1. business and industrial
2. company
3. earnings

Chapter 1
How to analyze ethical dilemmas
1) Recognize ethical situation and ethical issues involved
2) Identify and analyze the main elements in the situation
3) Identify the alternatives, and weight the impact of each alternative on different groups
3 types of organizations:
1) Proprietorships
a. simple to set up and gives you control
b. Personally liable for all debts
c. Pay personal income tax on their share of profits
2) Partnerships
a. often formed because of lack of economic resources
b. Each partner has unique skills
c. Personally liable for all debts
d. Pay personal income tax on their share of profits
3) Corporations
a. More attractive to invest in because ownership is easily transferred
b. Small amounts of money required to invest
c. Easier to raise large amounts of funds
d. Not personally liable for company debts
e. Corporations pay taxes as a separate entity
f. Sometimes receive tax cuts
2 types of users of financial documents:
1) Internal Users
a. Marketing managers
b. Production supervisors
c. Finance directors
d. Company officers
2) External Users
a. Investors
b. Creditors
c. Taxing authorities
d. Regulatory Agencies
e. Customers
f. Labour unions
g. Economic Planners
Businesses involved in 3 types of activities:
1) Financing Activities
a. Borrowing money and selling shares for cash
i. Notes payable
ii. Bank indebtedness
iii. Long-term debt
iv. Mortgage payable
v. Share capital
*creditors are paid before shareholders in the event of liquidation
2) Investing Activities
a. Buying assets (property, plant and equipment)
b. Investments
3) Operating Activities: (sales revenue, service revenue, interest revenue)
a. Accounts receivable
b. Inventory
Revenues > Expenses = Net Earnings (Net income)
Revenues < Expenses = Net Loss
Statement of earnings – reports revenues and expenses to show how successful a company performed
during a period of time
Statement of retained earnings – indicates how much was distributed to you and other shareholders of
a company in the form of dividends, and how much was retained in the business for future growth
Balance Sheet – Presents a picture of what a company owns (assets), what it owes (Liabilities), and its
net worth (share holders’ equity) at a specific point of time
Cash flow statement – show where a company obtained cash during period of time and how the cash
was used.
Statement of Earnings
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Reports results over a period of time
EBIT = earnings before income tax
Issue of shares and distribution of dividends do not affect net earnings
o Cash from issuing shares goes to balance sheet under cash not revenue
Normally rounded to the nearest dollar
Statement of retained earnings
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Retained means not paid out to shareholders
Change of retained earnings over a time period
Lenders monitor dividend payments because paying dividends will reduce a company’s ability to
pay its debts
A company looking for rapid growth will pay little to no dividends
The balance sheet
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Reports assets and claims to those assets at a specific period of time
Accounting equation
o Assets = Liabilities + Shareholders’ equity
Does the company rely mainly on debt or equity to finance its assets?
Two types of claims on its assets on a balance sheet
o
Liabilities and share holders equity
Cash flow statement
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Cash payments and cash receipts over a given period of time
o Operating activities
o Investing activities
o Financing activities
This affects the balance sheet’s cash number
Does the company generate enough cash from operating activities to fund its investing
activities?
Relationships between the statements:
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The number from the statement of earnings is used on the statement of retained earnings
The number from retained earnings is used on the balance sheet
The ending amount of cash on the balance sheet must equal the amount on the cash flow
statement
Other info included on company reports (non financial)
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Company’s missions
Goals and objectives
Products
People
Glossary
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Comparative Statements:
o Presentation of statements of a company for 2 or more years
Chapter 2
The objective of financial reporting:
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Provide useful information for decision-makers
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Communicate information to internal and external users
Qualitative Characteristics of Accounting Information:
Understandibility
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The average user is assumed to have a reasonable understanding of accounting concepts and
procedures, as well as of general business and economic conditions
This average person needs to be able to understand the information
Sophisticated and detailed
Relevance
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Has predictive value or feedback value and is timely
o Predictive value
 Helps users forecast events
o Feedback Value
 Confirms or corrects prior expectations
o Timely
 Must be available to decision makers when it can still influence their decision
Reliability
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Verifiable
o Prove that there are no errors or bias
o Source documents
Faithful Representation
o Statements be based on transactions
o External auditors are also needed
Neutral
o Cannot be prepared or presented to favour one group over another
o Verifiable, faithfully represented, objective
Conservatism
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When preparing financial statements a company should choose the accounting method that will
be least likely to overstate assets and earning. It does not mean, however that a company
should intentionally understate its assets or earnings.
Worst case scenario
Do not overstate/understate
Comparability
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Companies of similar circumstances use the same accounting principles (apples to apples)
These principals need to be used consistently over a period of time (year to year)
Recognition and Measurement Criteria (Assumptions):
Monetary Unit Assumption
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Everything is in dollars
Things that can’t be measured in dollars need to be included on the financial statements
Monetary unit is stable over time
o Effects of inflation/deflation assumed to be minor therefore ignored
Economic Entity Assumption
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Personal and business transactions/assets/liabilities are separate
Time Period Assumption
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Assumes that the life of a business can be divided into artificial time periods and that useful
reports covering those periods can be prepared for the business
All companies must produce yearly reports
Publicly traded companies must report quarterly
o Interim financial reporting
Going Concern Assumption
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The business will remain in operation for the foreseeable future
Only inappropriate when it is likely that the business will be liquidated
Generally Accepted Accounting Principles (GAAP) - All companies whose shares or debt are
publicly traded must follow GAAP
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US GAAP is based on rules. Canadian and International GAAP is based on principles
Cost Principle
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Assets are recorded at their cost
Their value stays at their purchase price
Critics say that it would be more useful for decision making if the value on the balance sheet
was market value but supporters believe that it would be too subjective and that the price it
was bought for is more verifiable
Full Disclosure Principle
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Requires that all circumstances and events which would make a difference to financial
statement are disclosed
If it can’t be included in one of the 4 financial statements it needs to be included in the notes
Constraints in Accounting - Constraints permit a company to make changes to GAAP as long as
the reported information is still useful
Cost-Benefit
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Ensures that the value of the information is greater than the cost of providing it
If accountants include too much information then the cost of providing it offsets the benefits of
it
Materiality
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Material if it is likely to influence the decision of an investor
Immaterial if it will have no impact on a decision maker
The Classified Balance Sheet
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Assets
o Current Assets
 Expected to be converted into cash or used up within 1 year
 Listed in order of liquidity
o Long-Term Investments
 Generally investments in debt
o Property, Plant, and Equipment
 Assets with relatively long useful lives
 Normally listed in order of permanency
 Land is not amortized
 Everything else is
o Intangible Assets
 Noncurrent assets that do not have physical substance that represent a privilege
or right granted to or held by the company
 Goodwill, patents, copyrights, trademarks, trade names and licences
 Normally divided into 2 groups
 Those with definite lives
o Amortized
o Patents and copyrights
 Those with indefinite lives
o Not amortized
o Goodwill, trademarks, trade names and licenses
Liabilities
o
o
o
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Obligations that result from past transactions
Current and non current
Current Liabilities
 Obligations that are to be paid in the coming year
 Often listed in order of what will be paid first
o Long Term Liabilities
 Paid after one year
 Sometimes lumped together
Shareholders’ Equity
o Divided into 2 parts: share capital and retained earnings
 Share capital
 Shareholders’ investments recorded as common or preferred shares
 Retained Earnings
 Cumulative earnings that have been retained for use in a company
Using the Financial Statements
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Ratio analysis express relationships between selected items of financial statements
o Liquidity
 Measures a company’s short term ability to pay its maturing obligations and to
meet unexpected needs for cash
o Profitability
 Measure a company’s earnings or operating success for a given period of time
o Solvency
 Measure a company’s ability to survive over a long period of time
Comparing Ratios
o Intracompany Comparisons
 Covering two years for the same company
o Intercompany Comparisons
 Based on comparisons with a competitor in the same industry
o Industry Average Comparisons
 Based on average ratios for particular industries
Ratios:
Profitability
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Earnings per share (EPS)
o Measures net earnings for each common share
 Earnings per share = net earnings available to common share holders divided by
weighted average number of common shares
o Not very meaningful among companies because of a large variety of shares and in the
share prices, thus no industry average
Price-earnings Ratio
o Measures the ratio of the market price of each common share to its earnings per share
 Price-earnings ratio = market price per share divided by earnings per share
Liquidity
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Working Capital
o Difference between current assets and liabilities
o When it is positive there is a greater chance that the company will pay its liabilities
 Working capital = currents assets minus current liabilities
o Industry averages aren’t very meaningful
Current Ratio
o Current assets divided by current liabilities
o More meaningful than working capital
 Current ratio = current assets divided by current liabilities
o Example 1.4:1
 1.4 times as much assets as liabilities
o Does not take into account the composition of the current assets
Solvency
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Debt to Total Assets
o Measures the percentage of assets financed by creditors rather than shareholders
o Financing by creditors is riskier than financing by shareholders
 Debt to Total Assets = total liabilities divided by total assets
o The higher the percentage the worse off the company is
Free Cash Flow
o Measures how much cash a company has to use for various purposes
 Free cash flow = Cash provided (used) by operating activities minus net capital
expenditures minus dividends paid
Chapter 3
Accounting information system – Collecting, processing transaction data and communication
financial information to decision makers
Debit = left side
Credit = right side
All transactions effect both credits and debits = double-entry accounting system
Debit Balance Accounts
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Assets
Expenses
Dividends
Credit Balance Accounts
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Liabilities
Revenue
Shareholder’s Equity
DEBITS INCREASE
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A - Assets
D - Dividends
E – Expenses
Aren’t Debits Exciting
CREDITS INCREASE
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RE – Retained Earnings
L - Liabilities
CS - Common Shares
R - Revenues
Remember Learning CreateS Rulers
Journal - general journal is used to record transactions
Ledger – Collection of accounts arranged in order in which accounts are presented in the
financial statements
Assets
Liabilities
Shareholder’s Equity
Revenues
Expenses
Posting – transferring journal entries to the general ledger
Trial Balance – List of general ledger account and their balances at a specific time
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Prepared monthly and at end of accounting cycle
Purpose is to prove the mathematical equality if debits and credits after posting
Uncovers errors in journalizing and posting
Useful in the preparation of financial statements
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Limits of the trial balance
1. Transaction not journalized
2. A correct journal entry is not posted
3. A journal entry is posted twice
4. Incorrect amounts are used in journalizing or posting
5. Errors that cancel each other out
Time period assumption – the fact that accounting can divide the economic life of a business into
artificial periods
The revenue recognition principle
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Revenue must be recognized in the accounting period for which it is earned
Merchandising companies – earned when good is sold
Service companies – earned when service is performed
Matching Principle
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Let expenses follow the revenue
Expenses must be matched with revenues
Accrual vs Cash Basis
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Accrual basis accounting means that transactions that affect a company’s financial statements
are recorded in the periods in which the events occur
o Recognizing revenue when it is earned
Cash basis accounting - revenue is recorded only when cash is received and an expense is
recorded only when cash is paid
Adjusting Entries
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In order for expenses and revenues to be recorded in the right time period adjusting entries
must be made
Some events are not journalized every day because it wouldn’t make sense to do so
Types of adjusting entries
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Prepayments
o Prepaid expenses: expenses paid in cash and recorded as assets before they are used or
consumed
o Unearned revenues: Cash received and recorded as liabilities before revenue is earned
Accruals
o Accrued expenses: Expenses incurred but not yet paid in cash or recorded
o Accrued revenue: Revenues earned but not yet received in cash or recorded
Adjusting Entries for Prepayments
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Either prepaid expenses or unearned revenues
Prepaid expenses are costs that expire over time or through use (supplies)
Adjusting entries are made to record
o The expenses (expired costs) applicable to the current accounting period
o Made to show the remaining amount in the asset accounts
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Until prepaid expenses are adjusted assets are overstated and expenses are understated thus
net earnings and shareholder’s equity will be overstated
Amortization is an allocation concept not a valuation concept
o Straight-line method of amortization is cost divided by useful life in years
Statement Presentation
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Contra account is an account that is offset against a related account
Net book value is difference between the cost of any amortizable asset and its accumulated
amortization
Unearned revenues are the opposite of prepaid expenses
Adjusting entries for accruals
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Required in order to record revenues earned, or expenses incurred
o Accrued revenues and accrued expenses
Accrued Revenues
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Revenues earned but not yet received in cash or recorded at the statement date are accrued
revenues
1) To show the receivable that exists at the balance sheet date
2) To record the revenue that has been earned during the period
Accrued Expenses
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Expenses incurred but not yet paid or recorded at the statement date are called accrued
expenses
1) Record the obligations that exist at the balance sheet date
2) Recognize the expenses that apply to the current accounting period
Closing the books
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All expense accounts
All revenue accounts
Dividends account
Revenues and expenses are first closed to the income statement which is then closed to the retained
earnings. Dividends go directly to retained earnings
Closing Accounts
1) Debit each individual revenue account for its balance and credit the income summary for
total revenues
2) Debit income summary for total expenses and credit each individual expense account for its
balance
3) Debit income summary for the balance in the account and credit retained earnings
4) Debit retained earnings and credit dividends
Post closing trial Balance
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Lists all permanent accounts and their balances
The purpose of this trial balance is to prove the equality of the permanent account balances that
are carried forward into the next accounting period
Accounting Cycle
1)
2)
3)
4)
5)
6)
7)
Analyze business transactions
Journalize the transactions
Post to general ledger accounts
Prepare a trial balance
Journalize and post adjusting entries: prepayments/accruals
Prepare an adjusted trial balance
Prepare financial statements: statement of earnings, statement of retained earnings,
balance sheet
8) Journalize and post closing entries
9) Prepare a post-closing trial balance
Chapter Five
Merchandising Operations – Purchasing products (Merchandise Inventory) to resell to customers
Expenses for a merchandizing company are divided into 2 categories
1. Cost of goods sold - the total cost of merchandise sold during the period. Expense is directly
related to the revenue recognized from the sale of goods.
2. Operating expenses – expenses that are incurred in the process of earning sales revenue like
salaries, insurance, utilities, and amortization
Sales revenue – cost of goods sold = gross profit
Gross profit – operating expenses = earnings before income tax
Earnings before income tax – income tax expense = Net Earnings
Operating Cycles - The time it takes to go from cash to cash in producing revenue
Two Inventory Systems
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Perpetual Inventory System – detailed records of the cost of each product purchased and sold
are maintained through a sophisticated electronic system
o Always know how much inventory one has
o Inventory is usually the largest current asset for a merchandiser
o Physical account taken once a year
o Effective control over the inventory, can be counted anytime to see if it matches
records; shortages can be investigated
Periodic Inventory System – detailed inventory records of the merchandise on hand are not kept
throughout the period
o The cost of goods sold is determined only at the end of the accounting period
o Physical inventory count is done to determine the cost of goods sold on hand
o cost of goods sold = Beginning inventory + cost of goods purchased = cost of goods
available for sale – ending inventory
Purchases
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Purchases are recorded by the buyer when they receive the inventory
Every purchase should be supported with written evidence; in large companies when an order is
made with a supplier, it is documented with a purchase order
o Paid with cash: cash register receipt; credit purchase is a purchase invoice
Dr. Merchandise Inventory
XXX
Cr. Accounts Payable
- Recording Goods purchased on Account
XXX
Free on Board = FOB
o
o
Fob shipping point = buyer pays freight costs; seller delivers to the buyer
o Freight paid by the buyer is part of the cost of the merchandise purchased
Fob Destination = seller pays freight costs; seller delivers to the buyer
Dr. Merchandise Inventory
XXX
Cr. Cash
XXX
- To record payment of freight (FOB Shipping Point)
Purchase Returns and Allowances – Buyer may return goods to the seller
Dr. Account Payable
XXX
Cr. Merchandise Inventory
- Return of goods we bought to the seller
XXX
Quantity Discount – A quantity discount gives a reduction in price according to volume of the purchase
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Are for bulk purchases
Quantity discount are not recorded
Usually when purchase is on account
2/10 n/30 = two-ten net 30 = a 2 percent discount is given if payment is made within 10 days,
otherwise, the invoice price, less any returns or allowances, is due within 30 days
Purchase discounts – Offered to customers for early payment
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Advantage for both parties, the buyer saves money; the seller is able to shorten the operating
cycle by converting Account Receivable to Cash
Do not take on Freight costs
Decrease in merchandise inventory occurs
Dr. Account Payable
XXX
Cr. Cash
Cr. Merchandise Inventory
- Payment within a Discount Period
XXX
XXX
Recording Sales of Merchandise
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Revenue is earned when the goods are transferred to the buyer
Sales invoice are for credit sales
2 entries for each sale in a perpetual inventory system
o
o
First records sales revenue
Second records cost of goods sold
Dr. Account Receivable
Cr. Sales
- To Record Credit Sale
XXX
XXX
Dr. COGS
Cr. Merchandise Inventory
- To Record Cost of Goods Sold
XXX
XXX
Freight costs - Freight out account is used to record shipping costs paid on outgoing merchandise; Fob
Destination
Sales returns and allowances – Buyers returning goods back to you
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Also requires two entries
Sales, returns and allowances is a contra revenue account to sales
Dr. Sales Returns and Allowances
Cr. Accounts Receivable
- To record Return of goods
XXX
XXX
Dr. Merchandise Inventory
XXX
Cr. COGS
- To Record Cost of merchandise returned
Discounts
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No separate entry made for quantity discount
Sales discount is a contra revenue account for sales
Dr. Cash
XXX
Dr. Sales Discount (XXX *2%)
XXX
Cr. Accounts Receivable
XXX
- To record collection of payment during discount period
Single Step Statement of Earnings – It has only 1 step of subtracting total expenses from total revenues
before income tax
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All data are classified into:
XXX
o
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Revenues: All Operating Revenues (Sales) and Non Operating Revenues (Interest
Revenue, Gain on Sale of equipment)
o Expenses: Cost of Goods sold, Operating Expenses and Non Operating Expenses
(Interest Expense and Loss on the sale of equipment)
2 Main Reasons for using this step statement:
o Company does not realize any type of profit or earnings until total revenues exceed total
expenses, so it makes sense to divide the state into two categories
o Simple and easy to read
Multiple-step statement of earnings – shows multiple steps in determining earnings before income tax
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Often considered more useful because it separately highlights the components of net earnings
Majority of Canadian companies use this format
5 Main steps:
1. Net sales: sales returns and allowances and sales discounts are subtracted from gross sales
to determine net sales
2. Gross profit: cost of goods sold is subtracted from net sales to determine gross profit
3. Earnings from operations: operating expenses are deducted from gross profit to determine
earnings from operations
4. Non-operating activities: the results of activities that are not related to operations are
added (as other revenue) or subtracted (as other expenses) to determine earnings before
income tax
5. Net earnings: income tax expense is subtracted from earnings before income tax is
deducted to determine net earnings
Net sales= sales – sales returns and allowances – sales discounts
Gross profit = net sales – cost of goods sold
Earnings from operations = gross profit – operating expenses
Non-operating expenses = earnings from operations + difference between other revenues and other
expenses
Net earnings = earnings before income tax – income tax expense
Evaluating Profitability
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Gross Profit Margin – Represents the merchandising profit of a company
o Gross profit expressed as a percentage
o Gross Profit/Net Sales
o Considered more informative than the gross profit amount, because it expresses’ a
more meaningful relationship between gross profit and net sales
o Not a measure of the overall profit of a company, operating expenses haven’t been
deducted
Profit Margin – Measures the percentage of each dollar of each dollar of sales that results from
net earnings
o Expressed as a percentage
o Net Earnings/Net Sales
How do the gross profit margin and profit margin differ?
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Gross profit measures the amount by which the selling price is greater than the cost of goods
sold. Profit margin measures the extent by which the selling price covers all expenses (including
COGS) A company can improve its profit margin by increasing its gross profit margin or by
controlling its operating expenses (or do both)