FINANCIAL ACCOUNTING:

A CRITICAL APPROACH

Chapter 2
Financial Statements:
A Window on an Entity

Learning Objectives

LO 1 Identify components of financial statements,

understand the info each statement provides, and
prepare simple examples

LO 2 Describe the accounting equation

LO 3 Explain the nature of assets, liabilities, owners

equity, revenues, and expenses

Copyright 2010 McGraw-Hill Ryerson Limited

Learning Objectives

LO 4 Differentiate between
accrual-basis and cash-basis
accounting, and prepare
simple income statements
using each method

LO 5 Use financial statement

information to assess the
liquidity, risk, and profitability
of an entity

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LO 1

Financial Statements

Balance Sheet
Income Statement and Statement of
Comprehensive Income
Statement of Changes in Equity
or Statement of Retained Earnings
Statement of Cash Flows
Notes to the Financial Statements

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LO 1

The Balance Sheet

A summary of an entitys financial position at a

point in time
Elements: Assets (A), Liabilities (L), Owners
Equity (OE)
Information about an entitys financial position
can help stakeholders:

evaluate its financial health

assess its risk
predict its future cash flows

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LO 2

Accounting Equation

The accounting equation is the conceptual

foundation of accounting

Assets (A)
Liabilities (L)
Owners Equity (OE)

(A = L + OE)
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Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 1 $425,000
?
$189,000

a. $614,000
b. $425,000
c. $189,000
d. $236,000
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Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 1 $425,000
?
$189,000

a. $614,000
b. $425,000
c. $189,000
d. $236,000
(425,000 189,000)

Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 2
?
$730,000
$620,000

a. $110,000
b. $1,350,000
c. $730,000
d. $620,000
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Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 2
?
$730,000
$620,000

a. $110,000
b. $1,350,000
c. $730,000
d. $620,000
(730,000 + 620,000)

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Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 3 $200,000
50,000
?

a. $150,000
b. $50,000
c. $250,000
d. $200,000
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Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 3 $200,000
50,000
?

a. $150,000
b. $50,000
c. $250,000
d. $200,000
(200,000 50,000)

12

Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 4 $420,000
?
$350,000

a. $420,000
b. $770,000
c. $70,000
d. $350,000
13

Exercise 2-1 page 63

For each of the following independent situations, fill in the
missing amount.
Assets = Liabilities + Owners Equity
Situation 4 $420,000
?
$350,000

a. $420,000
b. $770,000
c. $70,000
d. $350,000
(420,000 350,000)

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LO 3

Assets

According to IFRS, an asset

must have the following
characteristics:

Provide a future benefit to the

entity
it must be probable that the entity
will enjoy the benefit

Assets are economic resources

available to entity
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LO 3

Assets
Current

assets

Used up within one year (operating cycle)

Non-current

assets

Benefits extend beyond

one year

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LO 3

Asset Criteria

Result from transaction with another entity

Cost can be determined
Must provide future benefit
Benefit must be reasonably measurable

What are some current assets?

Long-term assets?
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Question
Which of the following would be considered an asset for
accounting purposes?

a. Employees who work for the company

b. Research into new products for the
company
c. A building owned by the company but
rented out
d. Advertising spent on attracting
customers to the company
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Question
Which of the following would be considered an asset for
accounting purposes?

a. Employees who work for the company

b. Research into new products for the
company
c. A building owned by the company but
rented out
d. Advertising spent on attracting
customers to the company
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LO 3

Liabilities

Liabilities are an entitys obligation to pay

money or provide goods or services to
suppliers, lenders, customers, and government

According to IFRS, a liability must

be the result of a past transaction or economic

event
require some kind of economic sacrifice to settle

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LO 3

Liabilities

Obligations incurred by entity

Not necessarily a legal obligation
Current liabilities

Paid or satisfied within one year

Non-current liabilities

Paid or satisfied beyond one year

What are some current liabilities?

Long-term liabilities?
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Question
Bass Ltd. borrowed $100,000 from the bank. They will
repay $10,000 a year for the next ten years plus 5% interest.
How would the loan be initially recorded on Basss balance
sheet?

a. $100,000 non-current liability

b. $100,000 current liability
c. $90,000 non-current liability
d. $10,000 current liability and $90,000
non-current liability

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Answer
Bass Ltd. borrowed $100,000 from the bank. They will
repay $10,000 a year for the next ten years plus 5% interest.
How would the loan be initially recorded on Basss balance
sheet?

a. $100,000 non-current liability

b. $100,000 current liability
c. $90,000 non-current liability
d. $10,000 current liability and $90,000
non-current liability

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LO 3

Owners Equity

Owners equity:

the amount owners have invested in an

entity
represents the amount of the assets
financed by the owners

Terms

Shareholders equity (corporation)

Partners equity (partnership)
Proprietors equity (proprietorship)

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LO 1

The Income Statement

Results for an accounting period

Unlike balance sheet

Revenues minus expenses

Net income (Bottom line)

What are some examples of

revenue?
What are some examples of
expenses?
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LO 1

The Income Statement

Measures an entitys economic activity over a

period of time, such as a year
Uses for an income statement are:

evaluating the performance of an entity and its

management
predicting future earnings and cash flows
estimating the value of an entity
determining the amount of tax that must be paid

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LO 1

The Income Statement

The income statement can have significant

economic consequences for entities and their
stakeholders including:

stock prices often change when a company

announces its net income
managers bonuses are often based on net income
net income is used to determine income taxes
the selling price of a business can be based on net
income

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LO 1

Format of Income Statement

Revenue
- Cost of Goods Sold
= Gross Margin
- Operating Expenses
= NI Before Income Taxes
- Income Taxes
= Net Income
Copyright 2010 McGraw-Hill Ryerson Limited

xxx
(xxx)
xxx
(xxx)
xxx
(xxx)
xxx
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Question
Lennox. Ltd. reported sales of $5,000,000, cost of goods sold
of $3,200,000, operating expenses of $1,400,000 and income
tax expense of $160,000 for the year. What was their net
income for the year?

a. $240,000
b. $400,000
c. $1,800,000
d. $3, 200,000
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Answer
Lennox. Ltd. reported sales of $5,000,000, cost of goods sold
of $3,200,000, operating expenses of $1,400,000 and income
tax expense of $160,000 for the year. What was their net
income for the year?

a. $240,000
b. $400,000
c. $1,800,000
d. $3, 200,000
(5,000,000 3,200,000 1,400,000 160,000)
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Exercise 2-19 page 67

Complete together with the class
Prepare an income statement.
What is the net income?
What is Sussexs gross margin for 2013?
What is Sussexs gross margin percentage for 2013?

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Exercise 2-10 page 65

Complete together with the class
Prepare a balance sheet

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LO 1

The Statement of
Comprehensive Income
Current

GAAP attempts to capture all

transactions and economic events that
involve non-owners and that affect equity

Net

income + Other comprehensive

income (OCI) = Comprehensive income

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LO 1

The Statement of
Comprehensive Income
Comprehensive

income also affects the

equity section of the balance sheet

In

the equity section of the balance

sheet, there is an account called
Accumulated Other Comprehensive
Income (AOCI)

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LO 1

Statement of Shareholders Equity

Companies

that follow IFRS must provide

a statement of shareholders equity

Presents

the changes in each account in

the equity section of the balance sheet
during a period

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LO 1

Statement of Retained Earnings

Canadian GAAP for private companies only

requires a statement of retained earnings

Summarizes changes during the period

Opening retained earnings
+ net income for period
- dividends declared
= ending retained earnings
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LO 1

Statement of Cash Flows

Cash from/used in operations

Cash from/used in financing

activities

From long-term liabilities and directly

from investors

Cash from/used in investing

activities

Used to buy capital assets

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LO 1

The Relationship Among Financial

Statements
The

individual financial statements are

closely related
Many transactions and economic events
involve both the Income Statement and
the Balance Sheet, and any transaction
that involves cash is included in the
Statement of cash flows
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LO 1

Notes to Financial Statements

The

notes to the financial statements

Expand and explain the information in the

statements
Explain the accounting policies
Provide additional information that may help
stakeholders assess an entity

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LO 1

Format of Financial Statements

Format

of general purpose financial

statements

No single way to format financial statements

An example of the balance sheet format suggested by
IFRS is seen in Exhibit 2.5
Notice that in contrast to the Leons balance sheet

Non-current assets are at the top of the asset side and

current assets at the bottom
On the liabilities and equity side, equity is at the top, followed
by non-current liabilities, and then current liabilities

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Cash Basis
Revenue recorded when receive cash
Expenses recorded when pay cash

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LO 3

Accrual Basis
Revenue
Economic benefit earned from providing goods
or services
Represents an increase in owners equity
Expenses
Economic sacrifices or costs made to earn
revenues
Using up an asset or incurring a liability
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LO 5

Analysis

Liquidity - the availability of cash or the ability

to convert assets to cash to meet obligations

important to creditors who are expecting to be paid

Liquidity measure:

Working capital

Current assets minus current liabilities

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LO 5

Analysis

Debt-to-equity ratio:
Liabilities
Shareholders equity

A measure of how an
entity is financed - the
higher the ratio, the more
debt an entity is using
relative to equity
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LO 5

Analysis

Using the income statement to

assess performance

Gross margin = sales cost of

sales

Gross margin % = Gross margin

Sales

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LO 1

Materiality

Materiality is the significance of financial

information to stakeholders

Info. is material if its omission or misstatement

affects the judgment of the users of the financial
statements

Financial statements should be free of material

misstatements or errors, & all material info should
be reported in the financial statements or notes
because its absence may affect decision making

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LO 2

Accounting Equation (Revisited)

The income statement is part of the owners

equity section of the balance sheet

A = L + (OE beginning + Revenue Expenses

of the period-Dividends)
OR
A = L + (OE beginning + Net Income-Dividends)
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