Understanding
Financial Accounting
Second Canadian Edition
By Christopher D. Burnley
Prepared by Debbie Musil, CPA, FCMA
Chapter 2
Analyzing Transactions and their Effects
on Financial Statements
Learning Objectives (1 of 3)
LO1 – Identify the accounting standards used by
Canadian Companies
LO2 – Identify and explain the qualitative
characteristics of useful financial
information and how the cost constraint
affects these
LO3 – Explain the difference between cash basis of
accounting and the accrual basis of
accounting
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Learning Objectives (2 of 3)
LO4 – Analyze basic transactions and record their
effects on the accounting equation
LO5 – Explain the limitations of using the
accounting equation template approach to
record transactions
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Learning Objectives (3 of 3)
LO6 – Summarize the effects of transactions on
the accounting equation and prepare and
interpret a simple set of financial
statements
LO7 – Calculate and interpret three ratios used to
assess the profitability of a company
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Accounting Standards (1 of 2)
• Broad set of rules and guidelines used in the
preparation of financial statements
• International Financial Reporting Standards
(IFRS)
• Accounting Standards for Private Enterprise
(ASPE)
• Objective of IFRS and ASPE is to produce
financial reporting that is useful to financial
statement users
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Accounting Standards (2 of 2)
• Canadian Accounting Standards Board (AcSB)
responsible for standards used by Canadian
companies
• IFRS is the responsibility of International
Accounting Standards Board (IASB)
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Conceptual Framework (1 of 2)
• The underlying set of objectives and concepts
that guide accounting standard-setting bodies
in justifying new standards and revising old
ones
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Conceptual Framework (2 of 2)
• Frameworks are developed with the following
objectives in mind:
• Assist organizations with developing financial
reporting standards
• Assist accountants in determining how to
account for items where there are no specific
standards
• Assist users with interpreting financial
statements
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Characteristics of Useful Information
Characteristics and constraints of accounting information according to the IFRS
conceptual framework
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Cash vs Accrual Basis of Accounting
• Under the Cash Basis:
• Revenues are recorded when the cash is
received
• Expenses are recorded when cash is paid
• Under the Accrual Basis:
• Revenues are recorded when they are earned in
accordance with the revenue recognition
criteria
• Expenses are recorded when they are incurred
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Revenue Recognition
• Revenue Recognition:
• Five-step process to determine when revenues
should be recognized in the financial
statements
• Generally companies should recognize revenues
when earned
• that is, when company has satisfied its
performance obligations in the contract by
providing goods or services to its customers
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Basic Accounting Equation and Effects (1 of 2)
• Accounting Equation
Assets = Liabilities + Shareholders’ Equity
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Basic Accounting Equation and Effects (2 of 2)
How to calculate Retained Earnings
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Recording Transactions
• Every transaction must effect at least two
accounts
• Equation must remain in balance after each
transaction
Assets = Liabilities + Shareholder’s Equity
• Retained earnings will be affected by changes
in revenues, expenses and dividends declared
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Transaction Analysis – Start-Up Period
• Sample Company Ltd. is formed as a
corporation January 1, 2016, and has the
following transactions for January:
• Transaction 1: Common shares are issued for
$250,000 cash
• Effects:
• Assets (Cash) increased by $250,000
• Shareholders’ Equity (Common shares)
increased by $250,000
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Transaction Analysis (1 of 14)
•
•
Transaction 2: Borrowed $100,000 from bank
Effects:
• Assets (Cash) increased by $100,000
• Liabilities (Bank Loan Payable) increased by
$100,000
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Transaction Analysis (2 of 14)
• Transaction 3: Paid $1,100 cash for January rent
• Effects:
• Assets (Cash) decreased by $1,100
• Shareholder’s Equity (Retained Earnings)
decreased by $1,100
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Transaction Analysis (3 of 14)
• Transaction 4: The company paid $65,000 to
purchase equipment
• Effects:
• Assets (Cash) decreased by $65,000
• Assets (Equipment) increased by $65,000
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Transaction Analysis (4 of 14)
• Transaction 5: The company purchased a one
year insurance policy for $1,800 cash
• Effects:
• Assets (Cash) decreased by $1,800
• Assets (Prepaid Insurance) increased by $1,800
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Transaction Analysis (5 of 14)
• Transaction 6: The company purchased land for
$180,000.
• Effects:
• Assets (Land) increased by $180,000
• Assets (Cash) decreased by $180,000
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Transaction Analysis (6 of 14)
• Transaction 7: The company purchased
inventory for $23,000 on account (SCL will pay
for these goods at a later date)
• Effects:
• Assets (Inventory) increased by $23,000
• Liability (Accounts Payable) increased by $23,000
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Transaction Analysis (7 of 14)
• Transaction 8: Sold $34,000 of product to
customers, $21,000 was received in cash the
balance was on account (SCL’s customers will pay
at a later date. Cost of products sold was $17,000
• Effects:
•
Part 1 (account for the sales revenue)
• Assets (Cash & Accounts Receivable) increased by
$34,000
• Shareholders’ Equity (Retained Earnings)
increased by $34,000
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Transaction Analysis (8 of 14)
• Transaction 8 (continued):
• Effects (continued):
•
Part 2 (account for the inventory that becomes
cost of goods sold)
• Assets (Inventory) decreased by $17,000
• Shareholders’ Equity (Retained Earnings)
decreased by $17,000
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Transaction Analysis (9 of 14)
• Transaction 9: The company received an
$11,000 payment from customers for sales
made on account
• Effects:
• Assets (Cash) increased by $11,000
• Assets (Accounts Receivable) decreased by
$11,000
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Transaction Analysis (10 of 14)
• Transaction 10: The company makes a payment
to suppliers for $13,500 for inventory
previously purchased on account
• Effects:
• Assets (Cash) decreased by $13,500
• Liabilities (Accounts Payable) decreased by
$13,500
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Transaction Analysis (11 of 14)
• Transaction 11: The company paid monthly
utility costs of $1,900
• Effects:
• Assets (Cash) decreased by $1,900
• Shareholder’s Equity (Retained Earnings)
decreased by $1,900
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Transaction Analysis (12 of 14)
• Transaction 12: The company paid advertising
costs for the month in the amount of $2,200
• Effects:
• Assets (Cash) decreased by $2,200
• Shareholder’s Equity (Retained Earnings)
decreased by $2,200
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Transaction Analysis (13 of 14)
• Transaction 13: The company paid $2,900 in
wages to its employees for the month of
January
• Effects:
• Assets (Cash) decreased by $2,900
• Shareholder’s Equity (Retained Earnings)
decreased by $2,900
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Transaction Analysis (14 of 14)
• Transaction 14: Dividends in the amount of
$400 were declared by SCL’s board of directors
and paid
• Effects:
• Assets (Cash) decreased by $400
• Shareholder’s Equity (Retained Earnings)
decreased by $400
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Depreciation of Assets (1 of 2)
• When an asset is used up over time, some of
the cost of the asset should be shown as an
expense in each period in which it is used
• The amount shown as an expense in any period
is called the Depreciation of the asset
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Depreciation of Assets (2 of 2)
• Straight-line depreciation expense
Original Cost −Estimated Residual Value
Estimated Useful Life
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Depreciation of Assets:
Transaction Analysis
• Transaction 15: Record depreciation expense of
$850 on equipment for January
• Effects:
• Assets (Equipment) decreased by $850
• Shareholders’ Equity (Retained Earnings)
decreased by $850
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Prepaid Expenses
• An amount paid in advance of the coverage
period is recorded as an asset (Prepaid
Expense)
• As time passes, the coverage is “consumed”
and is then recognized as an expense
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Prepaid Expenses:
Transaction Analysis
• Transaction 16: Record insurance expense of
$150 for January
$1,800 x 1/12
• Effects:
• Assets (Prepaid Insurance) decreased by $150
• Shareholders’ Equity (Retained Earnings)
decreased by $150
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Accrued Expenses
• Expenses that are recognized on the income
statement in the period in which they are
incurred, which is usually prior to the period in
which they are paid in cash
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Accrued Expenses:
Transaction Analysis
• Transaction 17: Interest expense on the bank
loan is 6% per annum and interest payments
are to be made quarterly.
$100,000 x 6% x 1/12 = $500
• Effects:
• Liabilities (Interest Payable) increased by $500
• Shareholders’ Equity (Retained Earnings)
decreased by $500
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Accounting Equation Template
• Major limitations to this approach include:
• The number of columns that can be included
with in the template
• Lack of specific information regarding revenues,
expenses and dividend accounts
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Financial Statements
We can use the SCL worksheet to prepare the
financial statements:
•
•
•
•
Statement of Income
Statement of Changes in Equity
Statement of Financial Position
Statement of Cash Flows
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Statement of Income (1 of 2)
• Calculates profit (net income) by subtracting
expenses from revenues for the period
• Dividends are not expenses
• Are distributions of earnings to shareholders
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Statement of Income (2 of 2)
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Statement of Changes in Equity
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Classified Statement of Financial
Position (1 of 3)
• Current assets and liabilities are distinguished
from non-current assets and non-current
liabilities
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Classified Statement of Financial
Position (2 of 3)
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Classified Statement of Financial
Position (3 of 3)
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Statement of Cash Flows (1 of 3)
• Measures the net cash position as a result of
cash inflows and outflows in the following three
categories of business activities:
• Operating Activities
• Investing Activities
• Financing Activities
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Statement of Cash Flows (2 of 3)
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Statement of Cash Flows (3 of 3)
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Profitability Ratios (1 of 3)
• Profit Margin Ratio:
Net Income
Sales Revenue
• Profit Margin for SCL:
= $7,400 / $34,000
= 0.217 or 21.7%
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Profitability Ratios (2 of 3)
• Return on Equity:
Net Income
Average total shareholders’ equity
• Return on Equity for SCL:
= $7,400 / $257,000
= 0.0288 or 2.88%
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Profitability Ratios (3 of 3)
• Return on Assets:
Net Income
Average total assets
• Return on assets for SCL:
= $7,400 / $367,000
= 0.020 or 2.0%
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COPYRIGHT
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information contained herein.
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