Investing and Financing Decisions

and the Accounting System

Chapter 2
Learning Objectives
 LO2-1 Define the objective of financial reporting, the
qualitative characteristics of accounting information, and
the related key accounting assumptions and principles.
 LO2-2 Define the elements of a classified statement of
financial position and analyze how the information is
relevant to investors and other decision makers.
 LO2-3 Identify what constitutes a business transaction
and recognize common account titles used in business.
 LO2-4 Apply transaction analysis to routine, simple
business transactions in terms of the accounting
equation: Assets = Liabilities + Shareholders’ Equity.
Learning Objectives Continued
 LO2-5 Determine the impact of business transactions on
the statement of financial position by using two basic
recording tools: journal entries and T-accounts.
 LO2-6 Prepare a trial balance and a classified statement
of financial position and analyze the company using the
current ratio.
 LO2-7 Identify investing and financing transactions, and
demonstrate how they are reported on the statement of
cash flows.
Understanding the Business
 To understand amounts appearing on a company’s
statement of financial position, we need to answer these
questions:
 What type of business activities cause changes in amounts
reported on the statement of financial position from one
period to the next?

 How do specific activities affect each of these amounts?

 How do companies keep track of these amounts?

The Conceptual Framework Overview
 Objective of External Financial Reporting
 To provide financial information about the reporting entity that is useful to
existing and potential investors, lenders, and other creditors in making decisions
about providing resources to the entity.
 Qualitative Characteristics of Useful Accounting Information:
 Fundamental characteristics: relevance, faithful representation
 Enhancing characteristics: comparability, verifiability, timeliness,
understandability
 Elements to Be Measured and Reported:
 Assets, liabilities, shareholders’ equity, investments by owners, distribution to
owners
 Revenues, expenses, gains and losses
 Comprehensive income
 Concepts for Measuring and Reporting Information:
 Assumptions: separate entity, stable monetary unit, continuity (going concern),
periodicity
 Principles: mixed-attribute measurement, revenue recognition, full disclosure
 Constraints: cost
The Conceptual Framework
 To fulfill the primary objective of providing useful
information, the conceptual framework provides
guidance on the essential characteristics that determine
the usefulness of accounting information.
 There are two fundamental qualitative characteristics—
relevance and faithful representation
 These two fundamental characteristics are supported by
four enhancing qualitative characteristics: comparability,
verifiability, timeliness, and understandability. 
 Accounting information that embodies the best balance
of these characteristics will be of high quality to external
decision makers.
Qualitative Characteristics of Accounting Information
Two Fundamental Qualitative Characteristics
 Relevance: makes a difference in a decision, predictive
value, feedback/confirmatory value
 Faithful representation: complete, neutral, reasonably
free from error or bias.
Four Enhancing Qualitative Characteristics
 Comparability: across companies
 Verifiability: similar results under independent measures
 Timeliness: information must be available before its loses
its usefulness
 Understandability: allows reasonably informed users to
see the significance of the information.
Constraint of Accounting Measurement
 Cost constraint: information should be produced only if
the perceived benefits of increased decision usefulness
exceed the expected costs of providing that information.
Recognition and Measurement Concepts
 Separate entity assumption: Activities of the business are
separate from activities of owners.
 Stable monetary unit assumption: Accounting
measurements will be in the national monetary unit (i.e.,
$ in Canada) without any adjustments for changes in
purchasing power (i.e., inflation).
 Continuity (going concern) assumption: The is assumed
to continue to operate into the foreseeable future.
 Historical cost principle: Cash equivalent cost given up is
the basis for the initial recording of elements.
Elements of the Classified Statement of Financial
Position - Assets
 Assets: Economic resources controlled by an entity as a
result of past transactions or events and from which
future economic benefits may be obtained. These are the
resources that the entity has and can use in its future
operations. 
 Current Assets: Assets that will be used or turned into
cash, normally within one year.
 Non-current Assets: Assets that are considered to be
long-term because they will be used or turned into cash
over a period longer than the next year.
Assets of a Company Typically include:
 Current assets (short term)
 Cash
 Short-term investments
 Accounts receivable
 Inventories
 Prepaid expenses (i.e., expenses paid in advance of use)
 Other current assets
 Non-current assets (long term)
 Property, plant, and equipment (at historical cost less accumulated
depreciation)
 Financial assets
 Goodwill
 Intangible assets
 Other (miscellaneous) assets
Elements of the Classified Statement of Financial
Position - Liabilities
 Liabilities: Present debts or obligations of the entity to
transfer an economic resource as a result of past events.
They represent future outflows of assets (mainly cash) or
services to the creditors that provided the corporation
with the resources needed to conduct its business.
 Current Liabilities: Short-term obligations that will be
settled within the coming year by providing cash, goods,
other current assets or services.
 Non-current Liabilities: All of the entity’s obligations not
classified as current liabilities.
Liabilities of a Company Typically include:
 Current liabilities (short term)
 Accounts payable
 Short-term debt (or borrowings)
 Income taxes payable
 Accrued liabilities
 Provisions
 Other current liabilities
 Non-current liabilities (long term)
 Long-term debt (or borrowings)
 Provisions
 Other liabilities
Elements of the Classified Statement of Financial
Position – Shareholders’ Equity
 Shareholders’ equity (owners’ equity): The financing
provided to the corporation by both its owners and the
operations of the business. 
 Typically, the shareholders’ equity of a corporation
includes the following:
1. Contributed capital
2. Retained earnings (accumulated earnings that have not
been declared as dividends)
3. Other components
Elements of the Classified Statement of Financial
Position – Shareholders’ Equity Part 2
 Financing provided by shareholders is referred to
as contributed capital. Shareholders invest in the
business by providing cash and sometimes other assets,
and receive shares as evidence of ownership. 
 Financing provided by operations is referred to as earned
capital or retained earnings. Most companies that
operate profitably retain part of their earnings for
reinvestment in their business. The other part is
distributed as dividends to shareholders. Earnings that
are not distributed to shareholders but instead are
reinvested in the business by management are called
retained earnings. 
Nature of Business Transactions
 Accounting focuses on specific events that have an
economic impact on the entity.
 Any event that is recorded as a part of the accounting
process is called a transaction.
 The first step in translating the results of business events
to financial statement amounts is determining which
events to include.
 Only economic resources and debts resulting from past
transactions are recorded on the statement of financial
position.
Nature of Business Transactions Continued
 Transactions include two types of events: external events
and Internal events.
 External events: These are exchanges of assets, goods, or
services by one party for assets, services, or promises to
pay (liabilities) by one or more other parties.
 Internal events: These include certain events that are not
exchanges between the business and other parties but,
nevertheless, have a direct and measurable effect on the
accounting entity.
Accounts
 An account is a standardized record that organizations
use to accumulate the monetary effects of transactions
on each financial statement item.
 The cumulative result of all transactions that affect a
specific account, or its ending balance, is then reported
on the appropriate financial statement.
Chart of Accounts
 To facilitate the recording of transactions, each company
establishes a chart of accounts—a list of accounts and
their unique numeric codes.
 The chart of accounts is organized by financial statement
element, with asset accounts listed first (by order of
liquidity), followed by liabilities (by order of time to
maturity), shareholders’ equity, revenue, and expense
accounts, in that order.
Chart of Accounts Continued
Elements of the Statement of Financial Position
 Assets: Economic resources with probable future benefits
owned or controlled by the entity. Measured by the
historical cost principle.
 Liabilities: Probable debts or obligations (claims to a
company’s resources) that result from a company’s past
transactions and will be paid with assets or services.
Entities that a company owes money to are called
creditors.
 Shareholders’ Equity: The financing provided by the
owners and by business operations. Often referred to as
contributed capital.
Principles of Transaction Analysis
 Every transaction affects at least two accounts (duality of
effects).
 The accounting equation must remain in balance after
each transaction.

A = L + SE
Dual Effects
 The idea that every transaction has at least two effects on
the basic accounting equation is known as the dual
effects concept.
 Most transactions with external parties involve
an exchange by which the business entity both receives
something and gives up something in return. 
Balancing the Accounting Equation
 Step 1: Ask → What was received and what was given?
 Identify the accounts affected by their titles (e.g., cash and
accounts payable). Make sure that at least two accounts
change.
 Classify each by type of account. Was each account an asset
(A), a liability (L), or shareholders’ equity (SE)?
 Determine the direction of the effect. Did the account
increase (+) or decrease (−)?
 Step 2: Verify → Is the accounting equation in balance?
(A = L + SE)
Analyzing Gildan’s Transactions (a)
 (a) Gildan issues shares to new investors in exchange for
$53 in cash.
 Step 1: What was received and what was
given? (account name, type of account, amount, and
direction of effect)
Received: Cash (+A)
Given: Additional share certificates; Contributed capital (+SE) $53
$53

Assets = Liabilities + Shareholders’ Equity

Cash       Contributed capital

(a) +53 =     +53

 Step 2: Is the accounting equation in balance?

Assets $53 = Liabilities $0 + Shareholders’ Equity $53
Analyzing Gildan’s Transactions (b)
 (b) Gildan borrows $45 from its local bank, signing a
note to be paid in two years.
 Step 1: What was received and what was
given? (account name, type of account, amount, and
direction of effect)
Received: Cash (+A) $45 Given: Written promise to bank; Long-term debt (+L) $45

Assets = Liabilities + Shareholders’ Equity

Long-term
Cash     Contributed capital
debt
(a) +53 =     +53
(b) +45 = +45    
 Step 2: Is the accounting equation in balance?
Assets $45 = Liabilities $45+ Shareholders’ Equity $0
Analyzing Gildan’s Transactions (c)
 (c) For expansion, Gildan opened new distribution centres. The company
purchased new shelving racks, counters, and other equipment for $22; paid $15 in
cash; and signed a note for $7, payable to the supplier in two years.
 Step 1:What was received and what was given? (account
name, type of account, amount, and direction of effect)
Given: (1) Cash (−A) $15 and a written promise to
Received: Property, plant, and equipment (+A) $22
pay the manufacturer; Long-term debt (+L) $7

Assets = Liabilities + Shareholders’ Equity

Property, plant,
Cash     Long-term debt   Contributed capital
and equipment
(a) +53     =     +53
(b) +45     = +45    
(c) −15   +22 = +7    
 Step 2: Is the accounting equation in balance?
Assets $7 = Liabilities $7 + Shareholders’ Equity $0
Analyzing Gildan’s Transactions (d)
 (d) Gildan lends $80 to a trade supplier in financial
difficulty. The trade supplier signs notes (a borrowing
contract) agreeing to repay the amount borrowed within
six months.
 Step 1: What was received and what was
given? (account name, type of account, amount, and
direction of effect)

Received: Written promise from the trade supplier;

Given: Cash (−A) $80
Notes receivable (+A) $80

 Step 2: Is the accounting equation in balance?

Assets $0 = Liabilities $0 + Shareholders’ Equity $0
Analyzing Gildan’s Transactions (e)
 (e) Gildan purchases shares issued by another company
as a long-term investment, paying $18 in cash. The
number of shares purchased allows Gildan to exert
significant influence over decisions made by that
company.
 Step 1: What was received and what was
given? (account name, type of account, amount, and
direction of effect)
Received: Share certificates from the other company; Long- Given: Cash (−A)
term investments (+A) $18 $18

 Step 2: Is the accounting equation in balance?

Assets $0 = Liabilities $0 + Shareholders’ Equity $0
Analyzing Gildan’s Transactions (f)
 (f) Gildan’s board of directors declares cash dividends of
$20 for shareholders. The dividends are paid
immediately.
 Step 1: What was received and what was
given? (account name, type of account, amount, and
direction of effect)

Received: Earnings retained in the business distributed to Given: Cash (−A)

investors; Retained earnings (−SE) $20 $20

 Step 2: Is the accounting equation in balance?

Assets −$20 = Liabilities $0 + Shareholders’ Equity −$20
The Accounting Cycle
The Direction of Transaction Effects
 “T-account” is a shorthand term for the entire ledger
account. The T-account has a left side, called the debit
side, and a right side, called the credit side
T-Account
(Any account)

debit credit
The Direction of Transaction Effects: Summary

Assets = Liabilities + Shareholders’ Equity

+ with Debits + with Credits + with Credits

Accounts Accounts Accounts

have debit balances have credit balances
have credit balances
Analytical Tool: The Journal Entry
 A journal entry might look like this:
The T-Account
 By themselves, journal entries do not provide the ending
balances in accounts. After the journal entries have been
recorded, the bookkeeper posts (transfers) the monetary
values to each account affected by the transaction to
determine the new account balances.
 In most computerized accounting systems, this happens
automatically upon recording the journal entry.
The T-Account Continued
 The T-accounts below show the cash and long-term debt
accounts for Gildan, based on transactions (a) through
(h). 
The Statement of Financial Position
 Usually, businesses will create a trial balance spreadsheet
first for internal purposes before preparing and reporting
financial statements for external users.
 A trial balance lists the titles of the T-accounts in the first
column, usually in financial statement order with their
ending debit or credit balances in the next two columns.
 Debit balances are indicated in the left column and credit
balances are indicated in the right column.
 Then the two columns are totalled to provide a check on
the equality of the debits and credits. 
Classified Statement of Financial Position
 In a classified statement of financial position assets and
liabilities are classified into two categories – current and
non-current.
 Current assets are those to be used or transformed into
cash within the upcoming 12 months whereas non-
current assets are those that will last longer than one
year.
 Current liabilities are those obligations to be paid or
settled within the next 12 months with current assets.
Ratio Analysis in Decision Making
 Users of financial information compute a number of
ratios when analyzing a company’s past performance and
financial condition as input in predicting its future
potential.
 The change in ratios over time and how they compare to
the ratios of the company’s competitors or industry
averages provide valuable information about a company’s
strategies for its operating, investing, and financing
activities.
Ratio Analysis in Decision Making Continued
 The Current Ratio:
 ANALYTICAL QUESTION → Does the company currently have
the resources to pay its short-term debt?
 RATIO AND COMPARISONS → Analysts use the current ratio as
an indicator of the amount of current assets available to satisfy
current liabilities. It is computed as follows:

​Current Ratio = Current Assets / Current Liabilities

Some Misconceptions
 Don’t confuse bookkeeping with accounting.
Bookkeeping involves the routine, clerical part of
accounting and requires only minimal knowledge of
accounting.
 An accountant is a trained professional who can design
information systems, analyze complex transactions, and
interpret financial data.
 Almost all accounting numbers are influenced by
estimates.
 Financial statements really report the cost of assets,
liabilities and shareholders’ equity.
End of Chapter Summary
 The primary objective of external financial reporting is to
provide financial information about a business to help
external parties, primarily investors, and creditors, make
sound financial decisions.
 Elements of the statement of financial position are;
Assets, Liabilities and Shareholders’ equity.
 Assets = Liabilities + Shareholders’ Equity
 Journal entries express the effects of a transaction on
accounts by using the debit–credit framework.
 T-accounts summarize transaction effects for each
account.