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Measuring andMeasuring and
EvaluatingEvaluating
Financial PositionFinancial Position
Main topics in Chapter 2:Main topics in Chapter 2:
Introduction to the balance sheetIntroduction to the balance sheet Some relevant history, ending with the invention of doubleSome relevant history, ending with the invention of double
entryentry DoubleDouble--entry bookkeeping for recording transactionsentry bookkeeping for recording transactions Journal entries, accounts and trial balanceJournal entries, accounts and trial balance Account classification on the balance sheetAccount classification on the balance sheet Activities that affect and are reported in the balance sheetActivities that affect and are reported in the balance sheet Introductory interpretation and analysis of the balance sheetIntroductory interpretation and analysis of the balance sheet Overview of a banks balance sheetOverview of a banks balance sheet
CHAPTER 2Measuring and Evaluating Financial Position
Balance SheetBalance Sheet
Summarizes an organizations financial resources,Summarizes an organizations financial resources,
obligations, and owners interestobligations, and owners interest Measures the financial position at a particular dateMeasures the financial position at a particular date
and is the basis for much financial analysisand is the basis for much financial analysis
Accumulates the financial history of theAccumulates the financial history of theorganization as recorded in the accounting systemorganization as recorded in the accounting system
Central part of a companysCentral part of a companysfinancial disclosurefinancial disclosure totothe shareholders (investors) and others outside thethe shareholders (investors) and others outside thecompanys managementcompanys management
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The Balance Sheet portrays the enterpriseby arranging its lists of accounts so that theleft side lists the total resources (assets)
and the right side shows how the assets
were financed.
Sources of Resources
LIABILITIES
Current
Non-current
EQUITY
Contributed Capital
Retained Earnings
Real ResourcesReal Resources
ASSETSASSETS
Current
Non-current
Asset:A resource available to do business in the future, represented by
an ownership of or right to expected future economic benefits.
Current Asset:Cash and other assets such as temporary investments, inventory,
receivables, and current prepayments that are realizable or will bconsumed within the normal operating cycle of an enterprise(usually one year).
Non-current Asset:Assets expected to bring benefit for more than one fiscal year.
ComponentsComponents-- AssetsAssets
The Balance Sheet portrays the enterpriseby arranging its lists of accounts so that the
left side lists the assets and the right sideshows how the assets were financed
(liabilities and equity).
Real ResourcesASSETS
Current
Non-current
EQUITY
Contributed Capital
Retained Earnings
Sources of ResourcesSources of ResourcesLIABILITIESLIABILITIES
Current
Non-current
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ComponentsComponents-- LiabilitiesLiabilities
Liability:
A debt or obligation, legally existing or estimated via accrualaccounting techniques, of the enterprise to another party(creditor) arising from a past transaction.
Current Liability:Debts or estimated claims on the resources of a firm that are
expected to be paid within the normal operating cycle of anenterprise (usually one year).
Non-current Liability:Liabilities expected to be repaid or otherwise removed more than
one year in the future.
LIABILITIES
Current
Non-current
ASSETS
Current
Non-current
Real Resources
EQUITYEQUITY
Contributed Capital
Retained Earnings
Sources of ResourcesSources of Resources
The Balance Sheet portrays the enterpriseby arranging its lists of accounts so that the
left side lists the assets and the right sideshows how the assets were financed
(liabilities and equity).
ComponentsComponents-- EquityEquity
Equity:The net assets or residual interest of an owner or shareholder
(Assets-Liabilities=Equity)
Contributed Capital:Direct investment(s) of the owner(s) in the business
Retained Earnings:Earnings not yet distributed to owners: the sum of net incomes
earned over the life of a company, less distributions (dividendsdeclared) to owners.
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ASSETS
ASSETS
LIABILITIES
EQUITY
= LIABILITIES + EQUITY
As at a particular date
Historical basis
Signed on behalf of the Board of Directors
Comparative to at least prior year
Many supplementary notes
History informed by estimates of future
Equity is the book value of the whole company:
Equity = Assets - Liabilities
Side-by-side style
Sound and Light Corporation
Balance Sheet as at April 30, 2001
in Thousands of Dollars
Assets
Current assets $245Non-current assets 250
TOTAL $495
Liabilities and Equity
Current liabilities $103Non-current liabilities 87
Total liabilities $190
Owners' equity:
Contr ibuted capital $130
Retained earnings 175 305
TOTAL $495
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Vertical style
Sound and Light Corporation
Balance Sheet as at April 30, 2001
in Thousands of Dollars
Assets
Current assets $245
Non-current assets 250
TOTAL $495
Liabilities and Equity
Current liabilities $103
Non-current liabilities 87
Total liabilities $190
Owners' equity:
Contributed capital $130
Retained earnings 175 305
TOTAL $495
Seven Key Ingredients that Led to the Creation of
Accounting: The Early Days
III.Commerce: The interchange of goods on many
levels (trade);
II. Capital: Wealth is desired and accumulated;
I. Private property: The beginnings of familybusiness and the ability to establish ownership,
Seven Key Ingredients that Led to the Creation of
Accounting: The Early Days
VII.Arithmetic: A means of computing the monetarydetails of the deal.
VI. Money: The "common denominator" forexchanges, and
V. Writing: A mechanism for making a permanentrecord (keeping track of possessions):
IV. Credit: The present use of future goods,recognizing cash exchanges expected to occur in
the future;
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Lets do an example of BalanceLets do an example of Balance SheetSheettransactions usingtransactions using XYZ IncXYZ Inc..
This morning, XYZ had the following amounts on its Balance Sheet:
ASSETS = LIABILITIES + EQUITYCA + NCA = CL + NCL + SC + RE
$50 + $210 = $30 + $80 + $60 + $90
Total Total
CA
NCA
CL
NCL
SCRE
$50
$210
$260
$90
$60
$30
$80
$260
ASSETSASSETS = LIABILITIES= LIABILITIES + EQUITY + EQUITYCA + NCA = CL + NCL + SC + RE
$50 + $210 = $30 + $80 + $60 + $90
EVENT #1:
New Shares were issued for $35 cash.
RESULT?
Left Side : CA (cash) increases by $35
+35 +35
Right Side : SC (Share Capital) increases by $35
ASSETSASSETS = LIABILITIES= LIABILITIES + EQUITY + EQUITYCA + NCA = CL + NCL + SC + RE
$50 + $210 = $30 + $80 + $60 + $90
EVENT #2:
The Share proceeds were used to reduce long-term debt.
RESULT?
+35 +35
Left Side : CA (cash) decreases by $35
-35 -35
Right Side : NCL decreases by $35
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ASSETSASSETS = LIABILITIES= LIABILITIES + EQUITY + EQUITYCA + NCA = CL + NCL + SC + RE
$50 + $210 = $30 + $80 + $60 + $90
+35 +35-35 -35
RESULT?
EVENT #3:A new delivery truck costing $55 was bought bypaying $15 down and promising to pay the rest inthree years.
Left Side : NCA increase by $55CA (cash) decreases by $15
+55-15
Right Side : NCL increases by $40
+40
ASSETSASSETS = LIABILITIES= LIABILITIES + EQUITY + EQUITYCA + NCA = CL + NCL + SC + RE
$50 + $210 = $30 + $80 + $60 + $90
+35 +35-35 -35
RESULT?
EVENT #4:
A demand loan of $20 was borrowed from the bank.
+55-15 +40
Left Side : CA (cash) increases by $20
+20
Right Side : CL increases by $20
+20
ASSETSASSETS = LIABILITIES= LIABILITIES + EQUITY + EQUITYCA + NCA = CL + NCL + SC + RE
$50 + $210 = $30 + $80 + $60 + $90
+35 +35-35 -35
+55-15 +40
+20 +20
$55 + $50 +$265 $85 + $95 + $90 =
$320 = $320
Total up each balance sheet component
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New totals forNew totals forXYZ IncXYZ Inc..
ASSETS = LIABILITIES + EQUITY
CA + NCA = CL + NCL + SC + RE$55 + $265 = $50 + $85 + $95 + $90
Total Total
CA
NCA
CL
NCL
SCRE
$55
$265
$320
$90
$95
$50
$85
$320
The Balance Sheet Equation always stays in balance.
Each transaction affects at least two accounts.
Often it affects more.
Some transactions affect only one side of the balance
sheet equation; some transactions affect both sides.
Some Information to Note:Some Information to Note:
Method of reducing error by recognizing aMethod of reducing error by recognizing a
transaction twice.transaction twice.
Onceto recognize theresource involved in the
transaction; and
Onceto recognize thesource or effect of that
resource change.
Double Entry AccountingDouble Entry Accounting
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As a Result of Double Entry Accounting:As a Result of Double Entry Accounting:
The lists of resources and sources, oncewith little connection, are now connected
Errors are more easily discovered. A quick
check is performed by summing both lists
(the resources and the sources). If they areequal, it is said that they balance, if not,
there is an error that needs to be found and
corrected.
How Does DoubleHow Does Double--Entry Accounting Work?Entry Accounting Work?
Remember: A transaction is the basis of bookkeeping and
must meet the following criteria:
1)Exchange 2)External
3)Evidence 4)Dollars
What do you do when you have a transaction?
We need to revisit the balance sheet to explain the
connection between transactions and double entry
accounting
Real Resources Sources of Resources
ASSETS
Current
Non-current
LIABILITIES
Current
Non-current
EQUITY
Contributed Capital
Retained Earnings
Positive: Debits
Negative: Credits
Positive: Credits
Negative: Debits
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RESOURCES (LEFT)RESOURCES (LEFT) SOURCES (RIGHT)SOURCES (RIGHT)
Sum of Resources = Sum of Sources
Assets = Liabilities + Equity
Positive Items (debits)
For Example : An increase in cash is a positive
item and thus a debit to resources
RESOURCES (LEFT)RESOURCES (LEFT) SOURCES (RIGHT)SOURCES (RIGHT)
Sum of Resources = Sum of Sources
Assets = Liabilities + Equity
Positive Items (debits) Positive Items (credits)
For Example: An increase in cash is funded by a
source such as an obligation of the organization torepay a loan. The obligation is a positive item on the
right and so is a credit to sources.
RESOURCES (LEFT)RESOURCES (LEFT) SOURCES (RIGHT)SOURCES (RIGHT)
Sum of Resources = Sum of Sources
Assets = Liabilities + Equity
Positive Items (debits) Positive Items (credits)
Negative Items (debits)
For Example: A reduction in an obligation, such as abank loan, is a negative item and thus a debit to
sources.
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RESOURCES (LEFT)RESOURCES (LEFT) SOURCES (RIGHT)SOURCES (RIGHT)
Sum of Resources = Sum of Sources
Assets = Liabilities + Equity
Positive Items (debits) Positive Items (credits)
Negative Items (debits)
For Example: A reduction in an obligation is paid by aresource such as cash. A reduction in cash is a negative
item and thus a credit to resources.
Negative Items (credits)
Like any equation, if you move any item to
the other side, it changes sign.
For example: Debits - Credits = 0
or 0 = Credits - Debits
Assets = Liabilities + EquityDebits = Credits
The Balance Sheet EquationThe Balance Sheet Equation
Journal Entries, Debits and CreditsJournal Entries, Debits and Credits
Increases in assets aredebits
Increases in liabilities and/or equityare credits (revenues and incomeincrease equity and are therefore
credits)Debits = Credits
Decreases in assets arecredits
Decreases in liabilities and/or equityare debits (expenses and dividendsdecrease equity and are thereforedebits)
Credits = Debits
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Journal Entries and AccountsJournal Entries and Accounts
A journal entry lists all the accounts debited and
creditedThe journal entrys debits = its credits
Accounts record all the journal entries (from the
general journal or more specialized journals)
For demonstration and analysis purposes a T-
account is often used as a simplified version of anaccount
Example of Journal Entry:
An organization takes out a bank loan worth $1000
DR Cash 1000
CR Bank Loan 1000
Using T- accounts we get:
1000 1000
CASH Bank LoanDR CR DR CR
Accounts are summaries of all the entries
Lets use a cash example:
CASH
Entries:
DR Cash 1000
CR Bank Loan 1000
1000
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Accounts are summaries of all the entries
Lets use a cash example:
CASH
Entries:
DR Cash 500
CR Share Capital 500
1000500
Accounts are summaries of all the entries
Lets use a cash example:
CASH
Entries:
DR Loan Payable 400
CR Cash 400
1000
500
400
Accounts are summaries of all the entries
Lets use a cash example:
CASH
Entries:
DR Rent 250
CR Cash 250
1000
500
400
250
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Accounts are summaries of all the entries
CASH
1000500
400250
850
The total of the cash account is $850. Its
balance is $850.
General Ledger and Trial BalanceGeneral Ledger and Trial Balance
The general ledger is made up of all the accounts
A trial balance determines if the ledger is in balance
(the sum of the debits = the sum of the credits)
Ledger can be in balance without being free of errors
The trial balance is the basis for the Balance Sheet,
Income Statement, and Retained Earnings Statement(Cash Flow Statement is derived from the other 3
statements)
A Balance Sheet ExampleA Balance Sheet Example
Calico Inc. had the following account balances at June 30, 2001.
Place each account in the appropriate location in the balance sheet
and show that the balance sheet balances.
$ $
Land 100,000 Accounts Receivable 43,000
Cash on Hand 5,000 Retained Earnings 223,000
Unsold Inventory 62,000 Buildings & Fixtures 193,000
Accum. Amortization 41,000 Cash in Bank 21,000
Accounts Payable 45,000 De mand Bank Loan 30,000
Share Capital 50,000 Mortgage Payable 35,000
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Calico Inc., Balance Sheet as at June 30, 2001
(Assets)
Current assets:
Cash on hand and in bank $26,000
Accounts receivable 43,000
Inventory 62,000
Non-current assets:
Land $100,000
Building and fixtures 193,000
Less: Accumulated amortization (41,000)
Assets
$131,000
$252,000
TOTAL $383,000
Calico Inc., Balance Sheet as at June 30, 2001
(Liabilities and Equity)
Current Liabilities:
Demand Bank Loan $30,000
Accounts Payable 45,000
Non-current liabilities:
Shareholders' equity:
Share capital $50,000
Retained earnings 223,000
Liabilities and Equity
$75,000
Mortgage payable $35,000
$273,000
TOTAL $383,000
Assets
Current assets:
Cash $4,000Inventory of unsold food 800
Inventory of supplies 1,900
$6,700
Non-current assets:
Equipment $9,000
Accum. Amortization (1,500)
$7,500
$14,200
Liabilities and Shareholders' Equity
Current liabilities:
Owing to suppliers $1,200Sales and other taxes owing 600
$1,800
Non-current liabilities:
Loan to buy equipment 5,000
$6,800
Shareholders' equity:
Share capital contributed $3, 000
Retained earnings 4,400
$7,400
$14,200
CappuMania Inc.
Balance Sheet as at March 31, 2001
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CappuMania Inc.
Trial Balance (March 31, 2001)
Account names Account balancesDebits Credits
Cash 4,000
Inventory of unsold food 800
Inventory of supplies 1,900
Equipment 9,000
Accumulated Amortization 1,500
Owing to suppliers 1,200
Sales and other taxes owing 600
Loan to buy equipment 5,000
Share capital contributed 3,000
Retained earnings 4,400
15,700 15,700
Journal EntriesJournal Entries-- CappuManiaCappuMania
DR Sales and other taxes owing 500CR Cash 500
Transaction 1 reduces an asset and a liability
DR Inventory of supplies 450CR Cash 100CR Owing to suppliers 350
Transaction 2 increases one asset, decreases another, and increases aliability
Journal EntriesJournal Entries-- CappuManiaCappuMania
DR Loan to buy equipment 1,100CR Share capital contributed 1,100
Transaction 3 reduces a liability and increases an equity, having no
effect on assets
DR Equipment cost 200CR Cash 200
Transaction 4 increases one asset and reduces another, with no other
effect
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CappuMania Inc.
Trial Balance (April 1, 2001)
Account names Account balancesDebits Credits
Cash 3,200
Inventory of unsold food 800
Inventory of supplies 2,350
Equipment 9,200
Accumulated Amortization 1,500
Owing to suppliers 1,550
Sales and other taxes owing 100
Loan to buy equipment 3,900
Share capital contributed 4,100
Retained earnings 4,400
15,550 15,550
Assets
Current assets:
Cash $3,200
Inventory of unsold food 800
Inventory of supplies 2,350
$6,350
Non-current assets:
Equipment $9,200
Accum. Amortization (1,500)
$7,700
$14,050
Liabilities and Shareholders' Equity
Current liabilities:
Owing to suppliers $1,550
Sales and other taxes owing 100
$1,650
Non-current liabilities:
Loan to buy equipment 3,900
$5,550
Shareholders' equity:
Share capital contributed $4, 100
Retained earnings 4,400
$8,500
$14,050
CappuMania Inc.
Balance Sheet as at April 1, 2001
IncreaseIncrease DecreaseDecrease
AssetsAssets DebitDebit CreditCredit
LiabilitiesLiabilities CreditCredit DebitDebit
EquityEquity CreditCredit DebitDebit
Using Debits and Credits
The following table is behind accounting's designation of a change inan account, or an account balance, as a debit or credit.
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Transaction Recording and Journal EntriesTransaction Recording and Journal Entries
Corey MacDonald formed Movie Inc. by purchasing
$95,000 of common shares on July 1, 2001 for cash.
Analyze the transaction:
What happens to Movie Inc.s Assets,Liabilities, and Equity??
DR Cash 95,000
CR Common Shares 95,000
RECORDING TRANSACTIONSRECORDING TRANSACTIONS
CASH COMMON SHARES
95,000 95,000
ASSETS = LIABILITIES + EQUITY
Transaction Recording and Journal EntriesTransaction Recording and Journal Entries
The business bought a building lot for $60,000 cash.
Increase/Decrease/NC Which Account?
ASSETS
LIABILITIES
EQUITY
INCREASE
NO CHANGE
NO CHANGECASHDECREASE
LAND
DR Land 60,000
CR Cash 60,000
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RECORDING TRANSACTIONSRECORDING TRANSACTIONS
CASH COMMON SHARES
95,000 95,000
ASSETS = LIABILITIES + EQUITY
LAND
60,000
60,000
Lets look at Movie Inc.s general ledger
at this point
Dr Cr
Cash 35,000
Land 60,000
Common Shares 95,000
95,00095,000
Movie Inc.s General LedgerMovie Inc.s General Ledger
Transaction Recording and Journal EntriesTransaction Recording and Journal Entries
The business purchased $600 of office supplies,
agreeing to pay in 30 days.
Increase/Decrease/NC Which Account?
ASSETS
LIABILITIES
EQUITY
INCREASE
NO CHANGE
INCREASE
OFFICE
SUPPLIESACCOUNTSPAYABLE
DR Office Supplies 600
CR Accounts Payable 600
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RECORDING TRANSACTIONSRECORDING TRANSACTIONS
CASH COMMON SHARES
95,000 95,000
ASSETS = LIABILITIES + EQUITY
LAND
60,000
60,000
OFFICESUPPLIES
ACCOUNTSPAYABLE
600
600
Increase/Decrease/NC Which Account?
Transaction Recording and Journal EntriesTransaction Recording and Journal EntriesMovie Inc. invested in $40,000 worth of equipment. Half of the total
was paid in cash, while the remainder was owed to the supplier.
ASSETS
LIABILITIES
EQUITY NO CHANGE
INCREASE
EQUIPMENT
ACCOUNTSPAYABLE
DR Equipment 40,000
CR Cash 20,000
INCREASE
DECREASE CASH
CR Accounts Payable 20,000
RECORDING TRANSACTIONSRECORDING TRANSACTIONS
CASH COMMON SHARES
95,000 95,000
ASSETS = LIABILITIES + EQUITY
LAND
60,000
60,000
OFFICESUPPLIES
ACCOUNTSPAYABLE
600
600
EQUIPMENT
20,000
20,000
40,000
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CASH COMMON SHARES
95,000 95,000
ASSETS = LIABILITIES + EQUITY
LAND
60,000
60,000
OFFICESUPPLIES
ACCOUNTSPAYABLE
600
600
EQUIPMENT
20,00020,000
40,000
15,000
60,000
600
20,600
95,000
40,000
Movie Inc.Movie Inc.
BALANCE SHEETBALANCE SHEET
AS AT JULY 1, 2001AS AT JULY 1, 2001
Cash $ 15,000
Office Supplies 600
Land 60,000
Accounts
Payable $ 20,600
Common
Shares 95,000
TOTAL $115,600 TOTAL $115,600
Liabilities and EquityAssets
Equipment 40,000
CURRENT ASSETS:
NON-CURRENT ASSETS:
CURRENT LIABILITIES:
EQUITY:
The right hand side of the balance sheet
indicates an organizations source of
financing.
Depending on the form of the organization,
the owners equity section found on thebalance sheet will vary. It might not even be
called that.
Financing an OrganizationFinancing an Organization
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Business FinancingBusiness Financing
The balance sheets right side lists the sources of assets (liabilities
& owners equity). Here is a list of a few of the main sources.
Current liabilities:
Demand loans from the bank
Financing provided by suppliers and trade creditors (buy now/pay
later)
Wages earned but not yet paid to employees
Non-current liabilities:
Mortgages, bonded debt, debentures, and other debts extending
over several years
Business FinancingBusiness Financing
Owners or Owners Equity:
For a proprietorship: owners capital (contributed capital and income
not withdrawn by proprietor)
For a partnership: owners capital (contributed capital and income
not withdrawn by partners)
For a corporation: share capital received plus retained earnings
Financial Instruments:
FIs may or may not be included in the balance sheet. FIs are the set
of contracts, debts, shares, etc. that a business uses for financing andprotection against harmful changes in the financial environment.
ProprietorshipProprietorship
Owned by a single individual.
Direct contributions and retained earnings are lumped
together in the equity section of the balance sheet. Thisequity is known as owners capital.
Example of Equity Section:
Owners equity
Owners capital $XXXX
A sole proprietorship is not a separate legal entity, therefore
the owner has unlimited liability for business debts.
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PartnershipPartnership
Owned by more than one individual.
A partnership has some legal existence but is not legally
separate from the owners, who are liable for business debts.
There is no distinction between direct contributions and
retained earnings in the equity section of the balance sheet.
Each owners total capital is identified on the balance sheet
or in a schedule.
PartnershipPartnership
Example of Equity Section:
Partners equity
Partner A $XXXXPartners capital:
Partner C XXXXPartner B XXXX
Total capital: $XXXX
CorporationCorporation
Legally exists on its own (a legal person).
Owners losses are limited (limited liability).
The equity section on the balance sheet is known asShareholders equity.
A distinction is made between direct contributions and
retained earnings in the equity section of the balance sheet.
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CorporationCorporation
DIRECT CONTRIBUTIONS:
People become owners by purchasing shares.
Shares entitle a person to voting rights or other
powers.
Share capital is only the amount received by the
corporation the first time a share was sold.
Classes of shares include:
Common Shares
Preferred Shares
CorporationCorporation
INDIRECT CONTRIBUTIONS (Retained Earnings):
Earnings belong to the corporation.
Retained Earnings equal the past earnings minus the
past dividends.
CorporationCorporation
Example of Equity Section:
Total issued capital $XXXX
Share capital:
Class B shares (for example) XXXXClass A shares (for example)$XXXX
Total shareholders equity $XXXX
Authorized (narrative describing all the classes ofshares authorized)
Retained earnings $XXXX
Issued capital received:
Shareholders equity
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Corporate GroupsCorporate GroupsCorporate GroupsCorporate GroupsCorporate GroupsCorporate GroupsCorporate GroupsCorporate Groups
Consist of several corporations.
Shareholders equity section represents the equity of the primary
corporation in the group (often called the parent).
Sometimes some of the other corporations in the group (called
subsidiaries) are partly owned by other corporations outside the
parent corporation.
Often contain the word consolidated at the top of the balance
sheet and the other financial statements. This consolidated balance
sheet likely has minority interest and goodwill.
Features of the Balance SheetFeatures of the Balance Sheet-- CAE Inc.CAE Inc.
Comparative: contains figures of two dates (e.g. 2001 and 2000) to
help the users recognize changes.
Units: to avoid clutter, figures are shown in thousands, millions or
even billions of dollars.
Notes: references are made to various notes, since it is not possible
to include them on the face of the balance sheet
Consolidated: this tells us that CAE is a corporate group, not a
single corporation
Date: The balance sheet date is March 31.
Signatures: The balance sheet has been signed by 2 members of theB of Ds, showing the boards approval.
As at October 31, 1999 (millions of dollars)
Assets
Cash and short-term securities $101,027
Loans (net of allowance for credit losses) 87,485
Other assets 25,905
Total assets $214,417
Liabilities
Deposits $140,386
Other liabilities 62,498
Total liabilities 202,884
Shareholders' Equity
Capital stock 2,839
Retained earnings 8,694
11,533
Total liabilities and shareholders' equity $214,417
The Toronto-Dominion Bank
Balance Sheet