lec 3 & 4 [compatibility mode]

8/9/2019 Lec 3 & 4 [Compatibility Mode]

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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


in Thousands of Dollars

Assets

Current assets $245

Non-current assets 250

TOTAL $495


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


$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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$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


$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


$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




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.





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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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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CASH

Entries:

DR Cash 500

CR Share Capital 500

1000500



CASH

Entries:

DR Loan Payable 400

CR Cash 400

1000

500

400



CASH

Entries:

DR Rent 250

CR Cash 250

1000

500

400

250


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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


$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


Loan to buy equipment 5,000

$6,800


Share capital contributed $3, 000


$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


Equipment 9,000

Accumulated Amortization 1,500

Owing to suppliers 1,200

Sales and other taxes owing 600


Share capital contributed 3,000


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



Equipment 9,200

Accumulated Amortization 1,500

Owing to suppliers 1,550



Share capital contributed 4,100


15,550 15,550

Assets

Current assets:

Cash $3,200



$6,350

Non-current assets:

Equipment $9,200

Accum. Amortization (1,500)

$7,700

$14,050

Liabilities and Shareholders' Equity


Owing to suppliers $1,550


$1,650



$5,550


Share capital contributed $4, 100


$8,500

$14,050

CappuMania Inc.


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



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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CASH COMMON SHARES

95,000 95,000


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


The business purchased $600 of office supplies,

agreeing to pay in 30 days.


ASSETS

LIABILITIES

EQUITY

INCREASE

NO CHANGE

INCREASE

OFFICE

SUPPLIESACCOUNTSPAYABLE

DR Office Supplies 600

CR Accounts Payable 600


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CASH COMMON SHARES

95,000 95,000


LAND

60,000

60,000

OFFICESUPPLIES

ACCOUNTSPAYABLE

600

600


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


CASH COMMON SHARES

95,000 95,000


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


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.


Demand loans from the bank

Financing provided by suppliers and trade creditors (buy now/pay

later)

Wages earned but not yet paid to employees


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


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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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


INDIRECT CONTRIBUTIONS (Retained Earnings):

Earnings belong to the corporation.

Retained Earnings equal the past earnings minus the

past dividends.



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


11,533

Total liabilities and shareholders' equity $214,417

The Toronto-Dominion Bank

Balance Sheet

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