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Financial Accounting_ Second Canadian Edition

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					           Chapter 2

Investing and Financing Decisions
      and the Balance Sheet




 2-1                Financial Accounting, Second Canadian Edition
                         Business Background


             To understand amounts appearing
             on a company’s balance sheet we
              need to answer these questions:

           What                   How do
                                                                 How do
         business                 specific
                                                               companies
      activities cause        activities affect
                                                              keep track of
        changes in             each balance
                                                              balance sheet
        the balance                 sheet
                                                                amounts?
           sheet?                 amount?


2-2                                               Financial Accounting, Second Canadian Edition
      The Conceptual Framework




2-3                     Financial Accounting, Second Canadian Edition
                     The Conceptual Framework

                              Objective of External Financial Reporting
 To provide [1]useful [2]economic (not customer satisfaction, not employee skill) information to
   [3] external users (not management, but instead to potential investors(help them choose to
         invest), customers(ensure their product will be delivered), suppliers(they sell us
inventory/hydro…), banker/creditor (want a return on and of their investment), empoyees(want to
              get paid) for [4] decision making and for assessing future cash flows.

                  Cash is the lifeblood of a company, more so than earnings.

Qualitative Characteristics                         Financial Statement Elements
      Understandability                          Asset                                 Liability
           Relevance                             Shareholders’ Equity
            Reliability                          Revenue                               Expense
         Comparability                           Gain                                  Loss
          Consistency

2-4                                                          Financial Accounting, Second Canadian Edition
                                The Conceptual Framework

          Objective of External Financial Reporting
To provide useful economic information to external users
for decision making and for assessing future cash flows.

                                                                       Primary Characteristics
 Qualitative Characteristics (one of the                                 Elements of Statements
          things on Exhibit 2.1)                                   •Understandability: easy to read
Understandability – done using general and specific                •Relevance: predictive value,
                                                                                         Asset
rules, and that readers have a general knowledge of these rules.
                                                                    feedback value, and timeliness.
                                                                                       Liability
Relevance         – more important in management accounting
                                                                   •Reliability: verifiability,
   for decision making on the future. Timeliness because
opportunies happen at certain times of the year. Current info is           Stockholders’ Equity
                          best info.                                representational faithfulness, and
                       Reliability -                                neutrality. Revenue
Comparability – What is the industry using, we should                 Secondary Characteristics
                                                                                       Expense
             present our info in a comparable way.
                                                                   •Comparability: across
Consistency – we usually choose one method, and use it                                    Gain
                     in subsequent years                            companies.
  2-5                                                              •Consistency: LossSecond Canadian Edition
                                                                                          over
                                                                             Financial Accounting, time.
                           The Conceptual Framework


 Assumptions

Separate entity: Transactions of the business entity                         are separate from transactions of
owners. Financisal statements of the company only represent the company. Company A separate from Company B and
owners of Company A.

Continuity: The entity is expected to continue its operations in the near future.
Unit-of-measure: Accounting measures are reported in             the national monetary unit ($).

Periodicity: The long life of a company can be                   reported over a series of short time
periods. Every month, quarter, year. The reason behind many of the items in Chapter 4. Without the periodicity assumption
we would just wait to see how everthing unfolds. Instead we make artificial breaking points.




 2-6                                                                         Financial Accounting, Second Canadian Edition
             The Conceptual Framework


Principles

Historical cost: The cash equivalent cost is the basis
for initial recording of financial statement elements.
What you originally paid for the items.

Revenue recognition: covered in Chapter 3.

Matching: covered in Chapter 3.

Full disclosure: covered in Chapter 6.

2-7                                   Financial Accounting, Second Canadian Edition
                    The Conceptual Framework



 Basic Accounting Principles

 Historical cost (expanded): The cost principle requires assets to be
 recorded at the historical cash – equivalent cost, which on the date of transaction is
 cash paid + the current dollar value of all non-cash considerations also given in the
 exchange.

 Non-Monitary Transaction. How do you value trade or barter transactions? Look at
 the fair market value of the item, say a car, and use that as the value of the
 transaction. If you can’t find an accurate value of what you are giving up, then look up
 what you are receiving. Ex. Lawyer fee of 10 hours, for 100$ an hour.




2-8                                                       Financial Accounting, Second Canadian Edition
                        The Conceptual Framework
                          (same as in Chapter 1)
Asset: economic resource with
         Objective of
  probable future benefit. External Financial Reporting
  To provide useful sacrifices of
Liability: probable future economic information to external users
  economic resources.
  for decision making and for assessing future cash flows.
Shareholders’ Equity: financing
  provided by owners and operations.
Revenue: increase in assets or
      Qualitative Characteristics         Financial Statement Elements
  settlement of liabilities from ongoing                       Asset
  operations.    Relevancy
                                                              Liability
Expense: decrease in assets or
                 Reliability                         Shareholders’ Equity
  increase in liabilities from ongoing
                Comparable                Revenue (normal business operations, not
  operations.                                              crazy things)
Gain: increase in assets or settlement
                Consistent                Expense (normal business operations, not
  of liabilities from peripheral                           crazy things)
  transactions.                           Gain (from periferal activities of business)
Loss: decrease in assets or                 Loss(periferal activities of business)
  increase in liabilities from peripheral
  transactions.
    2-9                                           Financial Accounting, Second Canadian Edition
                      The Conceptual Framework


   Current Assets (turned into cash in one year/operating cycle)are assets
   that will be used or turned into cash, normally within one year. Inventory is always
   considered to be a current asset, regardless of the time needed to produce and sell
   it.(INVENTORY: always a current asset)

   Non-current Assets (long term assets, not used in one year)are
   considered to be long term because they will be used or turned into cash over a period
   longer than the next year.




2 - 10                                                        Financial Accounting, Second Canadian Edition
                          The Conceptual Framework

         Typically, the assets of a company include:
1.       Current assets (short-term)                   2.    Non-current assets (long-term)
a.       Cash and cash equivalents                     a.    Long-term investment
b.       Short-term investments                        b.    Property, plant, and equipment (at cost less
c.       Accounts receivable                                 accumulated amortization) UNLESS you plan to
d.       Inventory                                           sell the equipment within a year.
e.       Prepaid expenses (i.e. expenses paid in       c.    Intangible assets
         advance of use) ex. Prepaid 3 year            d.    Other (miscellaneous) assets
         insurance policy, you pay now and have a
         current asset of the un-used pre-paid
         service.
f.       Other current assets
                                                       BOTH are listed by the ease of conversion to liquidity.
g.       Use it to pay off one of our current
         liabilities
h.       Investment (5year GIC) that will be used to
         pay a supplier in liu of other cash you owe
         within a year, then you will use that
         investment in a year, and it is a current
         asset.


2 - 11                                                                Financial Accounting, Second Canadian Edition
                     The Conceptual Framework


  Current Liabilities are obligations that will be paid in cash (or other current assets)
  or satisfied by providing service for the coming year. [ Debt you must pay off within
  the next year] [Listed in the order of maturity]

  Long-term Liabilities are a company’s debts that have maturities that extend
  beyond one year from the balance sheet date. [Debt you pay off outside a year. Ex.
  Mortgages.]



  ----
  These are classifications on the balance sheet. Provides more information, rather
  than just a list of accounts.




2 - 12                                                      Financial Accounting, Second Canadian Edition
                The Conceptual Framework

   Typically, the liabilities of a company include:


   1. Current Liabilities         2. Non-current liabilities
      (short term)                   (long term)

   a. Bank indebtedness           a. Notes and mortgages
   b. Accounts payable               payable
   c. Accrued liabilities         b. Lease obligations
   d. Current portion of          c. Bonds payable
      long-term debt              d. Other long-term
   e. Other current liabilities      liabilities
2 - 13                                    Financial Accounting, Second Canadian Edition
                         The Debt-To-Equity Ratio



                                                        Total Liabilities
   Debt-To-Equity Ratio =
                                                 Total Shareholders’ Equity
                                                   An increasing ratio over time signals more
                                                    reliance on debt financing and more risk.
 This ratio measures the relation between
total liabilities and the shareholders’ equity
           that finances the assets.                NOTE: you cant record the empoyee skill,
                                                  and are not reported. Thus there are not a lot
We only care about total liabilities compared
                                                    of assets in a service firm like a law firm.
        to total shareholders equity
                                                   Service firm has a lot of shareholder equity.
                                                    Bank wont want to loan a lot of money to
                                                                       them.
 How much is financed by banks/creditors
             versus owners                          An airline industry is the opposite. Banks
                                                   can lend knowing that they have assets that
                                                      they can get money back out of. High
                                                                 debt/equity ration.
2 - 14                                                       Financial Accounting, Second Canadian Edition
              The Debt-To-Equity Ratio

                                  Total Liabilities
   Debt-To-Equity Ratio =
                             Total Shareholders’ Equity

                            $139,300
   Debt-To-Equity Ratio =
                            $231,400

                        = 0.60

             Comparison with Competitors
    Van Houtte       Starbucks     Green Mountain
       2005             2004              2004
      60.00%           37.00%            76.00%
2 - 15                                 Financial Accounting, Second Canadian Edition
                 Nature of Business Transactions


         External events: [one of two transactions we record]
                                exchanges of assets
                        and liabilities between the business
         and one or more other parties. The ones we see most frequently in
                               Financial accounting.
                            We will deal this type most.




                               Borrow money


                               from the bank
2 - 16                                                Financial Accounting, Second Canadian Edition
                       Nature of Business Transactions


                     Internal events: not an exchange between
                               the business and other parties, but have
         a direct effect on the accounting entity. EX: Inventory Fire . A second event may
                          Transpire ex. An insurance claim (external event).

                             More likely in Management accounting.




Loss due to
fire damage.




2 - 17                                                        Financial Accounting, Second Canadian Edition
                                Accounts

An standardized format used by companies to accumulate the dollar effects
                       of transactions. “T Accounts”
                            Revenue = income
                               Cash = asset
         Are things a debit or a credit? We need to learn which.
           Cash            Your deposit is a
                          Credit to the bank.         Inventory
                            And is thus a
                             Debit to you
  My 100 in
  The bank                 Ex. You get 100$
                            For fixing a car
                           If we’ve done it
                            It is considered
         Equipment      Earned revenue. (asset) Notes Payable
                            If not, then its
                              Un-earned.
                       (an obligation == liability)


2 - 18                                                 Financial Accounting, Second Canadian Edition
                          Transaction Analysis


    Every transaction affects at least two accounts (duality of effects).
         A debit on one is a credit on another.
    The accounting equation must remain in balance after each
     transaction.




    A = L + SE
2 - 19                                            Financial Accounting, Second Canadian Edition
                Balancing the Accounting Equation

 Accounts and effects
      Identify the accounts affected. (cash, inventory, revnue, expense, earned revenue,
       ???)
      Classify each as an( asset, liability or shareholder equity) < balance sheet, (revenue,
       expense) < ??
      Determine the direction of the effect (increase or decrease) on each account.

      Cash is normally a debit account.
 Determine that the accounting equation remains in balance.




  2 - 20                                                     Financial Accounting, Second Canadian Edition
          Balancing the Accounting Equation


Let’s see how we keep the
 accounting equation in
 balance for Van Houtte.

           All amounts are in
         thousands of dollars.




2 - 21                           Financial Accounting, Second Canadian Edition
Van Houtte issues additional shares to new
  investors in exchange for $1,300 cash.

Identify & Classify the Accounts
Identify & Classify the Accounts
1. Cash (asset) we get cash. (L.H.S. cash goes up)
2. Share Capital (equity) and
   new owners. (right hand side gets bigger)




                     Determine the Direction of the Effect
                     1. Cash increases. (A) ++
                     2. Share Capital increases. (SE) ++


 2 - 22                              Financial Accounting, Second Canadian Edition
    Van Houtte issues additional shares to new
      investors in exchange for $1,300 cash.

                               Assets                   = Liabilities + Shareholders' Equity
            Cash    Investments Fixed Assets Notes Rec.   Notes Pay.          Share Capital
  (a)       1,300                                                                     1,300




Effect                         1,300                     =                        1,300




            A = L + SE
        2 - 23                                               Financial Accounting, Second Canadian Edition
   The company borrows $1,000 from the local
   bank, signing a note to be paid in one year.

                            Assets                   = Liabilities + Shareholders' Equity
         Cash    Investments Fixed Assets Notes Rec.   Notes Pay.          Share Capital
  (a)    1,300                                                                     1,300
  (b)    1,000                                              1,000




Effect                      2,300                     =                        2,300




         A = L + SE
     2 - 24                                               Financial Accounting, Second Canadian Edition
   Van Houtte purchases $2,200 of new coffee brewers, counters,
   etc., and other equipment (fixed assets) paying $1,500 in cash
           and signing a note for $700, payable in 2 years.

                                 Assets                   = Liabilities + Shareholders' Equity
              Cash    Investments Fixed Assets Notes Rec.   Notes Pay.          Share Capital
   (a)        1,300                                                                      1,300
   (b)        1,000                                              1,000
   (c)        1,500                      2,200                     700


Effect                           3,000                    =                        3,000




             A = L + SE
         2 - 25                                               Financial Accounting, Second Canadian Edition
   Van Houtte lends $450 to new franchisees
  who sign notes. (sometimes only one side is
  changed. Not always one asset, one liability)
                            Assets                   = Liabilities + Shareholders' Equity
            Cash Investments Fixed Assets Notes Rec.   Notes Pay.          Share Capital
  (a)        1,300                                                                 1,300
  (b)        1,000                                          1,000
  (c)       (1,500)                 2,200                     700
  (d)          450                              450

Effect                        3,000                    =                        3,000




            A = L + SE
        2 - 26                                             Financial Accounting, Second Canadian Edition
                 Direction of Transaction Effects

          A T-account is a tool used to represent an account.



        The left side of the                     The right side of the
T-account is always the debit side.      T-account is always the credit side.
        DENOTED “DR”                              DENOTED “CR”

 Doesn’t always mean increase.             Doesn’t always mean decrease
                             Account Name
                              Left    Right
                             Debit    Credit


 2 - 27                                        Financial Accounting, Second Canadian Edition
                   The Debit-Credit Framework

          Debits and credits affect the Balance Sheet
                      Model as follows:



          A = L + SE
          ASSETS           LIABILITIES                   EQUITIES
  Debit   Credit         Debit     Credit        Debit     Credit
   for      for            for      for            for      for
Increase Decrease       Decrease Increase       Decrease Increase


 2 - 28                                  Financial Accounting, Second Canadian Edition
                 Analytical Tool: The Journal Entry
                       (dates are important.)

      Provide a reference                      Debits are written first.
   date for each transaction.

            GENERAL JOURNAL                                        Page 1

 Date                            Description                    Debit              Credit
Jan. 2 Cash                                                     20,000
                         Share Capital                                              20,000


                                                     Total debits must equal
       Credits are indented and                            total credits.
          written after debits.
   Sometimes you can just list as they
     Become known by you (exam)
2 - 29                                                Financial Accounting, Second Canadian Edition
                               Analytical Tool: The T-Account


              After journal entries are prepared, the accountant posts (transfers)
                  the dollar amounts to each account that was affected by the
                                           transaction.




     GENERAL JOURNAL                 Page 1                               Ledger
 Date            Description      Debit       Credit     Post
Jan. 2 Cash                         20,000
              Share Capital                     20,000




    2 - 30                                                      Financial Accounting, Second Canadian Edition
         Transaction Analysis Illustrated




 Let’s prepare
 some journal
entries for Van
Houtte and post
  them to the
    ledger.

2 - 31                           Financial Accounting, Second Canadian Edition
Van Houtte issues additional shares to new
  investors in exchange for $1,300 cash.

            GENERAL JOURNAL                             Page 1

   Date                   Description                 Debit              Credit
             Cash                                      1,300
                       Share Capital                                        1,300
                       (description here)
                Cash                              Share Capital
Beg. Bal.    6,100                                            300 Beg. Bal.
      (a)    1,300                                          1,300 (a)




             7,400                                                1,600

 2 - 32                                     Financial Accounting, Second Canadian Edition
The company borrows $1,000 from the local
bank, signing a note to be paid in one year.

            GENERAL JOURNAL                            Page 1

   Date                   Description                Debit              Credit
             Cash                                     1,000
                       Notes Payable (L)                                   1,000


                Cash                              Notes Payable
Beg. Bal.    6,100                                             -  Beg. Bal.
      (a)    1,300                                          1,000 (b)
      (b)    1,000




             8,400                                                1,000

 2 - 33                                    Financial Accounting, Second Canadian Edition
                     Balance Sheet Preparation



         It is possible to prepare a balance
             sheet at any point in time from
              the balances in the accounts.

    We use the ending balance of all the
      T Accounts to create the balance
                   sheet.




2 - 34                                         Financial Accounting, Second Canadian Edition
                                                                  VAN HOUTTE INC.
                                                             Consolidated Balance Sheets
                                                                     April 30, 2005
                                                                (Dollars in thousands)
                            Assets                                                 April 30, 2005        April 2, 2005
                            Current assets:
                              Cash                                                   $         2,450      $       5,400
                              Accounts receivable                                             41,300             41,300
                              Inventories                                                     28,000             28,000
                              Prepaid expenses                                                 3,300              3,300
These balances come from Van Other current assets                                              1,700              1,700
  Houtte ledger accounts on Total current assets                                              76,750             79,700
         April 30, 2005     Note receivable                                                      150               ─
                            Investments                                                       21,900             18,900
                            Fixed assets, net                                                118,000            115,800
                            Goodwill                                                         141,700            141,700
    All the accounts must   Other long-term assets                                            14,600             14,600
             Match.         Total assets                                             $       373,100      $     370,700
                                 Liabilities and shareholders' Equity
                                 Current liabilities:
                                   Accounts payable                                  $         31,900     $       31,900
                                   Accrued liabilities                                          9,700               9,700
                                   Current portion of long-term debt                           28,000             28,000
                                 Total current liabilities                                     69,600             69,600
                                 Long-term notes payable                                       61,600             60,300
                                 Other long-term liabilities                                    9,400               9,400
                                 Total liabilities                                            140,600            139,300
                                 Shareholders' equity:
                                 Share capital                                                131,600            130,300
                                 Retained earnings                                            100,900            101,100
                                 Total shareholders' equity                                   232,500            231,400
  2 - 35                         Total liabilities and shareholders' equity          $        373,100     $      370,700
                                                                      Financial Accounting, Second Canadian Edition
                        Focus on Cash Flows
Purchasing long-term assets          -
for cash (decrease cash)
Selling long-term assets for         +
cash (decrease land, increase
cash)
Lending cash to others               -
(increase notes recieveable,
decrease cash on load out.
Receiving principal payments         +
in cash on loans to others

                                                                          Effect on
                                      Financing Activities               Cash Flows
                                Borrowing cash from banks                     +
                                Repaying in cash the
                                principal on loans to banks
                                Issuing shares for cash
                                Repurchasing shares with
                                cash
    2 - 36                      Paying cash dividendsAccounting, Second Canadian Edition
                                                  Financial
                       Some Misconceptions

               Don’t confuse bookkeeping with accounting.
Bookkeeping involves the routine, clerical part of accounting and requires only
                   minimal knowledge of accounting, but . . .




                                       An accountant is a trained
                                     professional who can design
                                     information systems, analyze
                                       complex transactions, and
                                        interpret financial data.


2 - 37                                               Financial Accounting, Second Canadian Edition
          Some Misconceptions


              Are all transactions subject to
         precise and objective measurement? No

            Everything is based on estimates.




                  Almost all
                 accounting
                   numbers
                are influenced
                by estimates.

2 - 38                                 Financial Accounting, Second Canadian Edition
                          Some Misconceptions
     Some people believe that financial statements report the market value of the
                                        company.

         Balance sheet has the historic cost principal. Doesn’t show the current
            Value of land, but rather the historic cost. What it was bought for.

  It will tell you that (because of the conservatism principle) that assets will not be
       overstated, and liabilities will not be understated, and net income will not be
                                           overstated




                        Financial statements
                  really report the cost of assets,
                            liabilities and
                        shareholders’ equity.

2 - 39                                                   Financial Accounting, Second Canadian Edition

				
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