER 5
The Statement of Cash Flows 
CORE QUESTIONS
If you are able to answer the following questions, then you
have achieved the related learning objectives.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Introduction
• How is “cash” defined?
• Why is the statement of cash flows of significance to
users?
1. Understand and explain why the statement of cash
flows is of significance to users.
Differences between the Statement of Cash Flows
and the Statement of Income
• How does the statement of cash flows differ from the
statement of income?
2. Explain how the statement of cash flows and the
statement of income differ.
Understanding the Statement of Cash Flows
• What are the categories of cash flows presented in
the statement of cash flows and what are typical
transactions included in each category?
• Why is so much significance placed on cash flows from
operating activities?
3. Identify the three major types of activities that are
presented in a statement of cash flows and describe
some of the typical transactions included in each
category of activity.
• What is the difference between the direct and indirect
methods of preparing cash flows from operating
activities?
• What are the options for classifying cash flows related
to interest and dividends paid and received?
• Are there investing and financing activities that do not
appear on the statement of cash flows?
Preparing the Statement of Cash Flows Using the
Indirect Method
• How is a statement of cash flows prepared using the
indirect method for operating activities?
4. Prepare a statement of cash flows using the indirect
method for operating activities.
Preparing the Statement of Cash Flows Using the
Direct Method
• How is a statement of cash flows prepared using the
direct method for operating activities?
5. Prepare a statement of cash flows using the direct
method for operating activities.
Interpreting Cash Flow Information
• How can the information presented in a statement of
cash flows be used to manage a company?
• What can cash flow patterns tell us?
6. Interpret a statement of cash flows and develop
potential solutions to any cash flow challenges
identified.
Financial Statement Analysis
• How do we determine what portion of a company’s
current liabilities could be met with cash flows from
operating activities?
• How do we determine how much net free cash flow a
company generates?
7. Calculate and interpret a company’s operating cash
flow ratio and determine the amount of net free cash
flow being generated.
Introduction 5-3
5.1
Introduction
LEARNING OBJECTIVE 1
Understand and explain why the statement of cash flows is of significance to users.
How Is “Cash” Defined?
Take5 Video
Many users consider the statement of cash flows to be the most important financial statement in determining a company’s future prospects. As we saw in the feature story on Bombardier Inc., investors keep a close eye on the cash that is flowing into and out of a company.
This information is presented in the statement of cash flows, which categorizes the inflows
and outflows of cash into operating, investing, and financing activities.
The statement of cash flows explains the net change in a company’s cash position during
an accounting period. While it may sound simple, having an understanding of how “cash” is
defined for purposes of this statement is important. Cash normally includes both cash and cash
equivalents (see the Key Points). To be included as part of cash and cash equivalents, the
amounts must be available to meet short-term cash needs. As you would expect, cash includes
amounts the company has on hand, together with balances in demand deposits (chequing and
savings accounts) with banks and other financial institutions. Cash equivalents include shortterm, highly liquid investments. They must be convertible into known amounts of cash and be
maturing within the next three months, meaning that there is little risk of a change in their value
due to changes in interest rates or other economic factors. Investments in money market funds,
short-term deposits, and Government of Canada treasury bills are examples of cash equivalents.
Bank borrowings and repayments are normally considered to be cash inflows and outflows from financing activities. However, it is possible for certain borrowings to be considered
as cash equivalents. For example, if a company has used a bank overdraft facility or has
drawn on a line of credit from its bank, then the amount of the borrowing can be considered
“negative cash” and included in the determination of the company’s cash and cash equivalents. This is normally done when the overdraft facility or line of credit is used as part of the
company’s normal cash management strategy. In other words, the company regularly draws
on these, but then repays these borrowings as cash is collected from customers.
For Example
picturelibrary/Alamy
Stock Photo
Financial Statements Alimentation Couche-Tard Inc. reported the following cash and
cash equivalents at April 26, 2020, and April 28, 2019:2
The company also reported restricted cash in both years, which is cash that is not available
to meet short-term cash needs due to restrictions that have been placed on it. As a result of these
restrictions, the restricted cash balances do not meet the definition of cash and cash equivalents
and are excluded from the ­statement of cash flows analysis.
(amounts in millions of US dollars)
Consolidated Balance Sheets
As at January
31, 2021
As at April
26, 2020
$2,719.3
$3641.5
4.1
8.0
Assets
Current assets
Cash and cash
equivalents
Restricted cash
KEY POINTS
“Cash” includes:
• cash on hand;
• bank deposits;
• cash equivalents
(money market funds,
short-term deposits,
and treasury bills).
5-4
CH A PT ER 5
The Statement of Cash Flows
Why Is the Statement of Cash Flows
of Significance to Users?
In Chapter 4, we discussed the five-step process for revenue recognition and the measurement
of income. Although this is a very important perspective on a company’s performance, other
aspects that affect the company’s overall health are not adequately captured by the statement
of income. For example, creditors want to be able to assess a company’s ability to generate sufficient cash to service its debts (to pay interest and repay the principal as it comes due). The use
of accrual accounting means that the revenues and expenses on the statement of income do not
correspond to the company’s cash flows—inflows and outflows of cash—and therefore do not
provide all of the information that creditors need. Aside from assessing profitability, creditors
and other external users of financial information need some way to assess an organization’s
cash flows and predict its future cash position. The statement of cash flows provides this perspective on an organization’s performance, by summarizing its cash inflows and outflows and
highlighting the activities that resulted in the net change in its cash position during the period.
Having an understanding of how cash flows into and out of a company is critical for
users. The information presented in this statement enables users to:
• assess the company’s ability to generate cash flows from its core operations
• evaluate the cash flows the company has been able to obtain from investors (through the
issuance of new shares) and creditors (through new borrowings)
• assess the extent to which the company has invested cash to replace or add revenue-generating assets such as property, plant, and equipment
• determine the amount of cash that the company has used to repay debt
• evaluate the amount of cash dividends distributed to shareholders, together with the
sources of that cash
All of this information on the statement of cash flows provides financial statement users
with a historical perspective—how the company performed in prior periods. It is important to
note that the information in the statement of cash flows is also used on a predictive basis—to
help users assess what can be expected in future periods. Specifically, information on a company’s cash flows is used to:
• estimate the value of the company, because a number of commonly used business valuation techniques are based on estimated future cash flows
• assess the company’s ability to repay debt in the future
• evaluate the potential for the company to be able to pay dividends in the future
• estimate the company’s future cash requirements and assess these needs relative to the
company’s existing cash and short-term investment balances, together with the company’s
access to funding that has already been secured (that is, existing operating lines of credit)
The statement of cash flows also serves as a key tool for financial statement users because
it illustrates the relationships between the other statements. For example, while the statement of financial position shows the net change in property, plant, and equipment, and the
statement of income shows the amount of any gain or loss on the sale of property, plant, and
equipment, only the statement of cash flows will explain these amounts by presenting the
amount of property, plant, and equipment purchased during the period along with the proceeds received from any disposals of these assets.
The statement of cash flows also explains the changes in key account balances. For example,
while the statement of financial position may indicate the net change in a company’s long-term
debt (an increase or decrease), the statement of cash flows will explain the change. It will indicate how much the company has borrowed and how much principal it repaid during the year.
In Chapters 1 and 2, we discussed how the statement of cash flows summarizes a company’s cash inflows and outflows by the three categories of business activities: operating activities, investing activities, and financing activities. Understanding what is included in each of
these categories assists financial statement users in assessing the significance of the cash flows
reported for each.
Differences between the Statement of Cash Flows and the Statement of Income 5-5
The primary focus of most financial statement users will be on the company’s operating
activities. These are the lifeblood of any company and should generate a positive cash flow
(an inflow of cash). After all, the operating activities include all of the inflows and outflows
related to the sale of goods and services—the activities that the company provides in its normal operations. A positive cash flow from operating activities indicates that a company’s core
business operations are generating more cash than it is using. This net inflow of cash may then
be used for other activities, such as purchasing new capital assets, repaying debts, or paying
dividends to shareholders. A negative cash flow from operations indicates that a company’s
regular operating activities required more cash than they generated. This may suggest that
investments or capital assets may have to be sold and/or external sources of financing have to
be found in order to offset this cash outflow and enable the company to continue to operate.
Assessing a company’s cash flows from investing activities enables users to examine a
company’s decisions regarding the purchase or sale of property, plant, and equipment. If the
company has made any long-term investments in other companies or disposed of ones made
previously, the cash flows related to these transactions will also be reflected in this cash flow category. This information enables users to assess the company’s strategy when it comes to replacing the property, plant, and equipment required to continue operations or to determine whether
additional assets are being acquired to provide the capacity to grow the company’s operations.
Users will also examine a company’s financing activities to assess the decisions made
by management and/or the board of directors in relation to the company’s debt and equity.
They will determine whether the company incurred more debt or repaid principal during the
period. They will also assess whether new shares were issued, whether any shares were repurchased, and whether any dividends were declared and paid. This information enables users
to evaluate the company’s financial strength and strategy, as well as to estimate its reliance on
debt versus equity financing in the future.
Even those users who consider the statement of income to be the most important statement will examine it together with the statement of cash flows and statement of financial
position to more fully understand and analyze a company. As a future user of financial information, it is important that you know what to look for on the statement of cash flows and
understand what the amounts in its various categories mean. For this reason, we are going to
show you how the statement is developed and how you can analyze it.
For Example
Canadian Tire Corporation, Limited began its 2020 fiscal
year with $205.5 million in cash and cash equivalents and ended
the year with $1,327.2 million. Users of the company’s financial statements would want to determine the reasons behind
this $1,121.7-million increase in cash and cash equivalents. Did
it result from the company’s retail operations? Is it because the
company took on additional debt? Is it because the company sold
V. Ben/Shutterstock
V.
Ben/Shutterstock
significant amounts of property, plant, and equipment during the
year? Being able to determine the answers to questions like these is critical for users, and the statement of cash flows provides them with the answers.3
Differences between the Statement of Cash Flows
and the Statement of Income
5.2
LEARNING OBJECTIVE 2
Explain how the statement of cash flows and the statement of income differ.
5-6
CH A PT ER 5
The Statement of Cash Flows
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KEY POINTS
The statement of cash
flows differs from the
statement of income
because it:
• reflects the cash basis
rather than the accrual
basis of accounting;
• focuses on more than
just operating activities
(it includes investing
and financing
activities).
How Does the Statement of Cash Flows Differ
from the Statement of Income?
In each of the preceding chapters, we have discussed how financial statements, including
the statement of income, are prepared using the accrual basis of accounting rather than the
cash basis of accounting. As such, revenues are recognized on the statement of income when
they have been earned rather than when cash is received from customers. In fact, as we saw
in Chapter 4, determining when revenue has been earned has nothing to do with the receipt
of cash. In terms of expenses, we have learned that these are recognized when they have been
incurred under the accrual basis of accounting. Again, there are often differences between
when an expense is incurred and when it is paid in cash.
As a result, the statement of income measures a company’s performance for a period (usually
a month, quarter, or year) on an accrual basis (see the Key Points). While the revenue, expense,
and net income amounts presented on this statement are very important, they do not represent
cash flowing into and out of the business during that same period. If management is paying attention only to the statement of income and not to cash flows, they may think that all is well with the
company, in spite of a looming cash shortfall. For example, if a significant portion of a company’s
sales are on account, there is a time lag between the sale and the receipt of cash. If customers are
not paying these accounts on a timely basis, the company may be running short of cash in spite of
an increase in sales. Alternatively, if a company’s suppliers require it to pay for goods in advance
or to make upfront deposits, the company may be paying out cash well in advance of these items
becoming expenses; the payments would be accounted for as inventory or prepaid expenses. In this
case, in spite of a statement of income that portrays the company as profitable, the company could
also be running short of cash due to these payments. In other cases, companies can have significant non-cash expenses, such as depreciation and amortization. While these reduce net income,
they have no impact on the amount of cash a company is able to generate from its operations.
Another key difference between the two statements is that the statement of income
focuses only on the operating activities of a company. It reflects the profit or earnings generated from the company’s sales to its customers less the expenses the company incurred to
generate them. The statement of income does not reflect many of the transactions a company
has with its creditors (such as borrowing funds or repaying principal) or shareholders (such as
the proceeds of issuing shares or the payment of dividends). As such, even if there was little
difference in the timing of revenues and expenses being recorded and their receipt and payment in cash, the statement of income would tell users only part of the story.
Another difference is that information related to a company’s cash payments for the purchase of property, plant, and equipment or cash receipts from their sale is not included on a
company’s statement of income. These cash flows related to a company’s investing activities
can be very significant and would not be apparent to financial statement users relying solely
on the statement of income.
For Example
Sleep product retailer Sleep Country Canada Holdings Inc. had net income of $63.307 million during the year ended December 31, 2020, yet it repaid $132.000 million in debt, purchased
$17.657 million in property, equipment, and intangible assets, and paid $13.627 million in dividends during the year. It did all of this while borrowing only $34.200 million during the year. A
quick review of the company’s statement of cash flows, specifically the company’s cash flows from
operating activities, illustrates how this was possible. It turns out that Sleep Country had depreciation and amortization expenses of $56.873 million. While these expenses reduced net income,
they were non-cash charges. In fact, the company’s cash flow from operating activities was an
inflow of $145.308 million—an amount significantly different from net income. This example
illustrates why it is important for financial statement users to consider both the statement of
income and the statement of cash flows when assessing corporate performance.4
As its name implies, the statement of cash flows reports all transactions involving the
receipt or payment of cash. This is not restricted to those transactions resulting from a company’s operating activities, but includes those related to its investing activities (from the purchase
Understanding the Statement of Cash Flows 5-7
and sale of capital assets) and its financing activities (the transactions a company has with its
creditors and investors).
5.3
Understanding the Statement of Cash Flows
LEARNING OBJECTIVE 3
Identify the three major types of activities that are presented in a statement of cash
flows and describe some of the typical transactions included in each category of
activity.
What Are the Categories of Cash Flows Presented in
the Statement of Cash Flows and What Are Typical
Transactions Included in Each Category?
In Chapter 1, we discussed how all of the activities that companies engage in can be grouped
into three categories: operating activities, investing activities, and financing activities. We also
discussed how these categories provided the structure for the statement of cash flows. As
such, we will not repeat that discussion here. It is beneficial, however, to review examples of
the typical transactions included in each category of cash flows. This information is presented
in Exhibit 5.1.
EXHIBIT 5.1 Typical Transactions for Each Category of Cash Flows
Inflows:
• Cash sales to customers
• Collections of amounts owed by customers
• Collections of interest and dividends*
Typical Operating
Activities
Outflows:
• Purchases of inventory
• Payments of amounts owed to suppliers
• Payments of expenses such as wages, rent, and utilities
• Payments of taxes owed to the government
• Payments of interest*
Inflows:
Typical Investing
Activities
• Proceeds from the sale of property, plant, and equipment
• Proceeds from the sale of shares of other companies
Outflows:
• Purchases of property, plant, and equipment
• Purchases of shares of other companies
Inflows:
Typical Financing
Activities
• Borrowing money
• Issuing shares
Outflows:
• Repaying loan principal
• Paying dividends*
*Later in this section, we will learn that companies using IFRS have options in terms of how these cash flows are
classified. Companies using ASPE must classify these cash flows as indicated in Exhibit 5.1. Unless stated otherwise,
assume that throughout the text we will be using the classifications above for both the payment and receipt of interest
and dividends.
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CH A PT ER 5
The Statement of Cash Flows
In terms of the order in which the three categories of cash flows are presented on the
statement of cash flows, all companies present cash flows from operating activities first. Some
companies then present cash flows from investing activities, while others present cash flows
from financing activities. This is something to watch for when reviewing statements of cash
flows. In this chapter, cash flows from investing activities will be presented after cash flows
from operating activities, followed by cash flows from financing activities.
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 5-1
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KEY POINTS
Cash flows from
operating activities are
key because they:
• result from what the
company is in the
business of doing;
• are an important
source of financing for
the company’s growth;
• Demonstration Problem 5-1 in Wiley’s course resources
Why Is So Much Significance Placed on Cash Flows
from Operating Activities?
As previously noted, cash flows from operating activities normally receive the greatest scrutiny from financial statement users (see the Key Points). The cash flows in this category
result from the company’s normal activities: the sale of goods and services to customers. In
other words, these cash flows are generated from what the company is in the business of
doing. As such, it is natural that users focus on how successful the company has been at doing
that. Since these cash flows are generated by the company’s operations, they are considered to
be internally generated, as opposed to cash flows that come from sources outside the company,
such as from investors or creditors. It will be these operating cash flows that can be reinvested
to grow the company, to repay debt, or to fund dividends (see the Helpful Hint).
• are the source for
future debt repayments;
Helpful Hint
• are the source for
future dividend
payments.
If a company is able to generate positive cash flows from operating activities, you know that it will
likely succeed and will continue to operate in the future. An inability to ­generate operating cash
flows means that the company will face significant challenges in continuing to operate.
The Conceptual Framework
Faithful Representation and the Statement of
Cash Flows
The conceptual framework notes that “information about cash
flows helps users understand a (company’s) operations, evaluate
its financing and investing activities, assess its liquidity or solvency
and interpret other information about its performance.” Given the
emphasis placed on the various cash flow categories, it is essential
that management faithfully represent these by presenting them
in the appropriate category. For example, prior to adopting IFRS,
Sino-Forest Corporation, which traded on the TSX, treated
timber sales as cash flows from operating activities but timber purchases as investing activities. This resulted in the company having
positive operating cash flows and negative investing cash flows,
the normal pattern for a successful, growing company. When it
restated its results under IFRS for the first quarter of 2010, timber sales and timber purchases were both included in cash flows
from operating activities. This changed cash flows from operating
activities from a positive U.S. $51.4 million to a negative U.S. $122
million. This significant change would have given the users of the
company’s financial statements a very different perspective on the
company’s operations and future prospects.5
Without operating cash flows, a company’s ability to continue would depend upon it
being able to attract new capital by issuing additional shares or securing new loans. Neither of
these is a likely possibility if investors or creditors are not confident in the company’s ability
Understanding the Statement of Cash Flows 5-9
to generate the operating cash flows that could be used to pay dividends, grow the company,
make interest payments, or repay loan principal. Without operating cash flows or financing
cash flows, the only cash inflows available would come from the company selling some of its
property, plant, and equipment. They would, in effect, be “cannibalizing the company” by
selling its cash-generating assets. Obviously, this would not be a sustainable strategy.
For Example
Financial Statements Le Château Inc. and Danier Leather Inc. are two examples of
Canadian retailers that ceased operations, sought creditor protection, and liquidated their assets
after failing to generate sufficient sustainable cash inflows from their operating activities.
Le Château Inc. was a Canadian fashion retailer and manufacturer for more than 60 years.
When it sought creditor protection in October 2020, the company was operating more than 120
retail locations across the country. In its last five fiscal years, the company had a combined net loss
of approximately $190 million. During this period, the company’s net cash flows from operating
activities were negative, and the company’s founder financed ongoing operations by investing an
additional $50 million in the company. The company’s efforts to improve its operating results by
closing underperforming stores and growing its online sales were insufficient. This, coupled with
the impacts of the COVID-19 pandemic, meant that the company was unable to refinance its debt
or attract new investors. As the company was no longer able to meet its financial obligations, it
sought creditor protection and began liquidating its assets. It is not surprising that lenders and
investors were unwilling to provide funds to Le Château, as they look for companies with the
ability to generate both profit and cash flows from operating activities.
Danier Leather Inc. was a manufacturer and retailer of leather apparel and accessories with
more than 85 retail locations across Canada before it declared bankruptcy in March 2016. In the
company’s last two years of operations, its cash flows were as follows:
Year Ended
(in thousands of Canadian dollars)
June 27, 2015
June 28, 2014
$(11,698)
$ (4,907)
2,293
(48)
(3,174)
(6,079)
Decrease in cash
(12,579)
(11,304)
Cash, beginning of period
13,507
24,541
Net cash used in operating activities
Net cash (used in) generated from financing
activities
Net cash used in investing activities
Cash, end of period
$ 928
$ 13,507
The company’s inability to generate cash inflows from its operating activities resulted in
significant outflows of cash in both 2014 and 2015, with cash falling from $24.5 million to under
$1 million. The company was unable to attract a sufficient amount of additional debt or equity
financing, resulting in bankruptcy. This is not surprising, because both lenders and investors look
at cash flows from operations because these cash flows will be the source of debt repayment or
dividend distributions.6
What Is the Difference between the Direct and
Indirect Methods of Preparing Cash Flows from
Operating Activities?
When preparing the statement of cash flows, companies have to make a decision regarding
which method they will use for determining cash flows from operating activities. Accounting
standard setters have identified two acceptable methods: the direct method and the indirect
method. It is important to note that the total cash flows from operating activities are exactly
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C H A PTE R 5
The Statement of Cash Flows
KEY POINTS
• The direct and indirect
methods differ in how
the cash flows from
operating activities are
determined.
• Total operating cash
flows are the same
under both methods.
• The choice of methods
has no effect on
determining cash
flows from investing or
financing activities.
the same regardless of the method; the only difference is in how the amount is determined
(see the Key Points). The choice of method has no impact on determining cash flows from
investing or financing activities.
The indirect method is also known as the reconciliation method. This is because when
using the indirect method to determine cash flows from operating activities, the starting point
is net income. Since net income is determined using the accrual basis of accounting, a reconciliation is required to adjust it to a cash basis. This reconciliation is a strength of the indirect
method, in that it makes the linkage between net income and cash flows from operating activities very clear.
Rather than reconciling net income from the accrual basis of accounting to the cash basis,
the direct method directly presents a company’s operating cash flows by major category of
cash receipts and payments. These categories commonly include:
• receipts from customers
• payments to suppliers
• payments to employees
• payments of interest
• payments of income taxes
Supporters of the direct method believe that presenting operating cash flows by major category of cash receipts and cash payments provides greater transparency to financial statement
users.
Companies are encouraged to use the direct method for determining cash flows from
operating activities under IFRS and ASPE. Standard setters have indicated a preference for
the direct method because it is considered more informative than the indirect method, but
have given companies the option to choose which method they think best meets the needs of
the users of their financial statements. Even though standard setters have indicated that the
direct method results in more meaningful information, the vast majority of public companies
in Canada use the indirect method to determine cash flows from operating activities. This is
due to the perception among financial statement preparers that the direct method is more
complicated to apply. There are also perceptions that it is more costly to use this method due
to the accounting information that must be captured and the impacts on the design of the
financial reporting system.7
For Example
Many public transit systems have express buses and local buses.
Both types of buses can run from the same starting point to
the same destination. The difference is normally the number
of stops along the way, with express buses making fewer stops,
meaning riders get to their destination faster. The express
bus may take the highway, while the local bus winds through
neighbourhoods.
This provides a good analogy for the two methods for
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Wangkun
Jia/Shutterstock
determining cash flows from operating activities. Both methods start with the same financial statements. However, like an express bus, the direct method
has fewer “stops” in calculating cash flows from operating activities than the indirect method,
which is more like a local bus. Both methods get to the same destination in that they arrive at
exactly the same amount of cash flows from operating activities. The direct method focuses
only on cash transactions, “stopping” only to calculate them rather than adjusting net income
for non-cash transactions and changes in each of the company’s current assets and current
liabilities.
It is also important to note that, just like in our transit example, the view from each bus is
different. The direct method allows users to focus on cash flows, while the indirect method allows
users to see the differences between net income and cash flows from operations.
Understanding the Statement of Cash Flows 5-11
What Are the Options for Classifying Cash Flows
Related to Interest and Dividends Paid and
Received?
Companies using IFRS have choices to make in terms of how they classify payments and receipts
of interest and dividends. Interest paid and interest and dividends received can be classified as
operating activities because they flow through net income as expenses and revenues. Alternatively, the interest paid can be classified as a financing activity because it’s a financing cost, while
interest and dividends received can be classified as an investing activity because they are returns
on investments. Dividends paid can be classified as a financing activity or an operating activity.
Whatever classifications are selected must be applied consistently from period to period.
IFRS provides these options to enable companies to present them in a way that management believes is most informative to the users of its financial statements. For example,
enabling companies to classify interest payments as a financing activity rather than an operating activity enables users to see the cash flows related to management’s decision to finance
using debt (which results in payments of interest) versus equity (which can result in payments
of dividends) in the same classification category (financing activities) rather than having to
look at two categories (operating and financing activities). With respect to the payment of dividends, management may classify these as an operating activity rather than a financing activity
so that users can more easily assess the company’s ability to generate sufficient operating cash
flows to fund dividend payments or the extent of operating cash flows available after the payment of dividends for reinvestment in the company.
For Example
Financial Statements Leon’s Furniture Limited, a
retailer of home furniture, electronics, and appliances, prepares its financial statements in accordance with IFRS. The
company has used one of the classification options under
IFRS and classifies interest payments as a financing activity
rather than an operating activity.8
kevin brine/Shutterstock
brine/Shutterstock
LEON’S FURNITURE LIMITED
Excerpt from Consolidated Statements of Cash Flows
For the
(C$ in thousands)
Year ended
Notes
December
31, 2020
December
31, 2019
13
(71,076)
(66,149)
(44,636)
(43,313)
Financing activities
Payment of lease liability
Dividends paid
Decrease of employee loans—
redeemable shares
15
2,499
5,063
Repurchase of common shares
16
(48,202)
(10,158)
Repayment of term loan
14
(5,000)
(50,000)
(22,336)
(27,900)
(188,751)
(192,457)
Interest paid
Cash used in financing activities
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C H A PTE R 5
The Statement of Cash Flows
For the end of chapter problem material, unless it is stated otherwise in the question,
assume that:
• Receipts of interest and dividends will be classified as operating activities.
• Payments of interest will be classified as operating activities.
• Payments of dividends will be classified as financing activities.
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Are There Investing and Financing Activities That
Do Not Appear on the Statement of Cash Flows?
Yes, it is possible for a company to have investing and financing activities that do not appear
on the statement of cash flows. This would be the case if any of the following occurred:
• The company purchased property, plant, and equipment by assuming debt or issuing
shares rather than paying cash.
• The company acquired the shares of another company by assuming debt or issuing shares
rather than paying cash.
• The company repaid debt by issuing shares rather than paying cash.
Because no cash is exchanged in these transactions, there are no inflows or outflows of
cash and they would not be presented on the statement of cash flows. However, because these
transactions alter the nature of a company’s long-term assets and the manner in which the
company is financed, they are significant to financial statement users. As a result, standard
setters require that they be disclosed in the notes to the company’s financial statements so that
financial statement users are made aware of them.
For Example
Financial Statements EastWest Bioscience Inc. is a
British Columbia–based company engaged in developing hemp
nutritional products for people and pets. In 2020, the company engaged in a number of non-cash investing and financing activities. This included issuing 2,769,000 common shares,
rather than cash, to acquire another company. The company
also issued 6,282,271 shares in two transactions to settle debt.
Zoe Lyons/Shutterstock.com
The shares issued in these three transactions were valued at
$388,387. The details of these transactions were discussed in the notes to the company’s financial
statements. If the details of this transaction were not disclosed, users of EastWest Bioscience’s
financial statements would see that the company’s share capital increased by $388,387 in 2020
and assume that the company received cash for these shares.9
Preparing the Statement of Cash Flows Using
the Indirect Method
5.4
LEARNING OBJECTIVE 4
Prepare a statement of cash flows using the indirect method for operating
activities.
Preparing the Statement of Cash Flows Using the Indirect Method 5-13
How Is a Statement of Cash Flows Prepared Using
the Indirect Method for Operating Activities?
As was discussed in Chapter 1, the statement of cash flows is the final financial statement prepared. This is because information from the statement of income, the statement of financial
position, and the statement of changes in equity is required in order to complete the statement
of cash flows. As such, these other statements, together with some additional information,
will be provided as the basis for preparing the statement of cash flows. Additional information
is often provided related to the company’s purchases and sales of property, plant, and equipment or the extent of bank borrowings or principal repayments during the period.
As previously discussed, while standard setters have encouraged companies to use the
direct method, the vast majority of public companies use the indirect method. This is because
it is considered simpler to prepare and it uses information that is easily obtained within most
accounting systems (see the Key Points). The indirect method also provides users with useful
information because it highlights the differences between net income and cash flows from operating activities. Given the prevalence of the indirect method, we will use this method as the basis
for our initial discussions on preparing the statement of cash flows. We will review the direct
method later in the chapter, so you can understand how it differs from the indirect method.
There are a number of approaches that can be used to prepare the statement of cash
flows. These include the T account and worksheet approaches. Both of these are very mechanical and do not promote a deeper understanding of the concepts underlying the statement of
cash flows. We will illustrate the preparation of the statement of cash flows using a hybrid
approach, which is based on a structured framework involving some T account analysis, but
that also involves analyzing the information in the financial statements to logically determine
the related cash flows. An overview of this methodical approach to preparing the statement of
cash flows is presented in Exhibit 5.2.
General
1. Determine the net change in cash during the period.
2. Read any additional information provided and cross-reference it to the related statement of
financial position accounts.
Cash Flows from Operating Activities
3. Using the statement of income, record net income and adjust it for any non-cash items
included on the statement (such as depreciation and amortization expense) and/or items
that do not involve operating activities, (such as gains and losses from the sale of property,
plant, and equipment, or investments).
4. Determine the net change in each current asset and current liability account (except for the
Cash and Dividends Payable accounts) and record the impact that these changes had on cash.
Cash Flows from Investing Activities
5. Determine and record the cash proceeds received from selling property, plant, and equipment
and the cost of property, plant, and equipment purchased with cash during the period.
6. Determine and record the cash proceeds from the sale of shares of other companies (from
the sale of investments) and the cost of any investments in other companies purchased with
cash during the period.
Cash Flows from Financing Activities
7. Determine the amount of cash dividends paid during the period.
8. Determine and record the amount of cash received from borrowings made during the year
(new loans or increases to existing loans) and the amount of cash principal repaid on loans
during the period.
9. Determine the cash received from shares issued during the period.
General
10. Calculate the sum of the cash flows from operating, investing, and financing activities and
agree it to the net change in cash for the period as determined in Step 1.
KEY POINTS
Advantages of the
indirect method are:
• It is simpler to prepare.
• It uses information
available in most
accounting systems.
• It provides a linkage
between net income
and cash flows from
operating activities.
EXHIBIT 5.2 Steps for the
Preparation of the Statement
of Cash Flows
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C H A PTE R 5
The Statement of Cash Flows
Next, we will discuss how to apply this framework to the financial statements of a hypothetical company. The statement of financial position and statement of income for Matchett
Manufacturing Ltd. (MML) are presented in Exhibits 5.3 and 5.4. Additional information on
the company’s investing and financing activities is presented in Exhibit 5.5. The information
provided, while typical of many small companies, has been simplified for illustrative purposes.
Matchett Manufacturing Ltd.
EXHIBIT 5.3
Matchett Manufacturing
Ltd. Statement of Financial
Position
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Statement of Financial Position
As at October 31, 2024
2024
ASSETS
2023
Current assets
Cash
$ 19,050
$ 11,250
Accounts receivable
45,200
57,700
Inventories
76,500
49,000
Total current assets
140,750
117,950
Equipment
127,000
62,000
Accumulated depreciation, equipment
(25,200)
(35,000)
$242,550
$144,950
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Accounts payable
$ 38,600
$ 36,200
Income tax payable
1,200
3,800
Dividends payable
3,200
5,200
Total current liabilities
43,000
45,200
Loans payable
43,000
36,000
Common shares
Retained earnings
EXHIBIT 5.4
50,000
40,000
106,550
23,750
$242,550
$144,950
Matchett Manufacturing Ltd.
Matchett Manufacturing Ltd.
Statement of Income
Statement of Income
For the year ended October 31, 2024
Sales revenue
$480,000
Cost of goods sold
305,000
Gross profit
175,000
Expenses
Wages expense
53,900
Rent expense
13,250
Utilities expense
7,600
Depreciation expense
10,200
Income from operations
90,050
Other revenue and expenses
Gain on sale of equipment
3,900
Interest expense
(2,970)
Income before income tax
Income tax expense
Net income
90,980
4,980
$ 86,000
Preparing the Statement of Cash Flows Using the Indirect Method 5-15
The following additional information was gathered in relation to the company’s investing and
financing activities:
EXHIBIT 5.5
Matchett Manufacturing Ltd.
Additional Information
a. Equipment that had originally cost $25,000 and had a net carrying amount of $5,000 was sold
for $8,900 during the year.
b. No principal repayments were made on the loan during the year.
The completed statement of cash flows for MML Manufacturing Ltd. is presented in
Exhibit 5.6, with each line item referenced to the related step from the suggested framework.
EXHIBIT 5.6
Matchett Manufacturing Ltd.
Matchett Manufacturing Ltd.
Statement of Cash Flows
Statement of Cash Flows
For the year ended October 31, 2024
Cash flows from operating activities
Net income
$ 86,000
Step 3
10,200
Step 3
Less: Gain on sale of equipment
(3,900)
Step 3
Add: Decrease in accounts receivable
12,500
Step 4
(27,500)
Step 4
2,400
Step 4
Less: Decrease in income tax payable
(2,600)
Step 4
Net cash provided by operating activities
77,100
Add: Depreciation expense
Less: Increase in inventory
Add: Increase in accounts payable
Cash flows from investing activities
Add: Proceeds from the sale of equipment
Less: Purchase of equipment
Net cash used in investing activities
8,900
Step 5
(90,000)
Step 5
(81,100)
Cash flows from financing activities
Less: Payment of dividends
(5,200)
Step 7
Add: Proceeds of borrowing—loan payable
7,000
Step 8
Add: Proceeds from issuing common shares
10,000
Step 9
Net cash provided by financing activities
11,800
Net change in cash
$ 7,800
Ending cash
$ 19,050
Step 1
11,250
Step 1
$ 7,800
Steps 1 and 10
Opening cash
Net change in cash
Supplementary disclosures:
Cash paid for interest
$ 2,970
Cash paid for income tax
$ 7,580
We will now review each line item from MML’s statement of cash flows in greater detail.
The first two steps are general steps, which are required to set up the statement of cash flows.
Step 1. Determine the net change in cash during the period. This can be determined
by subtracting the balance of cash and cash equivalents at the beginning of the accounting
­period from the balance of cash and cash equivalents at the end of the accounting period.
MML began the year with $11,250 in cash and cash equivalents and ended the year with
$19,050. We can quickly see that the company’s cash balance increased by $7,800 during the
year. The statement of cash flows will explain how the company’s various activities resulted in
this increased cash balance.
5-16
C H A PTE R 5
The Statement of Cash Flows
Step 2. Read any additional information provided and cross-reference it to the related statement of financial position accounts. This step, which may seem overly simplistic,
will help to ensure that you remember to take the additional information into account when
you are analyzing the related account(s). Without this step, many students forget to use these
pieces of additional information, so give it a try and see if it helps you. In this case, item (a)
from Exhibit 5.5, which relates to the sale of equipment, should be cross-referenced to the
equipment account on the statement of financial position. Cross-referencing just means that
the letter “a” should be added beside “Equipment” on the statement of financial position. Item
(b) relates to the company’s loans, so the letter “b” should be added next to “Loans payable.”
As previously noted, the first section of the statement of cash flows to be prepared is the cash
flows from operating activities. This section determines what the company’s net income would
have been if the cash basis of accounting had been used rather than the accrual basis. The calculation starts with net income. Two types of adjustments are made to this amount. The first type of
adjustment removes the effects of non-cash items that appear on most statements of income and
any items that have been included in net income that do not result from operating activities. The
most common non-cash item is depreciation and amortization expense, while the most common
non-operating activity adjustments involve gains and losses from the sale of property, plant, and
equipment. The second type of adjustment removes the income effects of accrual accounting. Net
income is reduced by the amount of accrued revenues (because no cash has been collected in relation to them) and increased by the amount of accrued expenses (because no cash has been paid
in relation to them). This is done by calculating the changes in the company’s current asset and
current liability accounts. These two types of adjustments are the next two steps in the process.
Step 3. Using the statement of income, record net income and adjust it for any noncash items included on the statement (such as depreciation and amortization expense)
and/or items that do not involve operating activities (such as gains and losses from the
sale of property, plant, and equipment or investments). From MML’s statement of earnings, we can see that the company’s net income for the year was $86,000. We can also see that
the company reported $10,200 in depreciation expense. As an expense, it reduced net income
for the period, but because it did not involve cash, we add it back in order to determine what net
income would have been without this amount. Amortization expense is treated the same way.
MML also reported a gain of $3,900 from the sale of equipment during the year. Since
this transaction involved the sale of property, plant, and equipment, it is considered to be an
investing activity and does not belong in the operating activities section. Because the gain
increased net income, it has to be subtracted in order to eliminate it; that is, to determine
what net income would have been without it. If there had been a loss on the sale, the opposite
would have been done. Because losses reduce net income, they are added back to net income
in order to eliminate them. Gains and losses from the sale of investments in other companies
are treated the same way, because they are also investing rather than operating activities (see
the Helpful Hint).
Helpful Hint
It can be helpful to cross out the statement of income once you have determined net income, the
amount of any non-cash items, and the amount of any gains or losses from investing activities.
This ensures that you will not be tempted to go back and try to use any additional information
from the statement of income.
Step 4. Determine the net change in each current asset and current liability account (except for the Cash and the Dividends Payable accounts) and record the impact that these changes had on cash. In this step, net income is adjusted to remove the
effects of accrual accounting. This is done by calculating the change in each of the company’s
current asset and current liability accounts, with the exception of the Cash account (because
the change in this account, which was determined in Step 1, is what the statement of cash
flows is explaining) and the Dividends Payable account (because the payment of dividends is
a financing activity rather than an operating activity). Once the amount of the change in each
Preparing the Statement of Cash Flows Using the Indirect Method 5-17
current asset and current liability account has been determined, it is analyzed to determine
whether it resulted in cash flowing into or out of the company. For example, a net increase in
the Inventory account would indicate that goods had been purchased, resulting in an outflow
of cash. Alternatively, a decrease in Accounts Receivable would indicate that customers paid
their accounts, resulting in an inflow of cash.
From MML’s statement of financial position, we can see that:
• Accounts Receivable decreased by $12,500; the company began the year with receivables
of $57,700 and ended with $45,200. This means that the company’s customers paid their
accounts, resulting in a cash inflow (an increase in cash flows from operating activities).
• Inventory increased by $27,500; the company began the year with $49,000 in inventory
and ended with $76,500. This means that the company purchased goods, resulting in a
cash outflow (a decrease in cash flows from operating activities).
• Accounts Payable increased by $2,400; the company owed its suppliers $36,200 at the start of
the year and ended owing them $38,600. This tells us that some of the expenses on the statement of income have not yet been paid, so we need to add them back to determine what net
income would have been without them. Sometimes it can help to think about what the cash
flow impact would have been if the opposite had happened. In this case, if Accounts Payable
had decreased, it would be clear that the company paid some of its accounts, resulting in a cash
outflow. Since the Accounts Payable increased, we do the opposite and treat it as a cash inflow
by adding the amount back to net income (an increase in cash flows from operating activities).
• Income Tax Payable decreased by $2,600; the company owed the government $3,800 at
the beginning of the year, but only $1,200 at the end of the year. This means that the
company paid the government, resulting in a cash outflow (a decrease in cash flows from
operating activities).
Exhibit 5.7 provides explanations for how changes in current asset and current liability
accounts affect cash flows.
EXHIBIT 5.7 Analyzing the Impact of Changes in Current Assets and Current
Liabilities on Cash Flows
Account
Accounts
Receivable
Inventory
Prepaid Expenses
Accounts Payable
Deferred Revenue
Wages Payable
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Would net income have to
Change in
What does the change indicate happened in terms be increased or reduced to
account balance of the cash flowing into or out of the company? adjust it to the cash basis?
Increase
Sales were made on account, which would have increased
sales revenue, but the cash from these sales has yet to be
received.
Reduced
Decrease
Collections from customers owing the company exceeded
new sales on account.
Increased
Increase
Inventory was purchased, resulting in an outflow of cash.
Reduced
Decrease
Cost of goods sold includes inventory that was purchased
and paid for in a prior period and not fully replaced.
Increased
Increase
Payments were made for insurance coverage or rent for
future periods.
Reduced
Decrease
Expenses include amounts for insurance or rent that were
paid for in a prior period.
Increased
Increase
Expenses include the cost of goods or services that have
yet to be paid for.
Increased
Decrease
Suppliers were paid.
Reduced
Increase
Customers paid deposits for goods or services to be
provided in future periods.
Increased
Decrease
Sales revenue includes amounts that were prepaid by
customers in prior periods.
Reduced
Increase
Employees worked and wage expense was incurred, but it
has yet to be paid.
Increased
Decrease
Employees were paid amounts owing from prior periods.
Reduced
5-18
C H A PTE R 5
The Statement of Cash Flows
From the above, you can see that, when determining cash flow from operations, increases
in current assets have to be subtracted from net income on the statement of cash flows, while
decreases in current assets have to be added. We do the opposite for current liabilities: increases
have to be added to net income on the statement of cash flows, while decreases in current liabilities have to be subtracted. Exhibit 5.8 presents this in a tabular format. It can be useful to
use this to support your analysis.
EXHIBIT 5.8
Cash Flow Impact of Changes
in Current Assets and Current
Liabilities
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Increase
Decrease
Current Asset
−
+
Current Liability
+
−
Once we have completed Step 4, we can determine the cash flows from operating activities for the period. From Exhibit 5.6, we can see that MML’s cash flows from operating activities totalled $77,100. As previously discussed, we would normally expect cash flows from
operating activities to be positive, meaning that the company generated a net inflow of cash
from its operations.
Once cash flows from operating activities have been determined, we will then calculate cash
flows from investing activities. The process for doing this is outlined in Steps 5 and 6. In Step
5, the extent of the company’s cash investments in long-term revenue-generating assets is calculated, together with the cash proceeds received from the sale of these assets. Step 6 involves
determining the cash outflows related to long-term investments in other companies. This
includes outflows related to purchasing shares of other companies, together with the proceeds from disposing of these investments. It is important to note that some companies may
not make investments in the shares of other companies. As this is the case with MML, Step 6
would not be required. This is discussed further below (see the Helpful Hint).
Helpful Hint
It can be helpful to check off or cross out each account on the statement of financial position once
you have determined and recorded the cash flows related to it. This ensures that you do not forget
any accounts. It also allows you to quickly see which accounts have yet to be dealt with as you
begin to prepare each section of the statement of cash flows.
Step 5. Determine and record the cash proceeds received from selling property,
plant, and equipment and the cost of property, plant, and equipment purchased with
cash during the period. When beginning our analysis of the Equipment account, the note
we added in Step 2 would remind us that we were provided with the following additional
information:
a. Equipment that had originally cost $25,000 and had a net carrying amount of $5,000 was
sold for $8,900 during the year.
The sale of this equipment would be the first investing activity reported in MML’s cash
flows from investing activities. Since cash was received, this would increase the company’s
cash flows from investing activities.
Notice that the equipment that was sold had an original cost of $25,000 and a net carrying
amount of $5,000. Since the term net carrying amount is equal to the original cost minus the
accumulated depreciation, this is an indirect way of telling us that the accumulated depreciation on the equipment was $20,000 ($25,000 − $5,000).
Considerable detail is often provided about disposals of property, plant, and equipment
such as this. However, you should bear in mind that, for purposes of the statement of cash
flows, what really matters is the amount of cash that was received from the sale. In this case,
Preparing the Statement of Cash Flows Using the Indirect Method 5-19
the amount of cash is given, $8,900, so it can be entered directly into the statement of cash
flows.
MML’s Equipment account had a balance of $62,000 at the beginning of the period (from
Exhibit 5.3). Remember that this amount reflects the original cost of the equipment purchased
by the company. We also know, from the preceding step, that equipment with a cost of $25,000
was sold during the year. When the disposal was recorded, the cost of the equipment sold
would have been removed from the Equipment account, bringing its balance down to $37,000.
Since the balance at the end of the period was $127,000 (from Exhibit 5.3), we can deduce
that additional equipment costing $90,000 must have been purchased during the period. The
purchase, which would have resulted in an outflow of cash, would be recorded as a negative
amount under cash flows from investing activities.
EXHIBIT 5.9 T Account for
Equipment Purchased by
MML
Equipment
Beginning balance (from
Exhibit 5.3)
62,000
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25,000
Balance after sale of equipment
37,000
Cost of equipment purchased
90,000
Ending balance
(from Exhibit 5.3)
Cost of equipment sold (given)
This is the missing amount, which
will produce the ending balance.
127,000
Our analysis of the Equipment account is sufficient to identify all of MML’s investing
activities related to equipment, and there is no need to analyze the company’s Accumulated
Depreciation account. It represents the cumulative depreciation expense related to all of the
company’s equipment, but as we have discussed, depreciation is a non-cash transaction. As
such, changes in this account balance do not affect cash flows. In more advanced accounting
courses, it is possible that you will need to analyze this account if the selling price of any dispositions of property, plant, and equipment is not provided, but this is beyond the scope of an
introductory accounting course.
When an account such as Equipment is affected by more than one transaction during the
period, you may find it helpful to use a T account to organize the known data and determine
any missing amount. For example, Exhibit 5.9 shows how a T account could be used to determine how much equipment MML purchased in 2024.
Step 6. Determine and record the cash proceeds from the sale of shares of other
companies (the sale of investments) and the cost of any investments in other companies purchased with cash during the period. From the assets section of MML’s statement
of financial position, we can see that the company had no investments in the shares of other
companies at either the beginning or end of the year. As such, no further analysis is required
to complete this step. When preparing the statement of cash flows for companies that have
invested in other companies, any proceeds received from the sale of these shares during the
period are treated as cash inflows from investing activities, while the cost of any shares purchased during the period is treated as an outflow of cash from investing activities.
Once a company’s long-term asset accounts have been analyzed, the cash flows from investing
activities are complete. We can then move on to determine the company’s cash flows from
financing activities. Steps 7, 8, and 9 outline how this is done. Financing activities generally
involve changes to long-term liabilities and shareholders’ equity accounts. However, they can
also involve a few current liabilities (see the Helpful Hint). For example, in Step 4 of this
analysis, we found that MML had one current liability, Dividends Payable, which was related
to financing activities. Accordingly, the changes in this current liability account, as well as
the changes in each long-term liability and shareholders’ equity account, will be analyzed to
determine the cash flows from financing activities.
5-20
C H A PTE R 5
The Statement of Cash Flows
Helpful Hint
Remember that, although most current liabilities relate to operating activities, some, such as dividends payable, relate to financing activities. Other examples are short-term bank loans or notes
payable that have been used to obtain financing through borrowing.
Step 7. Determine the amount of cash dividends paid during the period. From
­Exhibit 5.3, we can see that MML began the year with dividends payable of $5,200 and ended
the year with a balance of $3,200. Recall that in Chapter 1, we learned that dividends were
a distribution of a company’s retained earnings to its shareholders. As such, our analysis of
the changes in the Dividends Payable account must be done in conjunction with an analysis
of the Retained Earnings account. From Exhibit 5.3, we see that MML’s Retained Earnings
account had a balance of $23,750 at the beginning of the period and an ending balance of
$106,550. The key to analyzing this $82,800 increase in Retained Earnings is to remember
what affects this account. Each period, it is increased by net income (or decreased by a net
loss) and decreased by any dividends declared. Because MML had net income of $86,000 in
2024, we would have expected the company’s Retained Earnings balance to increase by this
amount. Since it only increased by $82,800, we can deduce that dividends of $3,200 must have
been declared during the year. However, the payment of dividends can take place weeks after
they have been declared. As such, it is possible that dividends that have been declared near
the end of an accounting period remain unpaid. An analysis of the Dividends Payable account
will enable us to determine the amount of dividends that have been paid. If MML began the
year with dividends payable of $5,200 and dividends of $3,200 were declared during the year,
the company would have had a dividends payable balance of $8,400. Because the company’s
ending balance in its Dividends Payable account was $3,200, we know that dividends of $5,200
were paid during the year. The payment of these dividends would be an outflow of cash and
reported as a negative cash flow from financing activities.
Exhibit 5.10 shows another example of how a T account can help you organize the known
data and determine a missing amount. It shows how the Dividends Payable and Retained
Earnings accounts can be used to determine the amount of dividends that MML declared and
paid during the year.
EXHIBIT 5.10
T Account to Determine
Dividends Declared and Paid
by MML
Retained Earnings
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Dividends declared during year
23,750
Beginning balance (from Exhibit 5.3)
86,000
Net income for 2024 (given)
109,750
Balance after earnings added
3,200
This is the missing amount, which
will produce the ending balance
106,550
Ending balance (from Exhibit 5.3)
Dividends Payable
Dividends paid during year
5,200
Beginning balance (from Exhibit 5.3)
3,200
Dividends declared during the year
(determined above)
8,400
Balance
5,200
This is the missing amount, which
will produce the ending balance
3,200
Ending balance (from Exhibit 5.3)
Preparing the Statement of Cash Flows Using the Indirect Method 5-21
Step 8. Determine and record the amount of cash received from borrowings (new
loans or increases to existing loans) made during the year and the amount of cash
principal repaid on loans during the period. When beginning our analysis of the Loans
Payable account, the note we added in Step 2 would remind us that we were provided with the
following additional information:
b. No principal repayments were made on the loan during the period.
From this note, we know that MML had no cash outflows related to the repayment of
principal on its loan payable during the year.
By looking at the Loans Payable account on MML’s statement of financial position
(Exhibit 5.3), we can see that the account increased by $7,000 during the year. The Loans Payable account had a balance of $36,000 at the beginning of the period and an ending balance of
$43,000. From this, we know that the company must have borrowed at least $7,000 during the
period. Since we know that the company repaid no principal on its loans during the year, we
can deduce that this increase represents all of the company’s borrowings. That is, there are no
principal repayments netted against it. These new borrowings would have resulted in an inflow
of cash and would be recorded as a positive amount under cash flows from financing activities.
Exhibit 5.11 is another example of how a T account can help you organize the known
data and determine a missing amount. It shows how the Loans Payable account can be used
to determine the principal repayments that MML made during 2024.
EXHIBIT 5.11
Loans Payable
Loan principal repaid during
year (given)
—
36,000
36,000
This is the missing amount,
which will produce the ending
balance.
7,000
43,000
Beginning balance (from Exhibit 5.3)
Balance after principal repayments
New borrowings
Ending balance (from Exhibit 5.3)
Step 9. Determine the cash received from shares issued during the period. From
­Exhibit 5.3, we can see that MML’s Common Shares account increased by $10,000 during the
year. The account balance was $40,000 at the beginning of the year and $50,000 at the end.
This tells us that that company must have issued new common shares during the year and
received proceeds of $10,000. The issuance of shares is a financing activity, and the proceeds
are recorded as a cash inflow.
Step 10. Calculate the sum of the cash flows from operating, investing, and financing activities and agree it to the net change in cash for the period as determined in
Step 1. We can now complete MML’s statement of cash flows by simply entering a subtotal
for each of the three sections, and then combining these into an overall net change in cash for
the period. This has been done in Exhibit 5.6. We then check that the total of the cash flows
determined for the three categories equals the overall change in cash for the period that was
determined in Step 1. In Step 1, we determined that MML’s cash balance had increased by
$7,800 during the period. This is equal to the total of cash flows from operating activities (an
inflow of $77,100), cash flows from investing activities (an outflow of $81,100), and cash flows
from financing activities (an inflow of $11,800).
Finally, to assist users in their analysis of cash flows, standard setters require a few additional pieces of cash flow-related information to be disclosed. Specifically, companies are
required to disclose the amount of:
• interest paid and received during the period
• dividends paid and received during the period
• income taxes paid during the period
Loans Payable T Account for
MML
5-22
C H A PTE R 5
The Statement of Cash Flows
These disclosures can be presented at the end of the statement of cash flows or in the
notes to the financial statements. MML has included the amount of dividends paid in its cash
flows from financing activities, so no additional disclosure is required. The company’s interest
expense for the period was $2,970 (per Exhibit 5.4) and the company had no Interest Payable
account. As such, this amount represents the interest paid by the company during the year.
The company’s income tax expense for the period was $4,980 (per Exhibit 5.4), but, as we saw
in Step 4, the company also paid $2,600 in taxes owing at the beginning of the period. As such,
the company’s total payments related to income taxes were $7,580, and this is disclosed at the
bottom of the statement of cash flows (Exhibit 5.6). No information is provided regarding any
interest or dividends received by MML, so we will assume that there were none during the
period.
Now that we have prepared a statement of cash flows, let’s step back and consider how
the various components of the financial statements were used. We have seen that the information on the statement of income was used exclusively in the determination of cash flows
from operating activities. The various components of the statement of financial position are
each linked to the determination of cash flows from specific activities. These relationships are
presented in Exhibit 5.12.
EXHIBIT 5.12 The Statement
of Cash Flow Classification of
Components of the Statement
of Financial Position
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Statement of Financial Position
Assets
Operating
Current Assets
Investing
Non-Current Assets
Liabilities
Operating*
Current Liabilities
Financing
Non-Current Liabilities
Financing
Shareholders’ Equity
*with the exception of dividends payable, which is normally financing
Assess Your Understanding
Attempt the following problems and review the solutions provided:
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• Chapter End Review Problem 5-2
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• Demonstration Problems 5-2 and 5-3 in Wiley’s course resources
Some companies present visualizations of their cash flow information. These visualizations
can be used to illustrate why the company’s cash balances have changed, making it easy for
financial statement users to see the extent of the impact each category of cash flows had. Exhibit
5.13 provides an example of a cash flow visualization for Matchett Manufacturing. This is a
summary of the details provided in the statement of cash flows presented in Exhibit 5.5 above.
EXHIBIT 5.13 Matchett
Manufacturing Ltd. Cash Flow
Visualization
2024
Cash flows from operating activities
$77,100
Cash flows from investing activities
(81,100)
Cash flows from financing activities
11,800
Net change in cash
7,800
Opening cash
11,250
Ending cash
$19,050
Preparing the Statement of Cash Flows Using the Indirect Method 5-23
EXHIBIT 5.13 Matchett
Manufacturing Ltd. Cash Flow
Visualization (continued)
Matchett Manufacturing—Cash Flow Visualization
$100,000
Investing
activities
$81,100
Operating
activities
$77,100
90,000
80,000
70,000
60,000
50,000
Dollars
40,000
30,000
20,000
10,000
Ending cash
$19,050
Financing
activities
$11,800
Opening cash
$11,250
$0
Increase
Decrease
Total
For Example
Financial Statements Nutrien Ltd.’s 2020 annual report included the following visualization
related to the company’s cash flows. It provides the users of Nutrien’s financial statements with another
way to interpret the changes to the company’s cash and cash equivalents during those periods.10
Sources and Uses of Cash
Our cash flows from operating, investing and financing activities are summarized in
the following table:
(millions of US dollars, except as otherwise noted)
2020
2019 % Change
Cash provided by operating activities
3,323
3,665
(9)
Cash used in investing activities
(1,204) (2,798)
(57)
Cash used in financing activities
(1,339) (2,479)
(46)
Effect of exchange rate changes on cash and cash
equivalents
3
(31)
n/m
Increase (decrease) in cash and cash equivalents
783
(1,643)
n/m
Cash Flows 2019 and 2020
1.5
December 31, 2020
(1.3)
Financing activities
Investing activities
(1.2)
Operating activities
3.3
January 1, 2020
0.7
December 31, 2019
0.7
(2.5)
Financing activities
(2.8)
Investing activities
3.7
Operating activities
January 1, 2019
2.3
0
1
2
3
($ billions)
4
5
6
5-24
C H A PTE R 5
The Statement of Cash Flows
Preparing the Statement of Cash Flows Using the Direct
Method
5.5
LEARNING OBJECTIVE 5
Prepare a statement of cash flows using the direct method for operating activities.
How Is a Statement of Cash Flows Prepared Using
the Direct Method for Operating Activities?
The direct method of preparing cash flows from operating activities differs from the indirect
method only in how the operating cash flows are determined and presented, but total cash
flows from operating activities are the same under either method.
Rather than reconciling net income from the accrual basis of accounting to the cash basis,
the direct method directly presents a company’s operating cash flows by major category of
cash receipts and payments. These categories commonly include:
• receipts from customers
• payments to suppliers
• payments to employees
• payments of interest
• payments of income taxes
Essentially, the company is adjusting each line of the statement of income (sales revenue,
cost of goods sold, wage expense, and so on) from the accrual basis to the cash basis, rather
than just the bottom line (net income). For example, to determine its receipts from customers, a company will start with the sales revenue reported on the statement of income and
then adjust it to remove the amount of sales made on account that have yet to be collected
and increase it by collections on customer receivables outstanding from prior periods. Similar
steps will be taken to adjust the expenses presented on the statement of income. For example,
to determine its payments to employees, a company will start with the wage expense reported
on the statement of income and then adjust it to remove the wages that remain unpaid and
increase it for any payments made to employees of wages owing from prior periods.
Exhibit 5.14 illustrates how each of the common categories of cash receipts and payments can be determined.
EXHIBIT 5.14 Direct Method:
Determining Cash Receipts/
Payments from Common
Categories
Category
Starting Point (from
Statement of Income)
Adjustments (from Statement
of Financial Position)
Receipts from customers
Sales Revenue
+/− Change in Accounts Receivable
Payments to suppliers
Expenses other than:
+/− Change in Inventory
• Wages Expense
+/− Change in Prepaid Expenses
• Interest Expense
+/− Change in Accounts Payable
+/− Change in Deferred Revenue
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• Income Tax Expense
• Depreciation and
Amortization Expense
Payments to employees
Wages Expense
+/− Change in Wages Payable
Payment of interest
Interest Expense
+/− Change in Interest Payable
Payment of income taxes
Income Tax Expense
+/− Change in Income Tax Payable
Preparing the Statement of Cash Flows Using the Direct Method 5-25
We can apply these steps to the information from Exhibits 5.3 and 5.4 to determine the
cash flows from operating activities for Matchett Manufacturing Ltd. using the direct method,
as shown in Exhibit 5.15.
EXHIBIT 5.15 Cash Flow from Operating Activities: Direct Method
Category
Starting Point (from
Statement of Income)
Adjustments (from Statement of
Financial Position)
Total
B
=A+B
12,500
492,500
A
Receipts from customers
Sales Revenue
480,000
Change in Accounts Receivable
Change in Deferred Revenue
Payments to suppliers
Cost of Goods Sold
(305,000)
Rent Expense
Utilities Expense
Change in Inventory
N/A
(27,500)
(13,250)
Change in Prepaid Expenses
N/A
(7,600)
Change in Accounts Payable
2,400
(350,950)
Payments to employees
Wages Expense
(53,900)
Change in Wages Payable
N/A
(53,900)
Payment of interest
Interest Expense
(2,970)
Change in Interest Payable
N/A
(2,970)
Payment of income taxes
Income Tax Expense
(4,980)
Change in Income Tax Payable
(2,600)
(7,580)
CASH FLOWS FROM OPERATING ACTIVITIES
Notice that the total cash flows from operating activities is $77,100, the same amount
that was determined using the indirect method. Also notice that Column B reflects the exact
same analysis that was required in Step 4 of the indirect method. Finally, note that it is not
necessary to have an adjustment for depreciation and amortization expenses (because these
are non-cash transactions), nor for any gains and losses (because these are related to investing
activities), because we are not starting our analysis with net income.
Other categories can be used under the direct method. Some companies separate payments to suppliers and payment of other operating expenses. Some companies combine payments to suppliers and employees. Also, if a company has earned interest income, it would
have a category presenting the receipts of interest.
While standard setters and many financial statement users have indicated a preference
for the direct method, the vast majority of public companies in Canada, the U.S., and other
countries use the indirect method. Research has supported these user preferences as it has
found that cash flow statements prepared using the direct method provide investors and analysts with more useful information than is available when the indirect method is used. While
there have been calls for standard setters to mandate use of the direct method, these have gone
unheeded to date.11
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 5-3
• Demonstration Problem 5-4 in Wiley’s course resources
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77,100
5-26
5.6
C H A PTE R 5
The Statement of Cash Flows
Interpreting Cash Flow Information
LEARNING OBJECTIVE 6
Interpret a statement of cash flows and develop potential solutions to any cash flow
challenges identified.
How Can the Information Presented in a Statement
of Cash Flows Be Used to Manage a Company?
Managing cash flows is a key challenge for most companies. It is essential that management
have information on the cash flows from the company’s operating, investing, and financing
activities. This information can then be analyzed to determine whether there may be opportunities to enhance cash inflows and/or minimize cash outflows. The causes of cash flow
challenges can be found in the statement of cash flows, and management can then develop
strategies to address them. Common cash flow challenges include:
• significant increases in sales volumes
• lengthy cash-to-cash cycles
• undercapitalization (or inadequate financing)
KEY POINT
The longer a company’s
cash-to-cash cycle, the
more pressure is placed
on cash flows.
We will look at each of these challenges in more detail.
While significant increases in sales volumes are a positive sign for a company, they can
lead to cash flow challenges. These increased sales require companies to purchase or produce
more and more inventory, as well as to expand their storage and operating capacity. Purchasing additional inventory and/or expanding production and storage capacity requires cash. This
challenge is very common among start-up companies, which can often experience rapid growth
of sales. Without adequate cash flow, these companies can “grow” themselves out of business.
Compounding the growth problem is the presence of a lengthy cash-to-cash cycle. As
illustrated in Exhibit 5.16, this cycle is the time between when a company pays out cash
to purchase goods or raw materials for manufacturing products and when those goods are
­ultimately paid for by the customer. The longer the cash-to-cash cycle, the greater the company’s cash requirements, and this issue is magnified in periods of high sales growth (see the
Key Point). Again, start-up companies often face challenges in this area because suppliers
require them to pay for goods and raw materials upfront, but it may take weeks or months
before the start-up is able to sell the product and collect from customers. As we saw in our
feature story on BRP, seasonal cash cycles for can also place pressure on cash flows.
EXHIBIT 5.16 The Cash-to-
Cash Cycle
Purchase of
inventory
(cash outflow)
Cash on hand
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1
Payments by
customers
(cash inflow)
2
Sale of goods
on account
1
Goods may be on hand for 30–90 days
2
Customers may have 30 or more days of free credit
Interpreting Cash Flow Information 5-27
Finally, companies, especially start-ups, can be undercapitalized; that is, they are not sufficiently financed. It is common for companies to begin operations without a large enough
pool of cash. This may be due to borrowing limitations or an inability to raise cash through the
issuance of shares. When the company faces the need for a large amount of cash due to rapid
growth, a lengthy cash-to-cash cycle, or the need to purchase capital assets, it may not have
sufficient cash reserves to get through prolonged periods of net cash outflows.
Each of these challenges would be evident on the company’s statement of cash flows. For
example, significant cash outflows to purchase inventory, payments to suppliers and employees, or increases in accounts receivable would be reported in the company’s cash flows from
operating activities. Significant cash payments for property, plant, and equipment would be
reflected in the company’s cash flows from investing activities, while a lack of cash inflows
from financing activities could also be observed.
Companies can resolve the common cash flow challenges by taking the following measures.
1. Alleviate cash flow problems by reducing the rate of growth.
One way to solve cash flow challenges is to slow down the sales growth rate. However,
reducing the growth rate may not be the best response because it will reduce revenue and
net income and may hurt the company in the long run, as it attempts to develop a strong
customer base. Limiting the growth in sales may divert customers to competing companies and, if these customers develop loyalties to the competitors, a company’s long-term
potential may be reduced. Regardless of these concerns, it may be a necessary step for
companies facing cash flow challenges related to growth.
2. Alleviate cash flow problems by shortening the cash-to-cash cycle.
Shortening the company’s cash-to-cash cycle is another way to improve cash flow. There
are many ways to do this. For example, increasing the amount of cash sales, accepting
credit cards, or reducing the credit period for customers who buy on account would all
reduce the cash-to-cash cycle. Alternatively, negotiating with suppliers to be able to purchase on credit would also reduce the cash-to-cash cycle; however, this generally requires
the company to have established its creditworthiness to suppliers, which takes time.
Companies have to carefully consider the sales terms they provide their customers. Customers may not be happy with having to pay cash or with reduced credit periods and may
be able to get better terms from competitors. While accepting credit cards would enable
the company to collect its receivables more quickly, credit card companies charge fees and
these additional costs will affect overall profitability.
3. Alleviate cash flow problems by increasing the amount of capitalization.
Another way to solve the cash flow concerns is to address any undercapitalization problem; that is, to raise additional cash through financing activities. Two typical ways of
doing this are to issue additional shares (equity financing) or to borrow the cash (debt
financing). If additional shares are issued, it may dilute the ownership interest of existing
shareholders, so this may be an unpopular decision. If the company enters into new borrowing arrangements, the company will have to service this debt by paying interest and
repaying principal in future periods. Therefore, this may only be a short-term solution to
the company’s cash flow problems.
It should now be clear to you that (1) cash flow considerations are extremely important,
and (2) the statement of cash flows provides additional information that is not captured by
either the statement of income or the statement of financial position. For managers or other
financial statement users, it is important to understand the relationship between the company’s net income, its cash-to-cash cycle, and its statement of cash flows. It is also extremely
important when evaluating a company’s performance and cash position to understand how
its receivables, payables, and inventory policies affect its cash flows.
Management and other financial statement users can also use three basic questions as a
starting point for analyzing the statement of cash flows:
1. Is the cash from operating activities sufficient to sustain the company over the long term?
A company can be healthy in the long run only when it produces sufficient cash from
its operations. Although cash can be obtained from financing activities (issuance of new
debt or shares) and from investing activities (the sale of investments or capital assets),
5-28
C H A PTE R 5
The Statement of Cash Flows
there is a limit to the cash inflows that can be achieved from financing and investing
activities. Financing inflows are limited by the willingness of lenders and shareholders
to invest their money in the company. As the level of debt rises, so does the risk; consequently, the interest rate that must be paid will also increase. At some level of debt, the
company becomes so risky that lenders simply will not lend more. Investing inflows are
limited by amount of property, plant, and equipment that the company can dispose of
and still remain in operation or the extent of any investments it has in the shares of other
companies that can be sold. When the inflows from financing and investing are limited,
if a company is to remain in business, it must generate sufficient cash inflows from operating activities to make the principal, interest, and dividend payments associated with the
financing activities, and to continue investing at appropriate levels in property, plant, and
equipment and other long-term assets.
2. Do any of the items on the statement of cash flows suggest that the business may be having problems?
For example, a large increase in accounts receivable may indicate that the company is
having difficulties collecting its receivables. A large increase in inventories may indicate
that it is having trouble selling its products. A large increase in accounts payable may
indicate that the company is having difficulty paying its bills. Large disposals of property,
plant, and equipment may indicate that it is contracting, rather than expanding.
3. Of the sources and uses of cash, which ones are related to items or activities that will
continue from period to period, and which are sporadic or non-continuing?
A large source or use of cash in one period may not have long-term implications if it will
not continue in the future. To address this question, the historical trend in the cash flow
data must be considered. While some users will be interested in what has happened to
cash in the current period, most are likely to be more interested in predicting the company’s future cash flows. For example, a bank loan officer wants assurance that, if money is
lent to the company, the company will be able to pay it back. A stock analyst, on the other
hand, will want to know what cash flows can be expected over a long period of time, to
ensure an adequate return on an investment in the company’s shares. Users interested in
the company’s future will analyze this statement to try to decide which cash flows will
continue in the future and which will not.
Ethics in Accounting
There are a number of actions that management can take that
improve a company’s cash flow from operating activities in the
short term, but that may be detrimental to the company over
the long term. For example, delaying payments to suppliers and
employees would improve operating cash flows, but may jeopardize relationships with suppliers and upset employees. Delaying
inventory purchases would also improve operating cash flows, but
could result in lost sales due to stockouts.
What Can Cash Flow Patterns Tell Us?
KEY POINTS
The most common
cash flow patterns are
(Operating / Investing /
Financing):
+/−/+
+/−/−
A company’s cash flow pattern is the direction (positive or negative) of its cash flows in
the three categories: operating, investing, and financing. Given the three categories and that
each could be positive (a net inflow of cash) or negative (a net outflow of cash), there are
eight possible cash flow patterns. These are presented in Exhibit 5.18. Reviewing a company’s cash flow pattern can provide financial statement users with a quick means of initially
assessing its financial condition. Of course, the dollar amount of each category is also critical,
but the pattern helps users to quickly identify situations where more in-depth analysis would
be required.
While it is possible to find companies that fit into each of the patterns, the majority of
public companies fit into pattern 3 (+ / − / +) or 4 (+ / − / −) (see the Key Point). These
companies are generating positive cash flows from their operating activities and are continuing to grow and replace property, plant, and equipment, which means negative cash flows
from investing activities. They are either able to attract new debt or investors to finance part
Interpreting Cash Flow Information 5-29
of this growth, which means positive cash flows from financing activities, or are repaying debt
and paying dividends, which means negative cash flows from financing activities. These two
common cash flow patterns are illustrated in Exhibit 5.17.
Operating
Activities
$
$
Cash and cash
equivalents
$
EXHIBIT 5.17 The Two Most
Common Cash Flow Patterns
Investing
Activities
$
Financing
Activities
For Example
Earlier in the chapter, we discussed Danier Leather Inc.,
which declared bankruptcy in March 2016. The company’s cash
flow patterns for its last two years of operation (June 27, 2015,
and June 28, 2014) were as follows:
Sergmam/Shutterstock
Operating
Investing
Financing
2015
−
−
+
2014
−
−
−
These basic patterns can quickly tell you a lot about the company. We can see that the company
struggled to generate cash flow from its operations, repaid more capital than it attracted in 2014,
yet continued to expand its operations and was able to attract some new financing in 2015. Of
course, it would be important to analyze the cash flow results in more detail as well as to consider
the dollar amounts of each cash flow, but this analysis would confirm the initial understanding
provided by the cash flow pattern.12
Exhibit 5.18 outlines the profile of the company that would fit within each cash flow
pattern. Being able to link the profile with the cash flow patterns enables financial statement
users to develop expectations in terms of cash flows for companies they are analyzing. Cases
in which the actual pattern differs from the expected pattern highlight the need for additional
analysis.
EXHIBIT 5.18 Cash Flow Patterns13
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Cash Flow
from Operating
Activities
Cash Flow
from Investing
Activities
Cash Flow
from Financing
Activities
+
+
+
1. Successful, but actively repositioning or relocating using
financing from operations together with cash from creditors
and shareholders
+
+
−
2. Successful, mature company that is downsizing and
returning capital to shareholders or repaying debt
+
−
+
3. Successful and growing, with growth partially financed by
creditors and shareholders
+
−
−
4. Successful, with operating activities providing sufficient cash
to finance growth and repay debt or pay dividends
Pattern Number and Company Profile
(continued)
5-30
C H A PTE R 5
The Statement of Cash Flows
EXHIBIT 5.18 Cash Flow Patterns (continued)
Cash Flow
from Operating
Activities
Cash Flow
from Investing
Activities
Cash Flow
from Financing
Activities
−
+
+
5. Struggling, but using cash inflows from the sale of property,
plant, and equipment and new borrowings to remain in
operation
−
+
−
6. Struggling and using cash from the sale of property, plant,
and equipment to repay creditors
−
−
+
7. A start-up or a struggling company that is able to attract
financing for growth or reorganization
−
−
−
8. Struggling, but using existing cash balances to cover losses,
purchase property, plant, and equipment, and repay creditors
Pattern Number and Company Profile
Assess Your Understanding
Attempt the following problems and review the solutions provided:
• Chapter End Review Problem 5-4
• Demonstration Problem 5-5 in Wiley’s course resources
5.7
Financial Statement Analysis
LEARNING OBJECTIVE 7
Calculate and interpret a company’s operating cash flow ratio and determine the
amount of net free cash flow being generated.
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How Do We Determine What Portion of a
Company’s Current Liabilities Could Be Met with
Cash Flows from Operating Activities?
Companies must be able to generate cash from their operating activities that is sufficient to
repay their current and long-term liabilities. There are a number of cash flow ratios that are
used to assess a company’s ability to meet its liabilities through its operating cash flows. We
will focus on one of these ratios, the operating cash flow ratio. This ratio is determined as
follows:
Operating cash flow ratio =
Cash flows from operating activities
Current liabilities
This ratio measures the percentage of a company’s current liabilities that could be met
with one year’s operating cash flows. It focuses on the company’s current liabilities, as these
are due within the next year. The higher the ratio, the better able the company is to meet its
current liabilities with the cash it generates from its operating activities. A ratio of 1 or more
indicates that the company is generating sufficient operating cash flows to cover all of its current liabilities. A ratio of less than 1 indicates that the company would need additional cash
flows from either financing or investing activities to meet its current liabilities.
Financial Statement Analysis
It is worth noting that some current liabilities will not be paid in cash. For example,
deferred revenues are often settled by providing services to customers. Maturing debt may be
refinanced rather than repaid. Also, the company may have other assets that could be used to
settle these liabilities, such as investments in the shares of other companies. In these circumstances, this ratio can safely be less than 1.
The operating cash flow ratio for Dollarama Inc. for the years ended January 31, 2021,
and February 2, 2020, are as follows:
($ in thousands)
2021
Operating cash flow ratio =
$889,082
= 0.673
$1,321,165
2020
$732,508
= 0.671
$1,092,484
From this, we can see that Dollarama’s cash flows from operating activities in 2021 could cover
67.3% of the company’s current liabilities. This was a slight increase from 2020, when it was
able to cover 67.1% of its current liabilities with its operating cash flows. It is worth noting that
approximately 63% of Dollarama’s current liabilities relate to debt that is maturing in the next
year. It is likely that at least a portion of this will be refinanced rather than repaid. Financial
statement users would want to assess the likelihood of this refinancing when interpreting the
operating cash flow ratio for the company.
How Do We Determine How Much Net Free Cash
Flow a Company Generates?
Free cash flow is a commonly used measure in the management discussion and analysis
(MD&A) section of annual reports. The concept of free cash flow is to measure the amount
of cash that a company generates from its operations that is in excess of the cash required to
maintain the company’s productive capacity. The term free cash flow is not a measure that has
been defined by accounting standard setters. As such, it is often referred to as a non-IFRS
financial measure. Chapter 12 includes a discussion of non-IFRS financial measures. The
implication of this is that there is no standardized definition for determining the measure. In
practice, a variety of different definitions are used for this measure, making it a challenge for
users to understand and interpret it.
Canadian accounting standard setters have attempted to address this by introducing net
free cash flow as a standardized measure with a consistent definition. They have defined net
free cash flow as follows:
Net free cash flow =
Cash flows from
Net capital
Dividends on
−
−
operating activities
expenditures*
preferred shares
*Net capital expenditures are equal to the total purchases of property, plant, and equipment, plus the total
purchases of intangible assets, less the proceeds from the sale of property, plant, and equipment and the
proceeds from the sale of intangible assets.
Net free cash flow is considered to be the cash flow generated from a company’s operating
activities that would be available to the company’s common shareholders. While management
has discretion with respect to the use of these cash flows, it is unlikely that the entire amount
would be distributed to common shareholders. Instead, portions of these cash flows are likely
to be used to repay debt, finance expansion plans, repurchase company shares, or make investments in other companies.
While a positive net free cash flow is considered to be a good thing, it is also important
to consider why a company may have a negative free cash flow amount. It may be due to the
company having made significant capital expenditures, such as buying property, plant, and
equipment, or intangible assets during the period. If this is the case, then this is also positive, because these assets will be available to generate revenues for the company in future
periods.
5-31
5-32
C H A PTE R 5
The Statement of Cash Flows
The net free cash flow for Dollarama Inc. for the years ended January 31, 2021, and February 2, 2020, would be as follows:
($ in thousands)
Net free
Cash flows from
Net capital
Dividends on
=
−
−
cash flow
operating activities
expenditures
preferred shares
2021
2020
=
$889,082
=
$721,838
=
$732,508
=
$592,741
−
$167,244
−
$0
−
$139,767
−
$0
From this we can see that Dollarama generated significant net free cash flow in both 2021
and 2020. We can see that more than 80% of the company’s cash flows from operating activities are free cash flows. As such, they are available for reinvestment to continue to grow the
company, repay debt, or distribute as dividends.
Now that you know how a statement of cash flows is created, in the next chapter we’ll
take a closer look at cash and at another significant liquid asset: accounts receivable.
Review and Practice
Summary
Understand and explain why the statement of cash
flows is of significance to users.
1
• Cash includes cash on hand, bank deposits, and cash equivalents (which are short-term, highly liquid investments with little
risk of a change in their value).
• The statement of cash flows enables users to assess the cash
generated from core operations, the cash that has been obtained
from investors and creditors, the extent of new investment in
capital assets, the cash available to repay debt, and the amount
of cash distributed to shareholders as dividends.
• The statement of cash flows also provides a basis for estimating
the value of a company and predicting its ability to service its
debt and pay dividends.
• There are two methods of preparing the statement of cash flows:
the direct method and indirect method. The only difference
between the two methods is how cash flows from operating activities are determined. Total operating cash flows are the same under
both methods and the choice of method has no effect on determining cash flows from investing or financing activities.
Identify the three major types of activities that are
presented in a statement of cash flows and describe some
of the typical transactions included in each category of
activity.
3
• The statement of cash flows categorizes a company’s cashrelated transactions into three categories: operating activities,
investing activities, and financing activities.
Explain how the statement of cash flows and the
statement of income differ.
• Typical operating activities include cash sales to customers,
collections of customer receivables, purchases of inventory,
payments to suppliers, payments of wages, and payments of
taxes.
• The statement of cash flows uses the cash basis of accounting,
whereas the statement of income is prepared using the accrual
basis.
• Typical investing activities include cash purchases of property,
plant, and equipment; purchases of shares of other companies;
sales of property, plant, and equipment; and sales of shares in
other companies.
2
• The statement of income focuses only on a company’s operating activities (its revenues and expenses). The statement of cash
flows includes cash flows from operating activities, but it also
includes cash flows related to investing and financing activities.
• Typical financing activities include the proceeds from issuing
shares, the proceeds received from new loans, repayments of
loan principal, and payments of cash dividends.
Key Terms
• Cash flows from operating activities normally receive the greatest scrutiny as these are the cash flows that result from what
the company is in the business of doing and are a key source for
financing future growth. They are also the source for future debt
repayments and/or dividend payments.
• Companies using IFRS have options in terms of how receipts
and payments of interest and dividends are classified.
• Any non-cash investing and financing activities should also be
disclosed.
Prepare a statement of cash flows using the indirect
method for operating activities.
4
• The indirect method is simpler to prepare, uses information
available in most accounting systems, and provides a linkage
between net income and cash flows from operating activities.
• To determine cash flows from operating activities under the indirect method, net income is adjusted for any non-cash expenses
(depreciation and amortization), any gains or losses from investing activities, and changes in current asset and liability accounts
(except for the Cash and Dividends Payable accounts).
• Cash flows from investing activities are equal to the cash payments to purchase property, plant, and equipment less any
cash receipts from sales of property, plant, and equipment. The
amount of cash payments to purchase the shares of other companies and any proceeds from the sale of such shares are also
included.
• Cash flows from financing activities are equal to the cash received
from issuing shares or the proceeds from any new loans less any
principal repayments or dividends paid during the period.
• The sum of the three cash flows should be equal to the net
change in cash and cash equivalents for the period.
• Companies are also required to disclose the amount of interest
paid and received, the amount of dividends paid and received,
and the amount of income taxes paid.
Prepare a statement of cash flows using the direct
method for operating activities.
5
• To determine cash flows from operating activities under the
direct method, cash flows are aggregated into categories that
commonly include receipts from customers, payments to suppliers, payments to employees, payments of interest, and payments
of income taxes. Each category is calculated using the relevant
revenue or expense account(s) and adjusted for changes in the
related current asset or current liability account.
• The investing and financing activities sections are completed
exactly the same as is done under the indirect method.
Interpret a statement of cash flows and develop poten­
tial solutions to any cash flow challenges identified.
6
• Information from the statement of cash flows can help to identify challenges related to significant increases in sales volumes,
lengthy cash-to-cash cycles, and undercapitalization.
• The cash-to-cash cycle is the time between a company paying
out cash to purchase goods and when those goods are ultimately
paid for by customers. The longer the cycle, the more pressure is
placed on cash flows.
• When assessing a company’s cash flows, users will consider
whether the cash flows from operating activities are sufficient
to sustain the company over time. They will also look for indications of concern related to the collection of receivables; excess
inventories; an inability to settle payables; or significant sales of
property, plant, and equipment.
• A company’s cash flow pattern is the direction (positive or negative) of its cash flows from operating, investing, and financing
activities. Reviewing a company’s cash flow pattern can provide
users with a quick means of initially assessing its financial condition. The most common cash flow patterns are positive operating cash flows, negative investing cash flows, and either positive
or negative financing cash flows.
Calculate and interpret a company’s operating cash
flow ratio and determine the amount of net free cash
flow being generated.
7
• The operating cash flow ratio can be determined by dividing cash
flows from operating activities by current liabilities.
• It measures the percentage of a company’s current liabilities that
could be met with one year’s operating cash flows. When interpreting this ratio, it is important to remember that not all of a
company’s current liabilities may be settled with cash.
• Net free cash flow is equal to cash flows from operating activities less net capital expenditures and any dividends on preferred
shares. Net capital expenditures equal the total purchases of
property, plant, and equipment less the proceeds from the sale
of property, plant, and equipment.
• It is considered to be the cash flow generated from operations
that would be available to the company’s common shareholders. It would be reinvested in the company to grow the business,
while a portion may be distributed to shareholders as dividends.
Key Terms
Bank overdraft facility 5-3
Cash 5-3
Cash equivalents 5-3
Cash flows 5-4
Cash flow pattern 5-28
Cash-to-cash cycle 5-26
Demand deposits 5-3
Direct method 5-9
5-33
Financing activities 5-5
Free cash flow 5-31
Indirect method 5-9
Investing activities 5-5
Line of credit 5-3
Management discussion and analysis
(MD&A) 5-31
Net free cash flow 5-31
Non-IFRS financial measure 5-31
Operating activities 5-5
Operating cash flow ratio 5-30
Restricted cash 5-3
Statement of cash flows 5-3
5-34
C H A PTE R 5
The Statement of Cash Flows
Abbreviations Used
IFRS
MD&A
International Financial Reporting Standards
Management discussion and analysis
Synonyms
Indirect method | Reconciliation method
Chapter End Review Problem 5-1
Yee Manufacturing Ltd. had the following transactions in 2024:
1. Issued 25,000 common shares at $9.00 per share.
2. Purchased office equipment for $126,000.
3. Hired five new warehouse staff. Each will earn $22 per hour.
4. Purchased inventory, paying $67,000.
5. Paid utilities costs of $7,800.
6. Declared and paid dividends of $0.25 per share.
Required
Complete a table, using the headings shown, indicating how each
transaction would be classified (Operating, Investing, Financing, or
Not Applicable) and whether it would result in a cash inflow, a cash
outflow, or no change in cash.
Transaction
Classification
(O/I/F or N/A)
Inflow/Outflow/No
Change
7. Sold some old equipment for $2,900.
8. Collected $4,900 from customers making payments on their
accounts.
9. Paid $2,300 in interest on a bank loan.
10. Purchased a one-year insurance policy for $3,700.
Chapter End Review Problem 5-2
The 2024 statement of financial position and statement of income
of Beaman Industries Ltd. are presented in Exhibit 5.19. Beaman
manufactures and distributes a broad range of electrical equipment to
contractors and home renovation stores.
EXHIBIT 5.19 Selected
Financial Statements for
Beaman Industries Ltd.
BEAMAN INDUSTRIES LTD.
Statement of Financial Position
As at March 31
2024
2023
$ 32,970
$ 45,900
Accounts receivable
62,000
105,000
Inventory
91,000
55,200
Total current assets
185,970
206,100
Equipment
307,800
297,000
Assets
Current assets:
Cash
Accumulated depreciation, equipment
(128,520)
$ 365,250
(111,420)
$ 391,680
(continued)
Chapter End Review Problem 5-4
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable
$ 74,900
$ 122,680
Total current liabilities
74,900
122,680
Bank loan payable
95,050
80,000
180,000
180,000
15,300
9,000
$ 365,250
$ 391,680
Common shares
Retained earnings
5-35
EXHIBIT 5.19 Selected
Financial Statements for
Beaman Industries Ltd.
(continued)
BEAMAN INDUSTRIES LTD.
Statement of Income
For the year ended March 31, 2024
Sales revenue
$333,900
Cost of goods sold
157,500
Gross profit
176,400
Expenses
Wages expense
$86,400
Interest expense
14,400
Depreciation expense
25,000
Loss on sale of equipment
Income tax expense
Net income
9,000
17,300
152,100
$ 24,300
Additional information:
STRATEGIES FOR SUCCESS
1. During the year, equipment costing $63,000 was sold for $46,100.
• Start by setting up the outline of the statement of cash
flows, with three sections labelled Operating Activities,
Investing Activities, and Financing Activities. Leave a lot of
space for the Operating Activities, because this is usually the
biggest section.
2. The company made no principal repayments on its loans during
the year.
Required
Prepare the statement of cash flows for Beaman for the year ended
March 31, 2024. Use the indirect method for determining cash flows
from operating activities.
• Follow the 10 steps from Exhibit 5.2.
Chapter End Review Problem 5-3
Required
Using the information for Chapter End Review Problem 5-2, determine the cash flows from operating
activities for Beaman Industries Ltd. for the year ended March 31, 2024, using the direct method.
Chapter End Review Problem 5-4
The statement of cash flows for Pomeroy Distributors Ltd. for 2022 to 2024 is presented in Exhibit 5.20.
5-36
C H A PTE R 5
The Statement of Cash Flows
EXHIBIT 5.20 Pomeroy
Distributors Ltd. Statement of
Cash Flows
POMEROY DISTRIBUTORS LTD.
Statement of Cash Flows
(in thousands)
For the year ended May 31
2024
2023
2022
$ 10,575
$ 19,202
$ 19,786
Depreciation expense
7,805
7,040
6,457
(Gain) loss on sale of property, plant, and equipment
1,070
488
Operating activities:
Net income
Adjustments to convert net income to net cash from operating
activities:
(212)
(Increase) decrease in:
Receivables
(8,797)
(7,072)
(935)
Inventories
(23,513)
(11,872)
(18,687)
(652)
(2,363)
Prepaid expenses
660
(Decrease) increase in:
Accounts payable
9,308
10,120
Accrued interest
(1,058)
1,458
Other accrued expenses
(2,332)
970
(620)
0
(6,902)
19,682
(18,130)
(9,395)
Income tax payable
Net cash provided (used) by operating activities
(3,734)
646
432
(402)
988
Investing activities:
Paid for purchase of property, plant, and equipment
Proceeds from sale of property, plant, and equipment
Net cash used by investing activities
2,722
(15,408)
415
(8,980)
(8,550)
2,324
(6,226)
Financing activities:
Additions to short-term borrowings
Repayments of long-term debt
4,000
0
Additions to long-term debt
22,000
Paid to purchase and retire shares
Paid for dividends
Net cash provided (used) by financing activities
Cash at beginning of period
Cash at end of period
Required
a. Consider Pomeroy’s cash flow patterns from 2022 to 2024. What
profile do these provide of the company?
b. Explain why so much cash was consumed by the company’s
operations in fiscal 2024.
18,500
(14,734)
0
(1,885)
Received from the issuance of shares
Net change in cash during period
1,000
(4,913)
678
0
(6,470)
(5,956)
20,208
(11,754)
(2,102)
(1,052)
5,000
(2,448)
0
(5,486)
832
(4,406)
3,226
4,278
8,684
$ 1,124
$ 3,226
$ 4,278
c. Identify the two most significant recurring non-operating cash
outflows over the last three years and comment on how the company has met these needs. Does this analysis support your initial
assessment from part (a)?
Solutions to Chapter End Review Problems
Solutions to Chapter End Review Problems
Suggested Solution to Chapter End Review Problem 5-1
Transaction
1
Classification
(O/I/F or N/A)
Inflow/Outflow/
No Change
F
Inflow
2
I
Outflow
3
N/A
No Change
4
O
Outflow
5
O
Outflow
6
F*
Outflow
7
I
Inflow
8
O
Inflow
9
O**
Outflow
O
Outflow
10
*Could also be classified as Operating under IFRS.
**Could also be classified as Financing under IFRS.
Suggested Solution to Chapter End Review Problem 5-2
The completed statement of cash flows for Beaman Industries Ltd. for the year ended March 31, 2024, is
shown below. Explanations for certain items follow the statement.
BEAMAN INDUSTRIES LTD.
Statement of Cash Flows
For the year ended March 31, 2024
Cash flows from operating activities:
Net income
Add: Depreciation expense
Add: Loss on sale of equipment
Add: Decrease in accounts receivable
$ 24,300
25,000
9,000
43,000
Less: Increase in inventory
(35,800)
Less: Decrease in accounts payable
(47,780)
Cash provided by operating activities
17,720
Cash flows from investing activities:
Add: Proceeds from sale of equipment
46,100
Less: Purchase of equipment
(73,800)
Cash used for investing activities
(27,700)
Cash flows from financing activities:
Less: Payment of dividends
Add: Proceeds of borrowing—loan payable
Cash used for financing activities
(18,000)
15,050
(2,950)
Net change in cash
$(12,930)
Ending cash
$ 32,970
Opening cash
Net change in cash
45,900
$(12,930)
5-37
5-38
C H A PTE R 5
The Statement of Cash Flows
a. Because both depreciation expense and the loss on sale of equipment reduced net income, they
are added back in order to eliminate the effect they had on net income. Depreciation is a non-cash
expense and the loss on sale is related to an investing activity.
b. The following T accounts illustrate how the amount of equipment purchased and the dividends paid
during the year were determined.
Equipment
Retained Earnings
297,000
Dividends Payable
9,000
63,000
—
24,300
73,800
18,000
307,800
18,000
18,000
15,300
—
Suggested Solution to Chapter End Review Problem 5-3
Category
Starting Point (from Statement
of Income)
Adjustments (from Statement
of Financial Position)
A
Receipts from customers
Sales Revenue
333,900
Payments to suppliers
Cost of Goods Sold
Change in Accounts Receivable
Change in Deferred Revenue
(157,500)
Total
B
=A+B
43,000
376,900
N/A
Change in Inventory
(35,800)
Change in Accounts Payable
(47,780)
(241,080)
Payments to employees
Wages Expense
(86,400)
Change in Wages Payable
N/A
(86,400)
Payment of interest
Interest Expense
(14,400)
Change in Interest Payable
N/A
(14,400)
Payment of income taxes
Income Tax Expense
(17,300)
Change in Income Tax Payable
N/A
(17,300)
CASH FLOWS FROM OPERATING ACTIVITIES
17,720
Suggested Solution to Chapter End Review Problem 5-4
a. Pomeroy’s cash flow patterns over the past three years were as follows:
2022:
+/−/+
The company was successful and growing, with growth financed by
operations and also from financing provided by creditors and shareholders.
2023:
+/−/−
The company was successful, with operating activities providing sufficient
cash to finance growth and repay debt or pay dividends.
2024:
−/ − / +
The company struggled operationally, but was able to attract financing to
fund the acquisition of capital assets and the cash deficiency resulting from
its operating activities.
A quick analysis of Pomeroy’s cash flow patterns illustrates that the company began to struggle
operationally in 2024. In 2022 and 2023, the company was able to generate cash from its operating
activities, with almost $20 million generated from operations in 2023. The company has continued
to increase its property, plant, and equipment each year, though some of these acquisitions were
asset replacements (that is, replacements of the property, plant, and equipment sold during the
period). In 2024, Pomeroy paid just over $18 million to acquire property, plant, and equipment,
while receiving just under $3 million from the sale of property, plant, and equipment the company
had finished using. In spite of its operational challenges in 2024, the company was able to attract
new financing, receiving $22 million from new long-term borrowings and another $4 million from
additional short-term borrowings. We would want to assess the company’s operational challenges
in greater depth to get a sense of where the difficulties were. For example, were they a result of
declining sales, growth in inventory or receivables, or a reduction in the payment periods offered by
suppliers?
b. In analyzing the company’s cash flows from operating activities for 2024, it is clear that the biggest
outflow was related to the increase in inventory. This resulted in cash outflows of more than $23
million during the year. This was a continuation of a trend that has seen the company’s inventory
Discussion Questions
5-39
levels increase significantly over the past three years, resulting in cash outflows of $54 million over
the period. It would be important to know why the levels of inventories have increased so much.
These changes in inventory level should also be compared with changes in sales revenues over the
same period.
Accounts receivable have also been steadily increasing over the three-year period, with significant increases in 2023 and 2024. Again, this growth in receivables should be compared with the
change in the sales revenues to determine if it is the growth in sales that is driving the increase in
receivables. We should also determine if the company lengthened its credit terms. If increased sales
and changes in credit terms do not explain the increase in receivables, it would indicate that Pomeroy is having trouble collecting from its customers.
A portion of the increased inventory levels was offset by financing provided by the company’s
suppliers through increased accounts payable. This covered almost all of the inventory increase in
2023, but only 40% of the increase in 2024. While the increase in accounts payable helps the company’s cash flow situation, it may also indicate that Pomeroy is having trouble paying its bills and is
therefore slowing down its payments to suppliers.
The fact that the company’s net income fell by 45% in 2024 had a significant impact on its cash
flow from operating activities for that year. In 2022 and 2023, Pomeroy was able to generate a net
income of approximately $19 million, and the company had positive cash flows from operations in
both years. The significant decrease in net income in 2024 was one of the reasons the company’s
operating cash flows were negative in that year.
Overall, the biggest concern is likely the increase in inventory levels. The reason for the very large
growth in inventories, particularly in 2024, should definitely be investigated.
c. Pomeroy’s two most significant recurring cash outflows in the three years between 2022 and 2024
were related to the purchase of property, plant, and equipment, and the payment of dividends.
Pomeroy’s cash outflows to acquire property, plant, and equipment, net of the proceeds received
from the sale of property, plant, and equipment, were over $30 million. Dividend payments during
the three-year period resulted in cash outflows of almost $18 million.
The company met these cash needs though increased borrowings (short-term and long-term
debt), cash flows from operations (in 2022 and 2023), and a drawdown of its existing cash balances.
Pomeroy increased its debt by almost $31 million, net of repayments, during the three-year period.
This was the largest source of cash inflows for the company, surpassing the net inflows of $14 million generated by the company’s operating activities. The company’s cash balances also decreased
by more than $7 million between 2022 and 2024.
Pomeroy’s operating activities produced a net inflow of cash in both 2022 and 2023, while there
was a negative cash flow from operations in 2024. Between 2023 and 2024, cash flow from operations
swung from close to a $20-million inflow to a $7-million outflow. This is consistent with the + / +
/ − pattern we observed for operating activities in part (a).
The net increase in property, plant, and equipment is consistent with the − / − / − pattern we
observed in part (a) for investing activities. This, coupled with the increase in inventory levels noted
in part (b), indicates that the company is expanding its current operation (that is, increasing its warehouse and increasing the quantity and range of goods carried in inventory) or opening new locations and acquiring the inventory to stock them. We would want to investigate to determine which,
if either, of these is the case. If one of these scenarios reflects the company’s actions, it could be that
cash is being spent upfront to expand its current operation or establish the new locations, while these
new products or new locations have yet to generate the expected cash flows through sales revenues.
This detailed analysis supports the assessment from part (a) that was based on an initial analysis
of the company’s cash flow patterns. This illustrates the usefulness of cash flow pattern analysis.
Assignment Material
Discussion Questions
DQ5-1 Discuss why, in addition to preparing a statement of income,
it is important for companies to also prepare a statement of cash flows.
DQ5-3 If a company has a net loss of $5 million for the year, does its
cash go down by $5 million as a result? Explain.
DQ5-2 Explain why a company’s net income is not normally equal
to its cash flows from operating activities.
DQ5-4 Describe the three major categories of activities that are
shown on the statement of cash flows.
5-40
C H A PTE R 5
The Statement of Cash Flows
DQ5-5 Discuss the major difference between the direct method and
the indirect method for presenting the operating section of a statement of cash flows.
DQ5-6 Explain why the indirect method of preparing cash flows
from operating activities is also known as the reconciliation method.
DQ5-7 Explain why it is important to a company’s financial health
to have a positive cash flow from operations.
DQ5-8 Explain whether or not a financial statement user can conclude that a company is doing well if its cash and cash equivalents
balance increased during the year.
DQ5-9 Explain why a company’s cash flows from operating activities could be negative and whether this is something that financial
statement users should be concerned about.
DQ5-10 Explain whether it is possible for a company to have negative cash flows from operating activities while being profitable.
DQ5-11 Explain why, under the indirect method, depreciation is
added to the net income to calculate the cash flow from operations.
Is depreciation a source of cash, as this treatment seems to suggest?
DQ5-12 Explain what the outcome will be if a company increases its
depreciation charges in an attempt to increase its cash flow from operations.
DQ5-13 During the year, a company’s accounts payable increased,
which was partially offset by increases in accounts receivable and
inventory. Explain the impact that these changes would have on the
company’s cash flows from operating activities.
DQ5-14 Explain how a company’s cash flows from operating activities could increase when its profitability is decreasing.
DQ5-15 Identify and explain two actions that a company’s management could take that would improve cash flows from operating activities, but that could be detrimental to the company in the long term.
DQ5-16 Explain why the net cash flow from investing activities is
usually a negative amount.
DQ5-17 Explain how the net cash flow from financing activities
could be a negative amount.
DQ5-18 Explain how a gain on the sale of equipment would be
treated in the operating activities section of a statement of cash flows
prepared using the indirect method.
DQ5-19 Explain what it means if the net cash flow from investing
activities is a positive amount.
DQ5-20 Explain how the net cash flow from financing activities
could be a positive amount.
DQ5-21 Explain why a high sales growth rate can create significant
cash flow problems for a company.
DQ5-22 Explain why operating cash flows are often lowest when a
company’s sales are growing rapidly.
DQ5-23 Explain how the timing of cash flows relates to the purchase, use, and ultimate disposal of property, plant, and equipment.
DQ5-24 Explain why it is common for companies to have positive
cash flows from operating activities and negative cash flows from
investing activities.
DQ5-25 Explain why management of a company using IFRS might
choose to classify payments of interest as a financing activity.
DQ5-26 Explain why management of a company using IFRS might
choose to classify the payment of dividends as an operating activity.
DQ5-27 Does the purchase of equipment lengthen a company’s
cash-to-cash cycle?
DQ5-28 Discuss how a company’s policies regarding receivables,
inventory, and payables affect its cash flows relative to the income
generated in a given period.
DQ5-29
cycle?
In terms of cash flows, what is meant by the cash-to-cash
DQ5-30 For a company with a cash flow problem related to the
length of its cash-to-cash cycle, list at least three potential reasons for
the problem and suggest a possible solution for each.
DQ5-31 Explain what cash flow pattern would normally be expected
in the first year of a new company.
DQ5-32 Explain what cash flow pattern would be expected of a successful company that generates sufficient cash flows from its operations to fund expansion and debt repayment.
DQ5-33 Explain how net free cash flow is determined and what it
represents.
DQ5-34 When analyzing the statement of cash flows, explain why
it is important to compare the current year’s amounts with those of
prior years.
DQ5-35 Explain why a company’s board of directors may want to
determine the CEO’s bonus based on cash flows from operating activities rather than based on net income.
Application Problems Set A
Note: For all AP problems, payments of interest are to be classified as operating activities,
while payments of dividends are to be classified as financing activities.
AP5-1A (Classification of activities)
Required
In what section of the statement of cash flows (operating, financing, or investing) would each of the
following items appear?
a. Proceeds from the sale of old equipment
b. Proceeds from a bank loan
c. Net income
d. Payment of dividends to shareholders
e. Proceeds from the sale of long-term investments
Application Problems Set A
f. Net change in accounts receivable
g. Repayment of loan principal
h. Issuance of common shares to investors
i. Gain or loss on the disposal of old equipment
j. Purchase of new computer equipment
AP5-2A
(Effect of transactions on cash flows)
Required
Classify each of the following transactions as increasing, decreasing, or having no effect on cash flows:
a. Purchasing inventory from a supplier on account
b. Purchasing office supplies and writing a cheque to cover the amount
c. Selling inventory to a customer on account
d. Buying a building by making a down payment and taking out a mortgage for the balance of the
amount owed
e. Depreciating capital assets
f. Making a payment on a bank loan, where the amount paid includes interest and a portion of the
principal
g. Issuing common shares
h. Declaring and paying dividends to shareholders
i. Paying wages owed to employees
j. Receiving interest owed from a customer
AP5-3A (Effect of transactions on cash flows) The following transactions occurred for Dussault Ltd.
1. Annual interest of 6% is paid on $500,000 of bonds payable that were issued last year.
2. A truck was purchased for $50,000 at the beginning of this year. The truck is being depreciated over
five years at a rate of $10,000 per year.
3. Old equipment is sold for $40,000. The asset originally cost $160,000 and has accumulated depreciation of $125,000.
4. New equipment is purchased for $200,000. A cash payment of $50,000 is made and a long-term note
payable for $150,000 is issued for the remainder.
5. A deposit of $2,000 is received in advance from a customer for goods to be delivered at a later date.
6. Income tax expense for the year is $85,000; $70,000 of this amount was paid during the year, and the
remainder will be paid next year.
Required
For each of the above items:
a. Identify the accounts affected and give the amounts by which they would be increased or decreased.
b. State the amount of any cash flow and whether cash is increased or decreased.
c. Identify how each item would be reported in Dussault’s statement of cash flows.
AP5-4A (Effect of transactions on cash flow and net income) Indicate the effect (increase,
decrease, or no effect) each of the following transactions would have on a company’s cash flow and net
income:
Transaction
1. Purchased inventory on account
2. Sold at a gain equipment that the company was
finished using
3. Repayment of loan principal
4. Declaration of dividends
5. Accrued interest owing on loan
6. Made sales on account
7. Collection of an account receivable from a customer
8. Cash purchase of equipment
Effect on
Cash Flow
Effect on
Net Income
5-41
5-42
C H A PTE R 5
The Statement of Cash Flows
AP5-5A (Cash flow from operations) The following is financial information for three companies:
Joulie Ltd.
Mansour Ltd.
Warren Ltd.
$456,000
$690,000
$1,123,200
252,000
396,000
744,000
78,000
114,000
126,000
Depreciation expense
8,400
21,600
33,600
Interest expense
3,600
1,200
2,400
21,600
42,000
54,000
8,400
6,000
30,000
(3,000)
6,000
(10,200)
4,800
(9,600)
16,800
Property, plant, and
equipment
60,000
(12,000)
72,000
Accounts payable
4,200
(7,800)
5,040
Sales revenue
Cost of goods sold
Selling and
administrative
expenses
Income tax expense
Dividends paid
Increase/(Decrease) in
Accounts receivable
Inventory
Interest payable
(1,800)
1,400
3,000
(1,800)
7,800
Notes payable
24,000
(48,000)
12,000
Common shares
36,000
(6,000)
(96,000)
Income tax payable
(600)
Required
For each of the above companies, calculate the cash flow from operations using the indirect method.
AP5-6A (Preparation of statement of cash flows) Nomad Adventures Ltd. (NAL) is a Canadian
manufacturer of Class B motorhomes. The company has been experiencing exponential growth and is
preparing to raise additional capital to fund its growth. As the vice-president of finance, you are tasked
with preparing the statement of cash flows that is required as part of the loan application or a public
offering. You have the statement of financial position and the statement of income to help you prepare
the statement of cash flows. In addition, you also have the following information:
1. In October, NAL acquired land with a value of $225,000 by issuing common shares with an equivalent value. The land is to be used as a site for a new manufacturing facility NAL hopes to construct
in the next year.
2. In February, NAL sold equipment for $9,900 cash. The equipment had originally cost $225,000 and
had a net carrying amount of $27,000 at the time of sale.
3. During the year, the company borrowed $23,100 by increasing its bank loan payable.
NOMAD ADVENTURES LTD.
Statement of Financial Position
As at March 31
2024
2023
$ 120,000
$ 54,000
Accounts receivable
145,000
102,000
Inventory
450,000
340,000
Total current assets
715,000
496,000
Assets
Current assets:
Cash
(continued)
Application Problems Set A
NOMAD ADVENTURES LTD.
Statement of Financial Position
As at March 31
Equipment
1,000,000
Accumulated depreciation, equipment
(455,000)
Land
810,000
(540,000)
225,000
0
$1,485,000
$766,000
$ 205,000
$ 60,000
Liabilities and shareholders’ equity
Current liabilities
Accounts payable
Dividends payable
75,000
54,000
Total current liabilities
280,000
114,000
Bank loan payable
185,000
180,000
Common shares
595,000
370,000
Retained earnings
425,000
102,000
$1,485,000
$766,000
NOMAD ADVENTURES LTD.
Statement of Income
For the year ended March 31, 2024
Sales revenue
$1,820,000
Cost of goods sold
920,000
Gross margin
900,000
Expenses
Advertising expense
$ 52,500
Wage expense
252,000
Utilities expense
21,000
Depreciation expense
113,000
Rent expense
45,500
Loss on sale of equipment
484,000
17,100
$ 398,900
Net income
Required
a. Using the information above, prepare the statement of cash flows for Nomad Adventures Ltd. for
the year ended March 31, 2024, using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
AP5-7A (Preparation of statement of cash flows) The following information is for Chamomile
Ltd. for the year ended June 30, 2024.
CHAMOMILE LTD.
Statement of Financial Position
As at June 30
2024
2023
$ 65,000
$ 45,000
Assets
Current assets:
Cash
Accounts receivable
96,800
65,000
Inventory
84,500
100,500
246,300
210,500
Total current assets
(continued)
5-43
5-44
C H A PTE R 5
The Statement of Cash Flows
CHAMOMILE LTD.
Statement of Financial Position
As at June 30
Equipment
155,000
115,000
Accumulated depreciation, equipment
(33,500)
(27,000)
Land
165,000
200,000
$532,800
$498,500
$ 47,000
$ 72,000
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable
Dividends payable
17,000
7,000
Total current liabilities
64,000
79,000
Bank loan payable
116,500
165,000
Common shares
165,000
110,000
Retained earnings
187,300
144,500
$532,800
$498,500
CHAMOMILE LTD.
Statement of Income
For the year ended June 30, 2024
Sales revenue
$425,000
Cost of goods sold
225,000
Gross profit
200,000
Expenses
Wages expense
$65,000
Depreciation expense
20,500
Rent expense
18,000
Income tax expense
17,500
Operation income
Gain on sale of equipment
Net income
121,000
79,000
5,000
$ 84,000
Additional information:
1. Land was sold at cost and none was purchased during the year.
2. In January, Chamomile sold for cash equipment that had an original cost of $27,000 and a net
­carrying amount of $13,000.
Required
a. Using the information above, prepare the statement of cash flows for Chamomile Ltd. for the year
ended June 30, 2024, using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
AP5-8A (Preparation of statement of cash flows) Graphene Plastics Company imports graphite
from Australia for conversion to graphene to make hockey sticks in Canada. As CEO, you are busy preparing a loan application, which asks for a cash flow statement for the most recent fiscal period. You have
the following financial information.
Application Problems Set A 5-45
GRAPHENE PLASTICS COMPANY
Comparative Statement of Financial Position
Oct. 31, 2024
Oct. 31, 2023
$ 76,000
$ 80,000
Accounts receivable (net)
120,000
135,000
Inventory
210,000
176,000
406,000
391,000
Assets
Cash
Total current assets
Equipment
Accumulated depreciation
Total assets
300,000
230,000
(145,000)
(170,000)
$ 561,000
$ 451,000
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable
$ 80,000
$ 65,000
Dividends payable
17,000
22,000
Total current liabilities
97,000
87,000
108,000
125,000
205,000
212,000
Common shares
110,000
110,000
Retained earnings
246,000
129,000
356,000
239,000
$ 561,000
$ 451,000
Loan payable
Total liabilities
Total shareholders’ equity
Total liabilities and shareholders’ equity
GRAPHENE PLASTICS COMPANY
Statement of Income
For the year ended October 31, 2024
Sales revenue
$605,000
Cost of goods sold
265,000
Gross profit
340,000
Expenses
Wages expense
$50,000
Utilities expenses
20,000
Depreciation expense
25,000
Rent expense
15,000
Interest expense
9,000
Total expenses
Loss on sale of equipment
Net income
119,000
9,000
$212,000
Additional information:
During the year, Graphene sold a piece of its equipment. The equipment sold had originally cost
$74,000 and was sold for $15,000.
Required
a. Using the information above, prepare Graphene’s statement of cash flows for the year ended October 31, 2024, using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
AP5-9A (Preparation of statement of cash flows) Financial statement data for Kanga Holdings
Ltd. for 2024 follow.
5-46
C H A PTE R 5
The Statement of Cash Flows
KANGA HOLDINGS LTD.
Comparative Statement of Financial Position
Sept. 30, 2024
Sept. 30, 2023
Assets
Cash
$ 230,000
$ 215,000
300,000
125,000
30,000
40,000
380,000
450,000
940,000
830,000
725,000
600,000
(215,000)
(170,000)
510,000
430,000
$1,450,000
$1,260,000
$
$
Accounts receivable
Prepaid insurance
Inventory
Total current assets
Property, plant, and equipment
Accumulated depreciation
Net capital assets
Total assets
Liabilities and shareholders’ equity
Accounts payable
45,000
65,000
Deferred revenue
30,000
45,000
Wages payable
20,000
5,000
Income tax payable
25,000
20,000
120,000
135,000
Bonds payable
450,000
500,000
Total liabilities
Total current liabilities
570,000
635,000
Common shares
400,000
325,000
Retained earnings
480,000
300,000
Total shareholders’ equity
Total liabilities and shareholders’ equity
880,000
625,000
$1,450,000
$1,260,000
KANGA HOLDINGS LTD.
Statement of Income
For the year ended September 30, 2024
Sales revenue
$4,145,000
Gain on sale of equipment
30,000
4,175,000
Expenses
Cost of goods sold
$1,955,000
Other operating expenses
635,000
Wages expense
425,000
Depreciation expense
85,000
Interest expense
75,000
Income tax expense
395,000
Total expenses
Net income
3,570,000
$ 605,000
Additional information:
1. Equipment that cost $105,000 was sold for $95,000.
2. Dividends were declared and paid during the year.
Required
a. Prepare a statement of cash flows for Kanga Holdings Ltd. for the year ended September 30, 2024.
Include supplementary information to disclose the amounts paid for interest and income taxes
using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
Application Problems Set A 5-47
AP5-10A (Preparation of statement of cash flows) The comparative statement of financial position and statement of income for NextWave Company follow.
NEXTWAVE COMPANY
Comparative Statement of Financial Position
Dec. 31, 2024
Dec. 31, 2023
$ 66,700
$ 47,250
76,800
57,000
121,900
92,650
84,500
97,000
280,000
235,000
Assets
Cash
Accounts receivable
Inventory
Long-term investments
Property, plant, and equipment
Accumulated depreciation
(79,500)
(70,000)
$ 550,400
$458,900
$ 52,700
$ 49,200
12,000
18,000
Liabilities and shareholders’ equity
Accounts payable
Income tax payable
Bonds payable
100,000
70,000
Common shares
230,000
200,000
Retained earnings
155,700
121,700
$ 550,400
$458,900
NEXTWAVE COMPANY
Statement of Income
For the year ended December 31, 2024
Sales revenue
$437,500
Gain on sale of equipment
3,700
441,200
Expenses
Cost of goods sold
$200,500
Operating expenses (excluding depreciation)
63,800
Depreciation expense
49,700
Income tax expense
40,000
Net income
354,000
$ 87,200
Additional information:
1. Some of the long-term investments were sold at their carrying value. As a result, there was no gain
or loss on this transaction.
2. Equipment costing $47,000 was sold for $10,500, which was $3,700 more than its net carrying
amount at the time of disposal.
Required
a. Prepare the company’s statement of cash flows for 2024 using the indirect method.
b. Calculate the amount of cash that was paid for income taxes during 2024.
c. Determine the cash flows from operating activities using the direct method.
AP5-11A (Preparation of statement of cash flows) Digiread Technologies Ltd. (DTL) is a privately held distributor of e-readers and tablets. The Calgary-based company is well established and is
currently managed by its founder, Erin Jacobs. The company’s financial statements are presented below,
together with some additional information.
5-48
C H A PTE R 5
The Statement of Cash Flows
DIGIREAD TECHNOLOGIES LTD.
Statement of Income
For the year ended December 31, 2024
Sales revenue
$50,500,000
Cost of goods sold
34,400,000
Gross profit
16,100,000
Wages expense
4,000,000
Depreciation expense
1,200,000
Interest expense
1,900,000
Income tax expense
1,600,000
Gain on sale of equipment
(600,000)
$ 8,000,000
Net income
DIGIREAD TECHNOLOGIES LTD.
Statement of Financial Position
As at December 31
2024
2023
$15,500,000
$ 8,500,000
Assets
Current assets:
Cash
Accounts receivable (net)
11,500,000
15,500,000
Inventory
16,900,000
19,000,000
Total current assets
43,900,000
43,000,000
Equipment
39,400,000
30,000,000
Accumulated depreciation, equipment
(6,600,000)
(6,400,000)
Total assets
$76,700,000
$66,600,000
$11,900,000
$ 7,000,000
1,200,000
1,000,000
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable
Wages payable
Total current liabilities
13,100,000
8,000,000
Bonds payable
21,000,000
26,000,000
Common shares
14,000,000
9,000,000
Retained earnings
Total liabilities and shareholders’ equity
28,600,000
23,600,000
$76,700,000
$66,600,000
DIGIREAD TECHNOLOGIES LTD.
Other Selected Financial Information for the Year Ended December 31, 2024
1. Total sales in 2024 were consistent with the prior year’s, and the company’s dividend policy has
remained consistent for the past five years.
2. During 2024, DTL sold a piece of equipment for $2.1 million. The equipment had originally cost
$2.5 million and had a net carrying amount of $1.5 million at the time of sale.
3. On August 1, 2024, DTL’s board of directors approved the retirement of bonds with a carrying
amount of $5 million through the issuance of common shares.
Required
DTL’s management shareholders have asked you to prepare the statement of cash flows for DTL using
either the direct or indirect method for determining cash flows from operating activities. Prepare the
statement for them.
Application Problems Set A 5-49
AP5-12A (Preparation of statement of cash flows) Tangent Controls Ltd. is a manufacturer of
crash-protected event recorders that are used in railway systems around the world to record event data.
These data can be retrieved and analyzed to monitor and improve operations, but also to provide diagnostic data in the event of rail crashes. The small Ottawa-based company has customers across the world,
but its largest market is North America. The company has been hurt by the U.S. economy, seeing a 12%
decline in sales over the prior year. The company is hoping that the latest industry developments, which
call for a significant increase in the shipment of oil by railcar, will mean an increase in sales. In the
meantime, the company has been seeking new investors and has approached a leading Canadian venture
capital firm to see if it might be interested in investing. As part of its approach, Tangent has provided the
following financial information for the most recent fiscal year.
TANGENT CONTROLS LTD.
Statement of Financial Position
As at September 30
2024
2023
Assets
Current assets:
Cash
$
0
Accounts receivable (net)
$
72,000
601,000
Inventory
Total current assets
Equipment
Accumulated depreciation, equipment
Total assets
378,000
760,000
594,000
1,361,000
1,044,000
1,608,000
1,908,000
(1,425,000)
(1,440,000)
$ 1,544,000
$ 1,512,000
$ $
Liabilities and shareholders’ equity
Current liabilities:
Bank indebtedness
22,000
0
Accounts payable
260,000
252,000
Total current liabilities
282,000
252,000
Bank loan payable
152,000
144,000
Common shares
900,000
900,000
Retained earnings
210,000
216,000
$ 1,544,000
$ 1,512,000
Total liabilities and shareholders’ equity
TANGENT CONTROLS LTD.
Statement of Income
For the year ended September 30, 2024
Sales revenue
$6,070,000
Cost of goods sold
3,875,000
Gross profit
2,195,000
Wages expense
1,580,000
Utilities expense
290,000
Depreciation expense
225,000
Rent expense
79,000
Interest expense
47,000
Loss from operations
(26,000)
Gain on sale of equipment
40,000
Earnings before income tax
14,000
Income tax expense
Net income
3,000
$
11,000
5-50
C H A PTE R 5
The Statement of Cash Flows
Additional information:
1. During the year, the company repaid principal of $30,000 on its loan payable.
2. During the year, equipment with a net carrying amount of $60,000 was sold.
3. No equipment was purchased during the year.
Required
a. You work for the venture capital firm and have been tasked with preparing the statement of cash
flows for Tangent using either the direct or indirect method for determining cash flows from operating activities. Prepare the statement.
b. Discuss significant observations from the statement of cash flows that your firm would want to
consider.
AP5-13A (Determining cash collected from customers and paid to suppliers) Southbend
Company had sales of $734,000 for the year. The company reported accounts receivable of $54,000 at
the end of last year and $60,000 at the end of this year. Southbend’s cost of goods sold this year was
$440,000. In last year’s statement of financial position, the company reported inventory of $62,000 and
accounts payable of $32,000. In this year’s statement of financial position, Southbend reported inventory
of $66,000 and accounts payable of $38,000.
Required
a. Calculate the amount of cash that Southbend collected from its customers during the year.
b. Calculate the amount of cash that Southbend paid to its suppliers for inventory during the year.
AP5-14A (Interpreting statement of cash flows)
cash flows for Yellow Spruce Incorporated.
The following are the comparative statements of
YELLOW SPRUCE INCORPORATED
Statements of Cash Flows
(in millions)
2024
2023
2022
$ 57
$ 86
$ 98
82
75
65
2
0
(11)
Accounts receivable
(38)
30
(39)
Inventory
(21)
(17)
(21)
4
13
(9)
Operating activities
Net income
Add back:
Depreciation expense
Loss (gain) on sale of investments
Effect of changes in working capital items:
Prepaid expenses
Accounts payable
Net cash inflow from operations
27
(12)
35
113
175
118
(154)
(161)
(152)
(23)
(51)
(72)
Investing activities
Acquisition of property, plant, and equipment
Acquisition of investments
Proceeds from sale of property, plant, and equipment
Net cash outflow for investing activities
16
11
27
(161)
(201)
(197)
213
156
332
(131)
(72)
(93)
12
0
0
Financing activities
Issuance of long-term debt
Repayment of long-term debt
Issuance of shares
Repurchase of shares
Dividends paid
Net cash inflow from financing activities
Overall increase in cash
Cash position at beginning of year
Cash position at end of year
0
(38)
(84)
(16)
(14)
(15)
78
32
140
30
6
61
100
94
33
$130
$100
$ 94
Application Problems Set B 5-51
Required
a. Discuss the company’s ability to meet its non-operating needs for cash over these three years, and
comment on the continuing nature of the major items that have appeared over this time period.
b. Comment on the changes in Yellow Spruce’s accounts receivable, accounts payable, and inventory
levels over these three years.
c. How did Yellow Spruce finance its repayment of long-term debt and its acquisition of property,
plant, and equipment and investments in 2024?
d. Describe how the company’s mix of long-term financing has changed during this three-year period,
in terms of the proportion of debt versus equity. (Hint: Start by calculating the total amount of the
increase or decrease in long-term debt and comparing it with the total amount of the increase or
decrease in shareholders’ equity.)
AP5-15A (Cash flow patterns) Urban Eats Ltd. (UEL) has been successfully operating upscale supermarkets in the Lower Mainland of British Columbia as well as a profitable online market through which
customers place orders for home delivery by UEL. In the current year, UEL sold one of its warehouses while
no new stores were acquired or opened. However, UEL’s management team completed a successful bond
issuance so the company can make a bid to acquire one of its competitors early in the next fiscal year.
Required
Determine the cash flow pattern that you expect UEL to have, and explain your rationale.
AP5-16A (Cash flow patterns) Sheek Décor Ltd. (SDL) has been profitably operating upscale furniture showrooms in Montreal, as well as a lucrative export business where customers place orders online
for home delivery by SDL. In the current year, SDL acquired, as part of its expansion plan, distribution
centres in Europe. SDL’s board of directors authorized a common share issuance, which was closed prior
to fiscal year end. Proceeds from the common share issue will allow SDL to make a bid to acquire a furniture manufacturer early in the next fiscal year.
Required
Determine the cash flow pattern that you expect SDL to have, and explain your rationale.
Application Problems Set B
Note: For all AP problems, payments of interest are to be classified as operating activities,
while payments of dividends are to be classified as financing activities.
AP5-1B (Classification of activities)
Required
Indicate whether each of the following items should be classified as an operating, investing, or financing
activity on the statement of cash flows. If an item does not belong on the statement, indicate why.
a. Declaration of dividends on common shares, to be paid later
b. Payment of dividends on common shares
c. Purchase of equipment
d. Receipt of cash from the sale of a warehouse
e. Receipt of cash through a long-term bank loan
f. Interest payments on a long-term bank loan
g. Acquisition of land for cash
h. Investment in another company by purchasing some of its shares
i. Net decrease in accounts payable
AP5-2B (Effect of transactions on cash flows)
Required
Classify each of the following transactions as increasing, decreasing, or having no effect on cash flows:
a. Prepaying rent for the month
b. Accruing the wages owed to employees at the end of the month, to be paid on the first payday of the
next month
5-52
C H A PTE R 5
The Statement of Cash Flows
c. Selling bonds to investors
d. Buying the company’s own shares on the stock market
e. Selling merchandise to a customer who uses a debit card to pay for the purchase
f. Paying for inventory purchased earlier on account
g. Buying new equipment for cash
h. Selling surplus equipment at a loss
i. Paying the interest owed on a bank loan
j. Paying the income taxes owed for the year
AP5-3B (Effect of transactions on cash flows) The following transactions occurred for Mouawad
Inc.
1. Inventory costing $300,000 was purchased on account.
2. A new vehicle costing $30,000 was purchased. Mouawad paid $5,000 as a down payment, and the
remaining $25,000 was financed through a bank loan.
3. Surplus land was sold for $80,000, which was $20,000 more than its original cost.
4. During the year, the company made a payment of $20,000 on its mortgage payable; $2,500 of this
amount was for the interest on the debt.
5. Wages of $45,000 were charged to expense as they were incurred. No wages were owing to the
employees at the end of the year.
6. The company declared and paid dividends of $30,000.
Required
For each of the above items:
a. Identify the accounts affected and give the amounts by which they would be increased or decreased.
b. State the amount of any cash flow and whether cash is increased or decreased.
c. Identify how each item would be reported in Mouawad’s statement of cash flows.
AP5-4B (Effect of transactions on cash flow and net income) Indicate the effect (increase,
decrease, or no effect) each of the following transactions would have on a company’s cash flow and net
income:
Effect on
Cash Flow
Transaction
Effect on
Net Income
1. Purchased supplies on account
2. Issued common shares
3. Received loan proceeds
4. Received a deposit from a customer
5. Payment of dividends
6. Made cash sales
7. Paid accounts payable owing to a supplier
8. Cash purchase of inventory
AP5-5B (Cash flow from operations)
The following is financial information for three companies.
Kotei & Sons Ltd.
SaskCo.
Movilla Ltd.
$453,000
$790,000
$960,000
235,000
420,000
550,000
Depreciation expense
40,000
70,000
80,000
Other operating expenses
50,000
60,000
70,000
Interest expense
15,000
20,000
35,000
9,000
(15,000)
(14,000)
Sales revenue
Cost of goods sold
Gain (loss) on sale of equipment
(continued)
Application Problems Set B
Dividends paid
6,000
10,000
12,000
Increase/(Decrease) in
Accounts receivable
Inventory
Prepaid expenses
Property, plant, and equipment
Accounts payable
Interest payable
Bonds payable
Common shares
14,000
(16,000)
15,000
(20,000)
25,000
(30,000)
1,000
(2,400)
(2,600)
220,000
(70,000)
150,000
(8,000)
12,000
(8,000)
3,000
(8,000)
5,000
(20,000)
50,000
60,000
70,000
(10,000)
120,000
Required
For each of the above companies, calculate the cash flow from operations using the indirect method.
AP5-6B (Preparation of statement of cash flows) Whiskey Industries Ltd., a Nanaimo, British
Columbia–based company, has a December 31 year end. The company’s comparative statement of financial position and its statement of income for the most recent fiscal year are presented here, along with
some additional information:
1. During the year, Whiskey Industries sold, for $500 cash, equipment that had an original cost of
$1,000 and a net carrying amount of $200.
2. Whiskey Industries borrowed an additional $8,000 by issuing notes payable in 2024.
3. During the year, the company purchased a piece of land for a future manufacturing site for $200,000.
The land was purchased with no money down and the company entered into a mortgage payable for
the full amount.
WHISKEY INDUSTRIES LTD.
Statement of Financial Position
As at December 31, 2024
2024
2023
$ 6,050
$ 19,500
10,000
20,000
Assets
Current assets
Cash
Accounts receivable
Prepaid rent
Inventory
Total current assets
600
500
40,000
30,000
56,650
70,000
Manufacturing equipment
159,000
100,000
Accumulated depreciation, manufacturing equipment
(69,200)
(50,000)
Land
Total assets
200,000
0
$346,450
$120,000
$ 11,000
$ 6,000
Liabilities and shareholders’ equity
Current liabilities
Accounts payable
Wages payable
600
400
Dividends payable
470
300
Total current liabilities
12,070
6,700
Mortgage payable
200,000
0
46,000
40,000
Common shares
29,000
25,000
Retained earnings
59,380
48,300
$346,450
$120,000
Notes payable
Total liabilities and shareholders’ equity
5-53
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C H A PTE R 5
The Statement of Cash Flows
WHISKEY INDUSTRIES LTD.
Statement of Income
For the year ended December 31, 2024
Sales
$130,000
Cost of goods sold
80,000
Gross margin
50,000
Expenses
Rent expense
7,100
Wages expense
9,600
Depreciation expense
20,000
Interest expense
600
Income tax expense
520
Gain on sale of equipment
(300)
$ 12,480
Net income
Required
a. Using the information above, prepare the statement of cash flows for Whiskey Industries Ltd. for the
year ended December 31, 2024, using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
AP5-7B (Preparation of statement of cash flows) Financial statement data for Metro Moving
Company for 2024 follow.
METRO MOVING COMPANY
Comparative Statement of Financial Position
Dec. 31, 2024
Dec. 31, 2023
$ 68,600
$ 49,100
95,000
59,400
Assets
Cash
Accounts receivable
Prepaid insurance
30,000
20,000
Total current assets
193,600
128,500
Property, equipment, and vehicles
400,000
345,000
(110,400)
(105,900)
289,600
239,100
$483,200
$367,600
$ 21,500
$ 18,600
Accumulated depreciation
Total non-current assets
Total assets
Liabilities and shareholders’ equity
Accounts payable
Wages payable
3,000
4,000
24,500
22,600
50,000
60,000
74,500
82,600
Common shares
200,000
200,000
Retained earnings
208,700
85,000
Total shareholders’ equity
408,700
285,000
$483,200
$367,600
Total current liabilities
Bank loan
Total liabilities
Total liabilities and shareholders’ equity
Application Problems Set B
METRO MOVING COMPANY
Statement of Income
For the year ended December 31, 2024
Moving revenue
$450,000
Gain on sale of vehicles
4,000
454,000
Expenses
Vehicle operating expenses
Wages expense
$102,400
134,000
Depreciation expense
59,500
Interest expense
5,400
Total expenses
301,300
$152,700
Net income
Additional information:
1. Vehicles that cost $65,000 and had a net carrying amount of $10,000 were sold for $14,000.
2. A cash payment was made to reduce the bank loan.
3. Dividends were declared and paid during the year.
Required
a. Prepare a statement of cash flows for Metro Moving Company for the year ended December 31,
2024, using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
AP5-8B (Preparation of statement of cash flows) Canbuild Materials Ltd. is a family-run
do-it-yourself building materials company located on Pelee Island, Ontario. The company produces
high-quality building materials for do-it-yourselfers. The company’s bookkeeper has gone on holiday and
the company has brought you in to help it prepare its monthly financial statement package, which the
bank requires as part of the terms of the loan financing. You have correctly completed the statement of
financial position and the statement of income statement. You only have the statement of cash flows left
to prepare based on the following information:
CANBUILD MATERIALS LTD.
Comparative Statement of Financial Position
Dec. 31, 2024
Dec. 31, 2023
$ 20,000
$ 50,000
Accounts receivable (net)
189,000
120,000
Assets
Cash
Inventory
167,000
187,000
Total current assets
376,000
357,000
Equipment
180,000
195,000
Accumulated depreciation
Total assets
(140,000)
(170,000)
$ 416,000
$ 382,000
$ 70,000
$ 68,000
Dividends payable
29,000
24,000
Total current liabilities
99,000
92,000
107,000
107,000
206,000
199,000
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable
Long-term loan payable
Total liabilities
(continued)
5-55
5-56
C H A PTE R 5
The Statement of Cash Flows
CANBUILD MATERIALS LTD.
Comparative Statement of Financial Position
Common shares
110,000
110,000
Retained earnings
100,000
73,000
$416,000
$382,000
Total liabilities and shareholders’ equity
CANBUILD MATERIALS LTD.
Statement of Income
For the year ended December 31, 2024
Sales revenue
$1,245,000
Cost of goods sold
655,000
Gross profit
590,000
Expenses
Wages expense
$221,000
Administrative expenses
46,000
Depreciation expense
98,000
Advertising expense
45,000
Interest expense
12,000
Total expenses
422,000
$ 168,000
Net income
Additional information:
During fiscal year 2024, Canbuild sold a piece of its equipment. The equipment sold had originally cost
$153,000 and was sold for $25,000.
Required
a. Using the information above, prepare Canbuild’s statement of cash flows for the year ended December 31, 2024, using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
AP5-9B (Preparation of statement of cash flows) Marchant Ltd. reported the following abbreviated statement of financial position and statement of income for 2024.
MARCHANT LTD.
Comparative Statement of Financial Position
Dec. 31, 2024
Dec. 31, 2023
$ 60,000
$ 70,000
Accounts receivable
120,000
140,000
Inventory
320,000
280,000
Property, plant, and equipment
700,000
650,000
Cash
Less: Accumulated depreciation
Total assets
Accounts payable
Wages payable
Loan payable
(260,000)
(230,000)
$940,000
$910,000
$ 82,000
$ 85,000
8,000
10,000
350,000
400,000
Common shares
200,000
150,000
Retained earnings
300,000
265,000
$940,000
$910,000
Total liabilities and shareholders’ equity
Application Problems Set B 5-57
MARCHANT LTD.
Statement of Income
For the year ended December 31, 2024
Sales revenue
$450,000
Cost of goods sold
240,000
Gross profit
210,000
Other expenses:
Supplies expense
Depreciation expense
Wages expense
Other operating expenses
Interest expense
$ 15,000
30,000
100,000
5,000
24,000
174,000
36,000
Other income
8,000
$ 44,000
Net income
Required
a. Prepare a statement of cash flows for Marchant Ltd. for the year ended December 31, 2024, using the
indirect method.
b. Determine the cash flows from operating activities using the direct method.
c. Was the cash flow generated by the company’s operating activities during the year larger or smaller
than the net income? Should these two amounts be the same? Explain.
d. Was the change in the amount of working capital during the year the same amount as cash from
operating activities? Should these two amounts be the same? Explain. (Hint: Working capital =
­current assets − current liabilities.)
AP5-10B (Preparation of statement of cash flows) A comparative statement of financial position
and a statement of earnings for Standard Card Company follow.
STANDARD CARD COMPANY
Statement of Financial Position
Dec. 31, 2024
Dec. 31, 2023
$134,000
$111,000
Assets
Current assets
Cash
Accounts receivable
Inventory
83,000
78,000
200,000
110,000
Prepaid insurance
10,000
20,000
Total current assets
427,000
319,000
Equipment
305,000
350,000
Accumulated depreciation
(67,000)
(75,000)
Total non-current assets
238,000
275,000
$ 665,000
$ 594,000
$ 88,000
$ 83,000
3,000
4,000
Non-current assets
Total assets
Liabilities
Current liabilities
Accounts payable
Interest payable
Deferred revenue
Total current liabilities
13,000
18,000
104,000
105,000
(continued)
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The Statement of Cash Flows
STANDARD CARD COMPANY
Statement of Financial Position
Long-term debt
100,000
150,000
Total liabilities
204,000
255,000
Common shares
200,000
115,000
Retained earnings
261,000
224,000
Total shareholders’ equity
461,000
339,000
$665,000
$594,000
Shareholders’ equity
Total liabilities and shareholders’ equity
STANDARD CARD COMPANY
Statement of Income
For the year ended December 31, 2024
Sales revenue
$207,000
Expenses
Cost of goods sold
$97,000
Depreciation expense
12,000
Insurance expense
10,000
Interest expense
8,000
Loss on sale of equipment
13,000
Income tax expense
23,000
Total expenses
163,000
$ 44,000
Net income
Additional information:
The loss on the sale of equipment occurred when a relatively new machine with a cost of $100,000 and
accumulated depreciation of $20,000 was sold because a technological change had made it obsolete.
Required
a. Prepare a statement of cash flows for the year ended December 31, 2024, using the indirect method.
b. Determine the cash flows from operating activities using the direct method.
AP5-11B (Preparation of statement of cash flows) Medicinal Plant Ltd. (MPL) is a privately held
distributor of medicinal marijuana tablets. The Vancouver Island-based company is well established and
is currently managed by its founder, Dylan Roberts. The company’s financial statements are presented
below, together with some additional information.
MEDICINAL PLANT LTD.
Statement of Income
For the year ended December 31, 2024
Sales revenue
$45,000,000
Cost of goods sold
29,500,000
Gross profit
15,500,000
Wages expense
1,800,000
Depreciation expense
1,500,000
Interest expense
1,350,000
Income tax expense
1,600,000
Gain on sale of equipment
Net income
(300,000)
$ 9,550,000
Application Problems Set B 5-59
MEDICINAL PLANT LTD.
Statement of Financial Position
As at December 31
2024
2023
$ 5,600,000
$ 6,400,000
Accounts receivable (net)
16,000,000
13,600,000
Inventory
20,000,000
17,000,000
Total current assets
41,600,000
37,000,000
Equipment
45,000,000
42,000,000
Accumulated depreciation, equipment
(8,750,000)
(9,250,000)
Assets
Current assets:
Cash
Total assets
$77,850,000
$69,750,000
$ 7,750,000
$ 8,000,000
1,800,000
2,000,000
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable
Wages payable
Total current liabilities
9,550,000
10,000,000
Bonds payable
24,000,000
28,000,000
Common shares
12,000,000
8,000,000
Retained earnings
Total liabilities and shareholders’ equity
32,300,000
23,750,000
$77,850,000
$69,750,000
Additional information:
MEDICINAL PLANT LTD.
Other Selected Financial Information for the Year Ended December 31, 2024
1. Total sales in 2024 were consistent with the prior years, and the company’s dividend policy has
remained consistent for the past five years.
2. During 2024, MPL sold a piece of equipment for $2.5 million. The equipment had originally cost
$4.2 million and had a net carrying amount of $2.2 million at the time of sale.
3. On August 1, 2024, MPL’s board of directors approved the retirement of bonds with a carrying
amount of $4.0 million through the issuance of common shares.
Required
MPL’s management shareholders have asked you to prepare the statement of cash flows for MPL using
either the direct or indirect method for determining cash flows from operating activities. Prepare the
statement for them.
AP5-12B (Preparation of statement of cash flows) Autonomous Control Ltd. (ACL) is a leading
automotive parts manufacturer supplying the large original equipment manufacturers (OEMs). ACL
manufactures sensors, electronics, and control technologies that are used by OEMs to make driverless
vehicles possible and safe. The London, Ontario–based company has customers across the world, but
its largest market is the United States. The company also manufactures traditional auto parts; however,
the shift by car manufacturers to more advanced technologies has meant that ACL’s sales declined by
15% over the prior year. The company is hoping that its move into control technologies and the trend
to safe driverless vehicles will translate to an increase in sales. In the meantime, the company has been
approaching its banks seeking a long-term loan. ACL provided the banks with the following financial
information:
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C H A PTE R 5
The Statement of Cash Flows
AUTONOMOUS CONTROL LTD.
Statement of Financial Position
As at September 30
2024
2023
Assets
Current assets:
Cash
$
–
$
20,000
Accounts receivable (net)
450,000
500,000
Inventory
692,000
600,000
1,142,000
1,120,000
Total current assets
Equipment
1,400,000
1,700,000
Accumulated depreciation, equipment
(1,282,000)
(1,350,000)
Total assets
$ 1,260,000
$1,470,000
$
$
Liabilities and shareholders’ equity
Current liabilities:
Bank indebtedness
10,000
0
Accounts payable
230,000
300,000
Total current liabilities
240,000
300,000
Bank loan payable
395,000
470,000
Common shares
400,000
400,000
Retained earnings
225,000
300,000
$ 1,260,000
$1,470,000
Total liabilities and shareholders’ equity
AUTONOMOUS CONTROL LTD.
Statement of Income
For the year ended September 30, 2024
Sales revenue
Cost of goods sold
$8,350,000
7,450,000
Gross profit
900,000
Wages expense
245,000
Utilities expense
276,000
Depreciation expense
170,000
Rent expense
200,000
Interest expense
30,000
Loss from operations
(21,000)
Gain on sale of equipment
35,000
Earnings before income tax
14,000
Income tax expense
Net income
5,000
$
9,000
Additional information:
1. During the year, the company made a principal repayment on the bank loan in the amount of
$75,000.
2. Equipment with a net carrying amount of $62,000 was sold during the year.
3. No equipment was purchased during the year.
Application Problems Set B 5-61
Required
a. You work for one of the banks in the lending group and have been tasked with preparing the statement of cash flows for ACL using either the direct or indirect method for determining cash flows
from operating activities. Prepare the statement.
b. Discuss significant observations from the statement of cash flows that your bank would want to
consider.
AP5-13B (Determining cash collected from customers and paid to suppliers) Practical Company had sales of $315,000 for the year. The company reported accounts receivable of $30,000 at the end
of last year and $34,000 at the end of this year. Practical’s cost of goods sold this year was $246,000. In last
year’s statement of financial position, the company reported inventory of $49,000 and accounts payable
of $33,000. In this year’s statement of financial position, Practical reported inventory of $43,000 and
accounts payable of $37,000.
Required
a. Calculate the amount of cash that Practical collected from customers during the year.
b. Calculate the amount of cash that Practical paid to suppliers for inventory during the year.
AP5-14B (Interpreting statement of cash flows) The following are the comparative statements of
cash flows for Italian Fine Leather Goods Incorporated (IFLG).
ITALIAN FINE LEATHER GOODS INCORPORATED
Statements of Cash Flows
(in thousands)
2024
2023
2022
$(19,869)
$(9,389)
$1,916
Operating activities
Net income (loss)
Adjustments for:
Depreciation expense
5,489
4,308
3,561
Loss on sale of equipment
3,210
663
327
(263)
(680)
Effect of changes in working capital items:
Accounts receivable
119
Inventory
202
Prepaid expenses
Accounts payable
Interest paid
Interest received
Income taxes (paid) recovered
Net cash inflow from operations
230
(2,181)
(81)
21
3,541
1,089
193
(1,752)
107
2,081
(53)
(60)
(12)
133
244
(183)
(664)
(9,319)
(5,094)
6,660
(2,728)
(4,972)
(4,500)
(446)
(1,107)
(829)
(3,174)
(6,079)
(5,329)
Investing activities
Acquisition of property and equipment
Acquisition of computer software
Net cash outflow for investing activities
Financing activities
Increase in bank loan
Repayment of bank loan
5,284
0
0
(2,900)
0
0
Issuance of common shares
0
227
Repurchase of common shares
0
(275)
(11,400)
2,384
(48)
(11,217)
Net cash inflow from financing activities
183
Overall increase (decrease) in cash
(10,109)
(11,221)
(9,886)
Cash position at beginning of year
13,225
24,446
34,332
$ 3,116
$13,225
$24,446
Cash position at end of year
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C H A PTE R 5
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Required
a. Discuss the company’s ability to meet its non-operating needs for cash over these three years, and
comment on the continuing nature of the major items that have appeared over this period.
b. Comment on the changes in IFLG’s accounts receivable, accounts payable, and inventory levels over
these three years.
c. How did the company finance its repayment of long-term debt and its acquisition of property, plant,
and equipment in 2024?
d. Describe how the company’s mix of long-term financing has changed during this three-year period,
in terms of the proportion of debt versus equity. (Hint: Start by calculating the total amount of the
increase or decrease in long-term debt and comparing it with the total amount of the increase or
decrease in shareholders’ equity.)
AP5-15B (Cash flow patterns) Crafty Resources Ltd. is a new creator and publisher of children’s craft kit books. It has created kits for dolls, twirled paper crafts, paper doll clothes, and so
on. The publishing industry is characterized by lengthy credit periods for bookstores and a lack
of credit granting on the part of paper suppliers and commercial grade copy and binding machine
manufacturers.
Required
Determine the cash flow pattern that you expect Crafty Resources to have in its first year of operation,
and explain your rationale.
AP5-16B (Cash flow patterns) Garcinia Health Foods Inc. (GHF) is a nutritional company that
produces weight management food supplements as well as healthy meals. The health supplement
industry is characterized by lengthy credit periods for health food stores and a lack of credit granting on the part of botanical suppliers. GHF recently completed the construction of a state-of-the-art
manufacturing facility and global infrastructure to meet demand for the company’s weight management supplements. The new manufacturing facility is expected to improve its global distribution and
increase sales, and management hopes it will result in the company becoming profitable. In the same
fiscal year, GHF announced that it had received the proceeds from a long-term loan from a group of
banks.
Required
Determine the cash flow pattern that you expect GHF to have. Explain your rationale.
User Perspective Problems
UP5-1 (Cash flows from operations) In this chapter, we have emphasized the importance of carefully analyzing the operating section of the statement of cash flows. In fact, the operating activities section is always the first one listed on the statement.
Required
From a user perspective, explain why this section is so important for understanding a company’s financial health.
UP5-2 (Cash flow and compensation plans)
Required
If you were the owner of a company and wanted to establish a management compensation plan to
motivate your top managers, would you want to base your performance targets on cash flows from
operations or on income from operations? Discuss the pros and cons of using the two measures of
performance.
User Perspective Problems 5-63
UP5-3
(Format of the statement of cash flows from a lender’s perspective)
Required
As a lender, discuss whether you would be satisfied with the current method of classifying cash flows into
only three categories. In addition, discuss the normal treatment of interest expense within the statement
of cash flows relative to the treatment of dividends and whether you think there are any problems with
this.
UP5-4
(Statement of cash flows and lending decisions)
Required
From the perspective of a bank loan officer, discuss why the statement of cash flows may or may not be
more important than the statement of income when you are analyzing a company that is applying for a
loan.
UP5-5 (Accrual accounting and cash flows) Loan officer Han Blackford once commented that
cash flow analysis has risen in importance due to a “trend over the past 20 years toward capitalizing
costs and deferring more and more expenses. Although the practice may be better in terms of reporting
expenses in the same period as the revenues they generated, it has also made it harder to find the available cash in a company, and easier for lenders to wind up with a loss.” He further noted that recessions,
and the bankruptcies that often result, draw attention to the need for better warning signals of the sort
that cash flow analysis could provide.
Required
a. Why would the process of capitalizing costs (recording them as assets to be depreciated over future
periods) be better in terms of reporting expenses in the same period as the revenues they generated,
yet make it harder to find the cash available in a company?
b. Explain why unexpected bankruptcies would draw attention to cash flow analysis. Your response
should include a discussion of why the statements of income and financial position might not adequately alert users to impending bankruptcies.
UP5-6
(Statement of cash flows and investing decisions)
Required
From the perspective of a stock analyst, discuss why the statement of cash flows may or may not be more
important than the statement of income when analyzing a company to make a recommendation about
investing in its shares.
UP5-7 (Analyzing investment decision) Jacques Rousseau is considering investing in Health Life
Ltd., a pharmaceutical company. He read in the paper that this company is doing cancer research and is
close to a breakthrough in developing a new drug that will be effective against bone cancer. The author of
the article said that this was a good time to buy because, once the breakthrough happens, the share price
is going to rise very rapidly. Jacques therefore decided to look at the company’s most recent financial
statements.
On the statement of financial position, he saw that the company had a significant amount of
cash and short-term investments. It had some assets listed as “buildings and equipment under capital
lease,” which he interpreted to mean that the company was leasing its buildings and equipment rather
than owning them. When he looked at the statement of income, he saw that there was no revenue. By
far the largest expense was for research and development. The company had a loss during the current
year, and the company reported a deficit on the statement of financial position. He thought that this
made sense, because the company had yet to make its first medical breakthrough. The company had
little debt, and its shares were recorded at approximately $35 million. When he looked at the notes, he
saw that there were about 7 million shares issued. In fact, 1 million of those shares had been issued
during the current year.
Required
Help Jacques with his decision by answering the following questions:
a. Do you think that investing in this company would be risky? Explain.
b. Does the fact that Health Life is holding a large amount of cash and short-term investments mean
that management is doing a good job? Explain in detail.
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C H A PTE R 5
The Statement of Cash Flows
c. Is it possible for Jacques to make a rough estimate of how much longer the cash and short-term
investments will last, assuming that the company does not get its breakthrough? What information
would help him make this estimate?
d. Based on the number of shares that have been issued and the amount that is recorded in the share
capital account, it is obvious that many investors have concluded that this is a good investment.
Think carefully about this, and then list three or four advantages and disadvantages of buying shares
in Health Life at this time.
UP5-8 (Interpreting statement of cash flows data) The 2024 financial statements of Green Company include the following statement of cash flows:
GREEN COMPANY
Statement of Cash Flows
For the year ended December 31, 2024
Operating:
Net income
$
644,000
Adjustments to convert to cash:
Depreciation expense
230,000
Gain on sale of operating assets
(14,000)
Change in current assets other than cash
Change in current liabilities
(120,000)
80,000
Cash provided by operations
$ 820,000
Investing:
Purchase of property, plant, and equipment
Proceeds from the sale of property, plant, and equipment
$ (1,200,000)
400,000
Cash used for investing
(800,000)
Financing:
Issuance of shares
Retirement of bonds
Dividends paid
Cash used for financing
Decrease in cash
1,000,000
(1,300,000)
(250,000)
(550,000)
$ (530,000)
Required
a. Did Green Company increase or decrease its current assets, other than cash, during 2024? Is this
change consistent with an increase in sales, or a decrease in sales, during the period? Explain.
b. From an investor’s point of view, has Green Company become more risky or less risky in 2024?
Explain.
c. Does Green Company appear to be expanding or contracting its operations? How can you tell? What
other financial statement information might you examine to determine whether the company is
expanding or contracting its operations?
d. Does Green Company appear to be able to maintain its productive capacity without additional
financing? Explain.
UP5-9 (Interpretation of operating section) The operating activities section of Johann Manufacturing Ltd.’s statement of cash flows is shown below. In answering the questions after the statement,
assume that the net cash flows from Johann’s investing and financing activities were zero; that is, that the
cash inflows within the investing and financing sections were offset by the cash outflows.
Work in Progress
JOHANN MANUFACTURING LTD.
Statement of Cash Flows
For the year ended December 31, 2024
Cash flows from operations:
Net income
$ 632,000
Adjustments to convert earnings to cash flows:
Depreciation expense
Loss on sale of investments
$110,000
50,000
160,000
Change in current items other than cash:
Accounts receivable
Inventory
Prepaid expenses
Accounts payable
Income tax payable
$ (80,000)
20,000
(45,000)
75,000
(14,000)
Cash provided by operations
Cash balance, January 1
Cash balance, December 31
(44,000)
748,000
566,000
$1,314,000
Required
Use the preceding information to answer the following questions. If a question cannot be answered based
on the information given, indicate why.
a. Have the accounts receivable increased or decreased this year? Explain briefly.
b. Has the inventory increased or decreased this year? Explain how this affects cash.
c. Did the amount of expenses prepaid by the company increase or decrease during the year? Does this
help or hurt its cash position? Explain briefly.
d. Compared with last year, does the company seem to be relying more heavily or less heavily on trade
credit from suppliers to finance its activities? Explain briefly.
e. If you were a potential creditor, would you see any warning signs in the statement of cash flows that
you would want to investigate before lending money to Johann Manufacturing? Explain briefly.
f. Johann Manufacturing has $2 million of bonds maturing in January 2025. Do you think the company will be able to meet its obligation to pay off the bonds, without obtaining additional long-term
financing? Explain briefly.
UP5-10
(Net free cash flow)
Required
As a lender, discuss why you might be interested in knowing a company’s net free cash flow. How might
it be factored into a lending decision?
UP5-11
(Net free cash flow)
Required
As a shareholder or potential investor, discuss why you might be interested in knowing a company’s net
free cash flow. Comment on whether this measure is of more use than cash flows from operating activities.
Work in Progress
WIP5-1 (Analyzing the statement of cash flows) You are part of a group of students analyzing a
company’s financial statements for a class project. At a team meeting, one of your group members makes
the following statement:
“After reviewing the statement of cash flows, I am certain there are some mistakes. In the section
for cash flows from operating activities, the gain on the sale of equipment was taken away. This
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C H A PTE R 5
The Statement of Cash Flows
cannot be correct as the company received cash from the sale. Also, the company’s annual report
indicates that dividends were declared at the end of the year, but there is nothing in the cash flows
from financing activities related to them, which must be another error.”
Required
Identify where your classmate’s analysis is flawed and explain why this is the case.
WIP5-2 (Dividends and the statement of cash flows) While preparing for an upcoming exam,
you are studying with some classmates when one of them states the following:
“I always get confused when I am preparing the financing activities section of the statement of cash
flows. I’m pretty certain that the payment of loan interest is a financing activity. I sometimes mix
this up with how dividend payments are treated. I think that the declaration of dividends reduces
retained earnings, but does not affect the statement of cash flow.”
Required
Evaluate your classmate’s response. Identify the elements that are correct and incorrect.
WIP5-3 (Difference between net income and cash flows from operating activities)
studying with some classmates, when one of them makes the following statement:
You are
“If a company reports a net loss on its statement of income, then we know the following:
• Expenses exceeded revenues for the period.
• Retained earnings will be reduced by the amount of the loss.
• Cash flows from operating activities will be negative.
• And finally, the company’s cash flows from financing activities will have to be positive or else
the company would have had to cease operations.”
Required
Evaluate your classmate’s statement. Identify the elements that are correct and incorrect. For any elements that are incorrect, explain why.
WIP5-4 (Difference between net income and cash flows) A co-worker states that “if the company
is profitable, that guarantees that it will have positive cash flow. Making profit means making money. As
a result, the company should experience increased cash by the same amount it reports as net income.”
Required
Evaluate your co-worker’s statement. Identify the elements that are correct and incorrect. For any elements that are incorrect, explain why.
WIP5-5 (Cash flows from operating activities) You are part of a group of students analyzing the
financial statements of a public company as part of a class project. At a team meeting, one of your group
members makes the following statement:
“The company’s cash flows from operating activities were $2.8 million for the year. Because these
profits belong to shareholders, the company would normally distribute dividends of $2.8 million to
them in the next year.”
Required
Identify where your classmate’s analysis is flawed and explain why this is the case.
WIP5-6 (Cash flows from operating activities)
While you are studying with a friend, she states:
“An increase in inventory or the payment of dividends has a negative effect on cash flows from operations, while an increase in accounts receivable or wages payable has a positive effect.”
Required
Evaluate your friend’s statement. Identify the elements that are correct and incorrect. For any elements
that are incorrect, explain why.
WIP5-7 (Classification of cash flows) You are part of the management team of Diggit Heavy
Equipment Ltd., which sells excavators, dump trucks, and other heavy equipment across Eastern Canada. At a management meeting to discuss how to improve the company’s profitability and cash flows, one
of your colleagues states the following:
Reading and Interpreting Published Financial Statements
5-67
“We need to set up a program where we can lend money to our customers to finance their equipment purchases. I think that if we offer three-year notes receivable at a low interest rate, it will
entice many of our customers to buy additional equipment. This will increase sales revenue and net
income, which will also increase cash flows from operating activities.”
Required
Review your co-worker’s proposal. Explain if her thinking is correct and whether or not it will help the
company meet its objectives. Identify and explain the flaws in your co-worker’s logic.
Reading and Interpreting Published Financial Statements
RI5-1 (Analysis of a company’s statement of cash flows) Exhibits 5.21A and 5.21B contain the
consolidated statements of cash flows and related note disclosure for Aritzia Inc.
EXHIBIT 5.21A
ARITZIA INC.
Aritzia Inc.’s 2020 Statements
of Cash Flows
Consolidated Statements of Cash Flows
For the years ended March 1, 2020 and March 3, 2019
(in thousands of Canadian dollars)
Note
March 1,
2020
March 3,
2019
$ 90,594
$ 78,728
6, 7, 8
93,502
27,065
Finance expense
16
28,319
4,821
Stock-based compensation expense
14
7,790
11,540
Operating activities
Net income for the year
Adjustments for:
Depreciation and amortization
Amortization of deferred rent and deferred lease
inducements
(652)
Unrealized foreign exchange loss on forward
contracts
12
Unrealized gain on equity derivative contracts
12
Other
Income tax expense
(650)
(37)
17
Proceeds from lease incentives
Cash generated before non-cash working capital
balances and interest and income taxes
Net change in non-cash working capital balances
—
21
Cash generated before interest and income taxes
Interest paid
(905)
415
—
—
35,544
32,922
11,537
12,148
265,947
166,734
18,625
(39,616)
284,572
127,118
(4,429)
(4,709)
Interest paid on lease liabilities
(23,763)
—
Income taxes paid
(34,304)
(26,234)
Net cash generated from operating activities
222,076
96,175
Financing activities
Repayment of principal on lease liabilities
8
(61,469)
(454)
Proceeds from options exercised
14
11,627
8,057
Shares repurchased for cancellation
13
(107,560)
(9,391)
(continued)
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C H A PTE R 5
The Statement of Cash Flows
EXHIBIT 5.21A
Aritzia Inc.’s 2020 Statements
of Cash Flows (continued)
ARITZIA INC.
Consolidated Statements of Cash Flows
For the years ended March 1, 2020 and March 3, 2019
(in thousands of Canadian dollars)
Note
March 1,
2020
March 3,
2019
Repayment of long-term debt
11
—
(43,738)
Payment of financing fees
11
—
Net cash used in financing activities
(667)
(157,402)
(46,193)
Investing activities
Purchase of property and equipment
6
(45,591)
(56,425)
Purchase of intangible assets
7
(2,199)
(5,585)
(47,790)
(62,010)
Net cash used in investing activities
Effect of exchange rate changes on cash and cash
equivalents
(31)
Increase (decrease) in cash and cash equivalents
Cash and cash equivalents – Beginning of year
Cash and cash equivalents – End of year
450
16,853
(11,578)
100,897
112,475
$117,750
$100,897
Supplemental cash flow information (note 21)
EXHIBIT 5.21B Excerpt from
Arizia Inc.’s 2020 Annual
Report
ARITZIA INC.
Notes to Consolidated Financial Statements
March 1, 2020 and March 3, 2019
(in thousands of Canadian dollars, unless otherwise noted)
21 Supplemental cash flow information
March 1,
2020
March 3,
2019
Net change in non-cash working capital balances
Accounts receivable
82
(1,545)
Inventory
$
18,462
(34,457)
Prepaid expenses and other current assets
(1,351)
(1,714)
Other assets
(2,186)
(217)
Accounts payable and accrued liabilities
(1,444)
(6,181)
Deferred revenue
5,062
4,498
$18,625
$ (39,616)
Required
a. In total, how much did Aritzia’s cash and cash equivalents change during 2020? Was this an increase
or a decrease? How did this compare with the previous year?
b. Did Aritzia have net income or a net loss in 2020? How did this compare with the cash flows from
operating activities? What was the largest difference between these two amounts?
c. What effect did the change in the company’s accounts payable and accrued liabilities have on cash
flows from operating activities in 2020? What does this tell you about the balance owed to these
creditors?
Reading and Interpreting Published Financial Statements 5-69
d. What effect did the change in the company’s inventory have on cash flows from operating activities
in 2020? What does this tell you about the company’s inventory balance at the end of the current
year relative to the prior one?
e. Did Aritzia purchase property and equipment during 2020? Did the company receive any proceeds
from the sale of property and equipment during the period?
f. Calculate Aritzia’s net free cash flow for 2020 and 2019. Is the trend positive or negative?
g. Arizia’s current liabilities were $153,843 at March 1, 2020, and $90,611 at March 3, 2019. Determine
the company’s operating cash flow ratio. Comment on the change year over year.
h. If you were a user of Aritzia’s financial statements—a banker or an investor—how would you interpret the company’s cash flow pattern? How would you assess the risk of a loan to or an investment
in Aritzia? Do you think the company is growing rapidly?
RI5-2 (Analysis of a company’s statement of cash flows) Exhibits 5.22A and 5.22B show the
consolidated statement of cash flows of Dollarama Inc. for the years ended January 31, 2021, and
­February 2, 2020, along with related note disclosure.
EXHIBIT 5.22A Dollarama
Inc.’s 2021 Consolidated
Statement of Cash Flows
DOLLARAMA INC.
Consolidated Statement of Cash Flows for the years ended
(Expressed in thousands of Canadian dollars)
January 31,
2021
February 2,
2020
$564,348
$564,039
17
269,633
242,785
17
2,673
2,677
Note
Operating activities
Net earnings
Adjustments to reconcile net earnings to net
cash generated from operating activities:
Depreciation of property, plant and equipment,
right-of-use assets and amortization of
intangible assets
Amortization of debt issue costs
Recognition of gains and losses on bond
lock and bond forward contracts
Share-based compensation
(354)
12
6,240
13
15,843
Financing costs on long-term debt
Deferred income taxes
(356)
Gain on lease modifications
Share of net earnings of equity-accounted
investment
9
Other income
Changes in non-cash working capital components
Net cash generated from operating activities
5,448
1,138
15,015
(4,822)
(762)
(19,654)
(10,263)
—
18
(378)
(2,835)
833,551
816,864
55,531
(84,356)
889,082
732,508
Investing activities
Acquisition of equity-accounted investment
9
(97,281)
(59,546)
Additions to property, plant and equipment
7
(140,040)
(120,963)
Additions to intangible assets
8
(27,797)
(19,659)
Proceeds from disposal of property, plant and
equipment
Net cash used in investing activities
593
(264,525)
855
(199,313)
(continued)
5-70
C H A PTE R 5
The Statement of Cash Flows
EXHIBIT 5.22A Dollarama
Inc.’s 2021 Consolidated
Statement of Cash Flows
(continued)
DOLLARAMA INC.
Consolidated Statement of Cash Flows for the years ended
(Expressed in thousands of Canadian dollars)
Note
January 31,
2021
Proceed from long-term debt issued
(1.505% Fixed Rate Notes)
11
300,000
Repayment of Credit Facility
11
Repayment of Series 2 Floating Rate Notes
11
February 2,
2020
Financing activities
Payment of debt issue costs
(25,000)
(2,200)
Payment of bond forward settlement
(260)
(460)
Principal elements of lease liabilities
—
6
(163,804)
(127,717)
Issuance of common shares
12
32,399
41,174
Dividends paid
12
(54,770)
(54,144)
Repurchase and cancellation of common shares
12
(87,042)
(327,155)
Net cash used in financing activities
(275,877)
(493,102)
Change in cash
348,680
40,093
90,464
50,371
$ 439,144
$ 90,464
Cash – beginning of year
Cash – end of year
EXHIBIT 5.22B Excerpt from
Dollarama Inc.’s 2021 Annual
Report
—
(300,000)
DOLLARAMA INC.
18 Details of statement of cash flows
Changes in non-cash working capital
(Expressed in thousands of Canadian dollars)
The changes in non-cash working capital components for the fiscal years ended on the
dates indicated below are as follows:
January 31,
2021
Accounts receivable
$ 14,061
Prepaid expenses
Prepaid income taxes
Inventories
Accounts payable and accrued liabilities
Income taxes payable
Cash paid for income taxes
Cash paid for interest
(1)
(1)
February 2,
2020
$
1,222
386
5,639
1,777
—
(7,164)
(42,262)
33,727
(12,600)
12,744
(36,355)
$ 55,531
$ (84,356)
$170,207
$227,669
93,877
97,801
As at February 2, 2020, the estimated balance of the purchase price for the acquisition of
a 50.1% interest in Dollarcity of US$52,674 ($69,816) was recorded in accounts payable and
accrued liabilities and was excluded from the change in non-cash working capital. See Note
9 for recent developments.
Reading and Interpreting Published Financial Statements 5-71
Required
a. How did Dollarama’s net income in 2021 compare with the cash flows from operating activities?
What was the largest difference between these two amounts?
b. Did Dollarama increase or decrease the amount of inventory in its stores between 2020 and 2021? Is
this consistent with the nature of the changes reflected in the company’s cash flows from investing
activities?
c. What effect did the change in the company’s accounts payable and accrued liabilities have on cash
flows from operating activities in 2021? What does this tell you about the balance owed to these
creditors?
d. Explain why depreciation and amortization expenses amounting to $269,633 were added back to net
earnings in determining Dollarama’s 2021 cash flows from operating activities.
e. Examine the financing activities section of Dollarama’s statement of cash flows and comment on
the main differences between 2021 and 2020.
f. How much did Dollarama pay in dividends during 2021? How did this compare with the amount of
cash the company paid to repurchase common shares that had been issued previously?
RI5-3 (Analysis of a company’s statement of cash flows) The consolidated statements of cash
flows and related note disclosure for Canada Goose Holdings Inc. are in Exhibits 5.23A and 5.23B. Canada Goose designs, manufactures, and sells luxury apparel, including parkas, down jackets, and footwear.
EXHIBIT 5.23A Canada Goose Holdings Inc.’s 2020 Consolidated Statements of Cash Flows
CANADA GOOSE HOLDINGS INC.
Consolidated Statements of Cash Flows
(in millions of Canadian dollars)
March 29,
2020
Year ended
March 31,
2019
March 31,
2018
$151.7
$143.6
$96.1
Depreciation and amortization
63.1
22.7
14.2
Income tax expense
12.0
38.9
29.1
Interest expense
20.4
13.7
12.5
Foreign exchange (gain) loss
(0.7)
2.7
(8.6)
7.0
—
—
1.7
0.2
0.2
Notes
Operating activities
Net income
Items not affecting cash:
Acceleration of unamortized costs on debt extinguishment
17
Loss on disposal of assets
Share-based payment
8.5
3.8
2.0
263.7
225.6
145.5
(130.6)
(100.7)
(2.3)
Income taxes paid
(52.1)
(41.0)
(7.4)
Interest paid
(18.5)
(10.5)
(9.6)
Net cash from operating activities
62.5
73.4
126.2
Purchase of property, plant and equipment
(45.3)
(30.3)
(26.1)
Investment in intangible assets
(17.0)
(19.0)
(7.7)
Changes in noncash operating items
19
23
Investing activities
Business combination
Net cash used in investing activities
5
—
(62.3)
(33.6)
(0.6)
(82.9)
(34.4)
(continued)
5-72
C H A PTE R 5
The Statement of Cash Flows
EXHIBIT 5.23A Canada Goose Holdings Inc.’s 2020 Consolidated Statements of Cash Flows (continued)
CANADA GOOSE HOLDINGS INC.
Consolidated Statements of Cash Flows
(in millions of Canadian dollars)
Notes
March 29,
2020
Year ended
March 31,
2019
March 31,
2018
Financing activities
Net repayments of debt facilities
17
—
—
(8.8)
Transaction costs on financing activities
17
(2.3)
—
(0.3)
Subordinate voting shares purchased for cancellation
18
(38.7)
—
—
9
(24.7)
—
—
Settlement of term loan derivative contracts
21
4.6
—
—
Exercise of stock options
19
Principal paid on lease liabilities
Net cash (used in) from financing activities
Effects of foreign currency exchange rate changes on cash
(Decrease) increase in cash
Cash, beginning of period
Cash, end of period
EXHIBIT 5.23B Excerpt from
Canada Goose Holdings Inc.’s
2020 Annual Report
2.4
3.1
1.2
(58.7)
3.1
(7.9)
1.6
(0.3)
1.7
(56.9)
(6.7)
85.6
88.6
95.3
9.7
$31.7
$88.6
$95.3
March 31,
2019
March 31,
2018
CANADA GOOSE HOLDINGS INC.
Notes to the Consolidated Financial Statements
March 29, 2020
(in millions of Canadian dollars, except share and per share data)
Note 23. Selected cash flow information
Changes in non-cash operating items
March 29,
2020
Trade receivables
Inventories
$ (10.6)
3.4
$ (3.1)
(87.3)
(39.5)
Other current assets
6.1
(10.3)
(5.6)
Accounts payable and accrued liabilities
(1.3)
(14.7)
41.5
Provisions
14.5
5.6
1.6
—
3.3
2.3
2.5
(0.7)
0.5
Deferred rent
Other
Change in non-cash operating items
(141.8)
$
$(130.6)
$(100.7)
$ (2.3)
Required
a. In total, how much did Canada Goose’s cash change during 2020? Was this an increase or a decrease?
How did this compare with the previous two years?
b. Did Canada Goose have net income or a net loss in 2020? How did this compare with the cash flows
from operating activities? What was the largest difference between these two amounts?
c. What effect did the change in the company’s trade receivables have on cash flows from operating
activities in 2020? What does this tell you about the balance owed by the company’s customers?
Reading and Interpreting Published Financial Statements 5-73
d. Did the company’s inventory balance increase or decrease during 2020? How does this compare
with 2019 and 2018? How did the change in inventory in 2020 compare with the change in accounts
payable for the same period? What does this tell you about whether or not the company’s suppliers
are helping to finance these changes in inventory balances?
e. Calculate Canada Goose’s net free cash flow for 2020, 2019 and 2018. Is the trend positive or
negative?
f. Assuming that the net free cash flow determine in part (e) continued in 2021, comment on
whether Canada Goose would have sufficient net free cash flow to finance the purchase of property, plant, and equipment and share repurchases if these activities continued at the same level as
in 2020.
g. Canada Goose had current liabilities of $201.3 million at the end of 2020 and $136.6 million at the
end of 2019. Calculate Canada Goose’s operating cash flow ratio for 2020. How did this compare
with the cash flow ratio for 2019?
RI5-4 (Analysis of a company’s statement of cash flows) The consolidated statements of cash
flows for Cargojet Inc. are in Exhibit 5.24. The company provides domestic air cargo services between
14 major Canadian cities and also operates international routes for cargo customers.
EXHIBIT 5.24 Cargojet Inc.’s
2020 Consolidated Statements
of Cash Flows
CARGOJET INC.
Consolidated Statements of Cash Flows
Year ended December 31, 2020 and 2019
(in millions of Canadian dollars)
Note
2020
2019
Cash flows from operating activities
Net (loss) earnings
$ (87.8)
$ 11.6
Adjustments to reconcile net cash from operating
activities
Depreciation of property, plant and equipment and
amortization of contract assets
5, 8
109.1
94.0
Share-based compensation
11
32.9
10.5
Finance costs
18
39.6
43.6
Crew incentive
11
8.5
1.9
Gain on disposal of property, plant and equipment
8
(0.8)
(1.3)
Impairment of property, plant and equipment
8
0.6
—
Employee pension liability
17
13.2
3.5
Income tax provision
15
44.0
9.2
Fair value adjustment on stock warrant
5
177.9
0.9
Gain on total return swap
27
(50.8)
(7.8)
Unrealized foreign exchange gain
19
(2.2)
(4.3)
Gain on extinguishment of debt
13
(1.1)
—
—
(4.7)
Other gains and expenses
Interest paid
Cash generated from operating activities
(24.1)
(25.4)
259.0
131.7
Changes in non-cash working capital items and deposits
Contract acquisition asset
Trade and other receivables
—
(6.5)
10.0
13.9
Inventories
0.8
(0.7)
Prepaid expenses and deposits
0.9
(0.7)
Trade and other payables
Net cash generated from operating activities
21.9
7.2
292.6
144.9
(continued)
5-74
C H A PTE R 5
The Statement of Cash Flows
CARGOJET INC.
Consolidated Statements of Cash Flows
Year ended December 31, 2020 and 2019
(in millions of Canadian dollars)
Note
2020
2019
(146.6)
(218.1)
Cash flows from investing activities
Purchase of property, plant and equipment
Proceeds from disposal of property, plant and equipment
Proceeds from insurance claim
Proceeds from total return swap & settlement of
derivative financial instrument
8
19
0.8
1.3
8
3.6
—
27
14.5
4.1
Acquisition of business
—
(3.1)
Settlement of provision
—
(1.4)
Net cash used in investing activities
(127.7)
(217.2)
(171.3)
(61.6)
Cash flows from financing activities
Repayment of borrowings
Proceeds from borrowings
Repayment of obligations under lease liabilities
—
99.8
10,13
(77.3)
(55.5)
Options settled in cash
11
(7.1)
(2.0)
Proceeds from debenture issuance net of issuance costs
14
Withholding tax paid on vested RSU’s
11
(2.4)
(3.2)
Dividends paid to shareholders
20
(14.6)
(12.4)
(162.8)
74.8
Net cash (used in) provided from financing activities
109.9
109.7
Net change in cash
2.1
2.5
Cash (bank overdraft), beginning of Year
1.6
(0.9)
Cash, end of year
$
3.7
$
1.6
Required
a. In total, how much did Cargojet’s cash change during 2020? Was this an increase or a decrease? How
did this compare with the previous year?
b. How did Cargojet’s net income or loss in 2020 compare with the cash flows from operating activities? What was the largest difference between these two amounts?
c. What effect did the change in the company’s trade and other receivables have on cash flows from
operating activities in 2020? What does this tell you about the balance owed by the company’s
customers?
d. What effect did the change in the company’s trade and other payables have on cash flows from operating activities in 2020? What does this tell you about the balance owed to these creditors?
e. Calculate Cargojet’s net free cash flow for 2020 and 2019. Is the trend positive or negative?
f. Cargojet had current liabilities of $180.6 million at the end of 2020 and $114.5 million at the end
of 2019. Calculate Cargojet’s operating cash flow ratio for both years. What do these results tell you
about the company’s ability to generate sufficient cash to cover its current liabilities?
g. If you were a user of Cargojet’s financial statements—a banker or an investor—how would you
interpret the company’s cash flow pattern? How would you assess the risk of a loan to or an investment in Cargojet? Do you think the company is growing rapidly?
Cases
RI5-5
(Analysis of a statement of cash flows)
Required
For a company of your own choosing, answer the following questions based on its statement of cash
flows:
a. Summarize the results for cash from operating, investing, and financing activities over the last two
years.
b. Explain any significant changes in the items listed in part (a), from last year to this year.
c. Treating operations as a single source, what were the three most significant (largest) sources of cash
in the most recent year?
d. Within the investing and financing sections, what were the four most significant (largest) uses of
cash in the most recent year?
e. How has the company been financing its investing activities—through operating activities, financing activities, or both? Support your answer with numbers from the statement of cash flows.
Cases
C5-1 Atlantic Service Company
Atlantic Service Company was established in Moncton, New Brunswick, five years ago to provide services
to the home construction industry. It has been very successful, with assets, sales, and profits increasing each
year. However, Atlantic is experiencing serious cash shortages and is in danger of going into bankruptcy,
because it cannot pay its suppliers and already has a very substantial overdraft at its bank. The president
has asked you to analyze the statement of cash flows for the years 2024 and 2023, which appears below.
ATLANTIC SERVICE COMPANY
Statement of Cash Flows
For the year ended December 31
2024
2023
$200,000
$185,000
25,000
20,000
3,000
2,000
Increase in accounts receivable
(35,000)
(25,000)
Increase in inventory
(30,000)
(20,000)
Operating activities:
Net income
Adjustments to convert earnings to cash flows:
Depreciation expense
Gain on sale of investments
Changes in non-cash working capital:
Increase in prepaid expenses
(5,000)
(4,000)
Increase in accounts payable
52,000
43,000
210,000
201,000
(100,000)
(60,000)
Renewal of short-term bank loan
180,000
100,000
Dividends paid
(15,000)
(10,000)
65,000
30,000
(300,000)
(250,000)
Net cash provided by operating activities
Financing activities:
Repayment of short-term bank loan
Net cash provided by financing activities
Investing activities:
Purchase of equipment
Net cash used by investing activities
(300,000)
(250,000)
Net decrease in cash during year
(25,000)
(19,000)
Cash position (bank overdraft) at beginning of year
(29,000)
(10,000)
$ (54,000)
$ (29,000)
Cash position (bank overdraft) at end of year
5-75
5-76
C H A PTE R 5
The Statement of Cash Flows
Required
Write a memo to:
a. Explain what appears to be causing the cash shortage.
b. Recommend a plan to save the company from bankruptcy.
C5-2 Robertson Furniture Ltd.
Kayla Martchenko has just received a small inheritance from her grandparents’ estate. She would like to
invest the money and is currently reviewing several opportunities. A friend has given her the financial
statements of Robertson Furniture Ltd., a company she found on the Internet. Kayla has reviewed the
financial statements and is ready to invest in Robertson Furniture.
Before she invests, Kayla comes to you for some financial advice, because she knows you are taking
an accounting course and may be able to give her some insights into the financial statements. She is
convinced that this company will be a profitable investment because the statement of financial position
indicates that the company’s cash balances have been increasing very rapidly, from only $8,000 two years
ago to $354,000 now.
Kayla has copied Robertson’s statement of cash flows for you, so that you can see how much cash
the company has been able to generate each year.
ROBERTSON FURNITURE LTD.
Statement of Cash Flows
For the year ended December 31
2024
2023
$ (4,000)
$ 12,000
Operating activities:
Net income (loss)
Add back items not representing cash flows:
Depreciation expense
20,000
40,000
Loss on disposal of property, plant, and equipment
12,000
10,000
4,000
3,000
Increase in accounts receivable
(40,000)
(36,000)
Increase in inventory
(54,000)
(42,000)
8,000
2,000
45,000
28,000
(9,000)
17,000
Loss on sale of investments
Adjustment for working capital items:
Decrease in prepaid insurance
Increase in accounts payable
Cash flow from operating activities
Financing activities:
Issuance of bonds payable
Issuance of shares
Payment of dividends
Cash flow from financing activities
100,000
20,000
50,000
30,000
(2,000)
(20,000)
148,000
30,000
Sale of property, plant, and equipment
70,000
22,000
Sale of investments
50,000
20,000
Cash flow from investing activities
120,000
42,000
Overall increase in cash during year
259,000
89,000
97,000
8,000
$356,000
$ 97,000
Investing activities
Cash—beginning of year
Cash—end of year
Required
a. Comment on Robertson Furniture’s statement of cash flows and address Kayla’s opinion that, in
light of the amount of cash it has generated, the company must be a good investment.
b. Based on the results of your analysis of Robertson’s statement of cash flows, outline several points
that Kayla should investigate about this company before investing her inheritance in it.
Cases
C5-3 Ridlow Shipping Ltd.
Jim Shea is an accountant at King and Associates, an accounting firm based in Halifax. The firm specializes in dealing with small business clients who generally are very successful business people but have
limited accounting knowledge.
Owen Ridlow is a client and the sole owner of Ridlow Shipping Ltd. He recently called Jim with
some questions about the financial statements prepared for the year ended December 31, 2024. During
the conversation, Owen made the following comment: “Jim, I am wondering why I have to pay you guys
to prepare a statement of cash flows. I understand the importance of the statement of financial position
and the statement of income, but since I always know how much cash I have in the bank and I reconcile
my bank accounts regularly, why do I need a statement of cash flows? It seems to me that paying to have
this statement prepared is an unnecessary expense.”
Required
Do you think Owen is at all justified in making this comment? Outline several points that Jim should raise in
his discussion with Owen to explain the importance of the statement of cash flows and justify the need for it.
Support your answer by referring to Ridlow Shipping’s most recent statement of cash flows, which follows.
RIDLOW SHIPPING LTD.
Statement of Cash Flows
For the year ended December 31
2024
2023
$206,250
$254,500
40,000
50,000
6,000
2,000
(40,000)
16,000
(5,000)
(2,000)
Operating activities:
Net income
Add back items not representing cash flows:
Depreciation
Loss on sale of investments
Adjustment for working capital items:
Decrease (increase) in accounts receivable
Increase in inventory
Decrease in prepaid rent
750
500
Increase (decrease) in accounts payable
45,000
(28,000)
Net cash provided by operating activities
253,000
293,000
Financing activities:
Repayment of bonds
Issuance of shares
Payment of dividends
Net cash consumed by financing activities
(100,000)
0
50,000
0
(75,000)
(75,000)
(125,000)
(75,000)
Investing activities:
Sale of investments
50,000
20,000
Purchase of capital assets
(215,000)
(197,000)
Net cash consumed by investing activities
(165,000)
(177,000)
Overall increase (decrease) in cash during year
(37,000)
41,000
50,000
9,000
$ 13,000
$ 50,000
Cash balance at beginning of year
Cash balance at end of year
C5-4 Jones Printing
Ben Jones would like to expand his small printing business to include a new computerized colour printing
system. To finance the purchase of this equipment, Ben has applied for a loan from a government venture
capital agency. The agency requires a complete set of financial statements before it can approve any loan
application, and assigns an employee to each applicant to help prepare the necessary financial statements.
You have been assigned to assist Ben with his application, and he has provided you with a statement of
income and a statement of financial position for his business. You explain to Ben that a complete set of financial statements includes a statement of cash flows, and that one will have to be prepared for his company
5-77
5-78
C H A PTE R 5
The Statement of Cash Flows
before the loan application can be processed. Ben does not understand the purpose of the statement of cash
flows and what types of information he will have to gather in order to have one prepared for his business.
Required
Prepare a brief memo to Ben explaining the purpose and structure of the statement of cash flows and outlining any additional information, beyond the statement of income and statement of financial position,
that he will have to provide to enable you to prepare a statement of cash flows for his business.
C5-5 Kralovec Company
As discussed in the chapter, there are two methods for presenting the information in the operating activities section of the statement of cash flows: the direct method and the indirect method. Accounting standards generally express a preference for the direct method but allow the indirect method. The vast majority
of companies prepare their statements of cash flows using the indirect method of presentation.
Presented below are two statements of cash flows for Kralovec Company. In the first one, the operating activities section is presented using the direct method; in the second statement, the indirect method
is used.
KRALOVEC COMPANY
Statement of Cash Flows
For the year ended December 31, 2024
1. Direct method
Cash flows from operating activities
Cash collections from customers
$ 6,446,000
Cash payments for operating expenses
(4,883,000)
Cash payments for interest
(80,000)
Cash payments for income taxes
(313,000)
Net cash provided by operating activities
1,170,000
Cash flows from investing activities
Sale of machinery
Purchase of machinery
$ 140,000
(750,000)
Net cash used by investing activities
(610,000)
Cash flows from financing activities
Retirement of bonds
$(100,000)
Payment of dividends
(200,000)
Net cash used by financing activities
(300,000)
Net increase in cash during year
260,000
Cash at beginning of year
130,000
Cash at end of year
$ 390,000
2. Indirect method
Cash flows from operating activities
Net income
$ 705,000
Adjustments to convert net earnings to net cash
provided by operating activities:
Depreciation expense
Loss on sale of machinery
Increase in accounts receivable
$ 470,000
34,000
(100,000)
Decrease in inventory
35,000
Increase in accounts payable
21,000
Decrease in interest payable
(5,000)
Increase in taxes payable
10,000
Net cash provided by operating activities
465,000
1,170,000
(continued)
Endnotes 5-79
KRALOVEC COMPANY
Statement of Cash Flows
For the year ended December 31, 2024
Cash flows from investing activities
Sale of machinery
Purchase of machinery
$ 140,000
(750,000)
Net cash used by investing activities
(610,000)
Cash flows from financing activities
Retirement of bonds
Payment of dividends
Net cash used by financing activities
$ (100,000)
(200,000)
(300,000)
Net increase in cash during year
260,000
Cash at beginning of year
130,000
Cash at end of year
$ 390,000
Required
a. As discussed in Chapter 2, understandability is an important qualitative characteristic of financial
statements. With this in mind, compare the two statements above and comment on the understandability of the direct versus the indirect method of presentation in the operating activities section.
Which approach do you think most users of financial statements would prefer?
b. Looking only at the first statement (presented using the direct method), analyze the cash flow data
for Kralovec Company and note any significant points that can be observed from it regarding the
company’s operations during the year. Then repeat this process, looking only at the second statement (presented using the indirect method).
c. Based on your experience in working through part (b), which method of presentation do you find
more useful (that is, more relevant) for analyzing the cash flow data, understanding the company’s
operations, and identifying points to be investigated further? Explain why.
Endnotes
1
BRP Inc., 2021 Annual Report; BRP corporate website, https://www.brp.com.
Alimentation Couche-Tard Inc., 2020 Annual Report.
3
Canadian Tire Corporation, Limited, 2020 Annual Report.
4
Sleep Country Canada Holdings Inc., 2020 Annual Report.
5
CPA Standards and Guidance Collection, Part 1 – International Financial Reporting Standards, The
Conceptual Framework, para. OB20; Jeff Gray and Andy Hoffman, “Report Alleges Possibility Sino-­
Forest ‘An Accounting Fiction,’” The Globe and Mail, April 15, 2012; Al and Mark Rosen, “Don’t Be
Suckered by Cash Flow Statements,” Advisor’s Edge, August 1, 2011.
6
PricewaterhouseCoopers Inc., Pre-filing Report of the Proposed Monitor on the Business and Financial
Affairs of the Debtors Companies (Le Chateau Inc.), October 22, 2020; Danier Leather Inc., 2015 Annual
Report.
7
Shadi Farshadfar and Reza Monem, “Further Evidence on the Usefulness of Direct Method Cash
Flow Components for Forecasting Future Cash Flows,” The International Journal of Accounting 48,
no. 1 (2013): 111–133.
8
Leon’s Furniture Limited, 2020 Annual Report.
9
EastWest Bioscience Inc., 2020 Annual Report.
10
Nutrien Ltd., 2020 Annual Report.
11
Shadi Farshadfar and Reza Monem, “Further Evidence on the Usefulness of Direct Method Cash Flow
Components for Forecasting Future Cash Flows,” The International Journal of Accounting 48, no. 1
(2013): 111–133.
12
Danier Leather Inc., 2015 Annual Report.
13
M. Dugan, B. Gup, and W. Samson, “Teaching the Statement of Cash Flows,” Journal of Accounting
Education 9, no. 1 (1999): 33–52.
2
D. Pimborough/Shutterstock.com
Pimborough/Shutterstock
CHAPTER 6
Cash and Accounts Receivable
Will That Be Cash or Credit?
If you had a summer lawn-mowing business, would you want
customers to pay you in cash every time or would you accept
an IOU for them to pay you later? If you allowed them to pay
later, how much time would you give them before you came
to collect your money, and how many of them do you think
would pay you in full eventually?
If you were a company in the wholesale apparel business,
like Montreal-based Gildan Activewear Inc., your credit policy
would have to follow certain industry practices but not be too
restrictive, or you could lose out on sales, and not be too loose,
or you could end up with credit losses.
Gildan, which makes and markets family apparel such as
underwear, fleece, and blank T-shirts ready for screen printing, invoices most sales with payment terms of 30 to 60 days.
But it had to be flexible during an extraordinary event. When
the COVID-19 pandemic hit in early 2020 and caused a global
economic slowdown, some of Gildan’s customers asked for
extended payment terms on previously invoiced shipments.
“The Company has been working closely with these customers
to agree on payment schedules for past due invoices and new
shipping and payment terms for new orders in this environment, which has resulted in a significant decrease in past due
amounts as compared to the first and second quarters” of the
previous year, Gildan said in its 2020 annual report.
Among other credit risks Gildan faces is that its sales are
concentrated: as of January 3, 2021, its 10 largest customers
accounted for 76% of trade receivables (outstanding invoices,
also known as accounts receivable). Many of those customers are highly leveraged, such as having bank loans for which
their inventory is pledged as collateral. If a customer can’t pay
off its loan or obtain additional financing, it could result in
Gildan having an uncollectible account receivable from that
customer. “Future credit losses relating to any one of our top
ten customers could be material and could result in a material charge to earnings,” the company’s credit risk note in its
2020 annual report stated. At January 3, 2021, Gildan had U.S.
$196.5 million in trade receivables while its sales in the 2020
fiscal year were almost U.S. $2.0 billion.
Gildan tries to reduce its credit risk. “The Company’s extension of credit to customers involves considerable
judgment and is based on an evaluation of each customer’s
financial condition and payment history. The Company has
established various internal controls designed to mitigate
credit risk, including a dedicated credit function which recommends customer credit limits and payment terms that are
reviewed and approved on a quarterly basis by senior management,” its annual report stated. “Where available, the
Company’s credit departments periodically review external
ratings and customer financial statements and, in some cases,
obtain bank and other references. New customers are subject
to a specific validation and pre-approval process.” Sometimes,
Gildan will require riskier customers to pay up front, just like a
lawn-mowing business might do with a new neighbour.1
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CORE QUESTIONS
If you are able to answer the following questions, then you
have achieved the related learning objectives.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Introduction
• Why are cash and accounts receivable of significance to
users?
1. Explain why cash and accounts receivable are of
significance to users.
Cash
• What is included in the definition of “cash”?
2. Describe the valuation methods for cash.
• At what amount is cash reflected on the statement of
financial position?
Internal Control
• Who is responsible for an organization’s internal
controls?
3. Explain the main principles of internal control and
their limitations.
• What are the main principles of internal control?
• What are the limitations of internal control?
Bank Reconciliation
• What is the purpose of a bank reconciliation and why
must it be prepared?
• How is a bank reconciliation prepared?
4. Explain the purpose of bank reconciliations,
including their preparation and the treatment of
related adjustments.
Accounts Receivable
• What are accounts receivable?
• Why do companies sell on account?
5. Explain why companies sell on account and identify
the additional costs that result from this decision.
• Are there any additional costs from selling on account?
The Carrying Amount of Accounts Receivable
• At what amount are accounts receivable reflected on
the statement of financial position?
6. Explain how the carrying amount of accounts
receivable is determined.
The Allowance Method
• What is the allowance method of accounting for
expected credit losses?
7. Explain the allowance method of accounting for
expected credit losses.
Estimating Expected Credit Losses under the
Allowance Method
• What are the various risk characteristics that could be
used to group receivables?
• How does management determine the company’s
expected rate of credit losses?
8. Identify the various risk characteristics that could be
used to group receivables, determine the expected
rates of credit losses for these groupings, and
quantify the total expected credit losses.
• How does management quantify the company’s
allowance for expected credit losses?
The Direct Writeoff Method
• What is the direct writeoff method and when is it
acceptable to use it?
9. Explain the direct writeoff method of accounting for
credit losses and when it is acceptable to use it.
Introduction 6-3
Cash-to-Cash Cycle
• How do companies shorten their cash-to-cash cycle?
10. Explain alternative ways in which companies shorten
their cash-to-cash cycle.
Financial Statement Analysis
• What is liquidity and how is it assessed?
• How can you determine how effective a company has
been at collecting its accounts receivable?
6.1
11. Explain the concept of liquidity. Calculate the current
ratio, quick ratio, accounts receivable turnover ratio,
and average collection period ratio, and assess the
results.
Introduction
LEARNING OBJECTIVE 1
Explain why cash and accounts receivable are of significance to users.
Our opening story talks about an apparel company’s efforts to control its accounts receivable
and limit the number of uncollectible accounts, or credit losses. Determining the accounts
receivable that are expected to be collected and estimating the amount of expected credit losses
are important for both external financial reporting and sound internal financial management.
This chapter discusses accounting and management control issues related to an organization’s
most liquid assets: its cash and its receivables.
Why Are Cash and Accounts Receivable
of Significance to Users?
Cash and accounts receivable are a company’s most liquid assets. These items, together
with inventory (which will be discussed in Chapter 7), give the company the resources
ne­cessary to meet its immediate, short-term financial obligations. Users therefore need to have
a good understanding of these items. For example, while cash seems to be straightforward,
in reality it constitutes a number of things, including money physically on hand, amounts
in bank accounts, and cheques held for deposit. Accounts receivable (also known as trade
receivables) are amounts due from customers as a result of sales of goods or services and are
typically due within 30 days. In some industries, this credit period may extend up to 180 days.
(As we saw in the opening story, Gildan Activewear Inc. grants credit up to two months,
or 60 days.) As a user, you need to know how much credit a company has extended to its
customers and be aware of the expected credit losses, also known as doubtful accounts or
bad debts, related to balances that will never be paid by customers. You should also be able to
assess how effective the company has been at collecting its receivables in the current period
and in comparison with prior periods.
Presenting cash and accounts receivable separately on the statement of financial ­position
helps users evaluate a company’s liquidity, or its ability to meet its obligations in the short
term. In other words, users can assess how well positioned the company is in terms of having
sufficient cash or current assets that will become cash (when the receivables are collected) to
pay the company’s current liabilities (such as accounts payable and wages payable) as they
come due.
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Cash
Take5 Video
LEARNING OBJECTIVE 2
Describe the valuation methods for cash.
What Is Included in the Definition of “Cash”?
As noted above, cash includes the cash physically on hand at a company, such as the cash in
the cash register drawers or in the company’s safe. Cash also includes the cash represented
by the customers’ cheques held by the company for deposit and the cash held on deposit in
the company’s accounts at financial institutions (banks, credit unions, and so on). Cash also
includes amounts known as cash equivalents. These are amounts that can be easily converted into known amounts of cash; that is, there is no doubt about the amount of cash that
will be received when they mature. Cash equivalents also have short maturity dates (within
three months of the date of acquisition). Examples of cash equivalents are government treas­
ury bills and guaranteed investment certificates (GICs).
It is also possible for a company to have a negative cash balance. This would be the case if
the company has a line of credit or overdraft facility and has drawn on it. We will discuss this
situation in Chapter 9 on current liabilities.
At What Amount Is Cash Reflected on the
Statement of Financial Position?
The amount of cash and cash equivalents is presented on the statement of financial position.
Cash is measured at its face value at the reporting date—the date that the statement of financial position is being prepared at. Cash that is held in foreign currencies, such as U.S. dollars
or euros, must be translated or converted into Canadian dollars using the rate of exchange at
the statement of financial position date.
Companies normally prepare their financial statements using the currency of the country
in which they are headquartered. Canadian companies typically prepare their financial statements in Canadian dollars, U.S. companies prepare their financial statements in U.S. dollars,
and so on. It is possible for Canadian companies that are also listed on U.S. stock exchanges and
that file their financial statements in the United States to prepare their financial statements in
U.S. dollars rather than Canadian dollars. We will see excerpts in this textbook from the financial
statements of several Canadian companies that report in U.S. dollars, such as Gildan Activewear.
6.3
Internal Control
LEARNING OBJECTIVE 3
Explain the main principles of internal control and their limitations.
Who Is Responsible for an Organization’s
Internal Controls?
The board of directors is ultimately responsible for an organization’s internal controls. The
board normally oversees the development and implementation of the controls. It also monitors
Internal Control
the effectiveness of the controls, often relying on the work of the independent auditor to assess
this. Perhaps most importantly, the board establishes the tone at the top regarding the import­
ance of internal controls. This is critical, because this tone tends to permeate the organization.
If the board places a strong emphasis on internal controls, then senior management will too.
If senior management does this, then the other employees in the organization will as well.
Management is generally delegated the responsibility for establishing and operating the
organization’s internal control system. They are also responsible for developing a system for
monitoring the effectiveness of the controls and reporting on this to the board.
For Example
StockLite/Shutterstock
StockLite/Shutterstock.com
Financial Statements Cineplex Inc.’s annual report for
the year ended December 31, 2020, included a statement of
management responsibility that noted: “Management maintains
a system of internal accounting controls designed to provide
reasonable assurance that transactions are authorized, assets are
safeguarded, and financial records are reliable for preparing consolidated financial statements. The Board of Directors of Cineplex Inc. is responsible for ensuring that management fulfills its
responsibilities for financial reporting and internal control.”2
What Are the Main Principles of Internal
Control?
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One of management’s key responsibilities is to safeguard the company’s assets. This includes
ensuring that the company’s assets are used effectively within the business and are not lost or
stolen. Many assets, including cash, inventory, and equipment, are common targets of theft,
either internally (by management or employees) or externally (by customers, delivery companies, and so on). To fulfill its responsibility to safeguard assets, management establishes many
internal controls related to this. These controls can be preventative (they prevent the theft or
loss of an asset from occurring) or detective (they detect when an asset has been lost or stolen).
These internal controls are then continually monitored.
Generally, cash is the asset most susceptible to theft. We will use it as an example to
explain the elements of an internal control system, listed in the Key Points.
The key elements of an effective internal control system include:
1. Physical Controls
These controls are designed to protect assets from theft, diversion, damage, or destruction. Management protects assets by ensuring that premises and resources are secure
through the use of such things as clothing security tags, safes, locks, alarms, and fencing.
Access controls such as computer passwords or biometric identifiers (fingerprint or facial
recognition) are also considered to be physical controls.
Control Element Applied to Cash
In the case of cash, regular bank deposits should be made, and any cash on hand should
be securely stored in cash registers and safes.
2. Assignment of Responsibilities
An essential characteristic of internal control is the assignment of responsibility to specific individuals. Control is most effective when only one person is responsible for each
task, because that person can be held accountable.
Control Element Applied to Cash
Assume that, at the end of the day, the cash in the cash register drawer is less than
the amount of cash sales rung up on the cash register. If only one person has operated
the register, responsibility for the shortage can be determined immediately. If more than
KEY POINTS
An internal control
system includes:
• physical controls
• assignment of
responsibilities
• separation of duties
• independent
verification
• documentation
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one individual has worked the register, it may be impossible to determine who is responsible for the shortage, unless each person is assigned a separate cash drawer.
KEY POINTS
Where possible, the
following duties should
be separated:
• transaction
authorization
• recording of
transactions
• asset custody
3. Separation of Duties
Separation of duties involves ensuring that individual employees cannot authorize transactions, record them, and have custody of the related assets. If these responsibilities are
assigned to separate employees, no single employee will have the opportunity to defraud a
company and conceal th