Understanding

Financial Accounting
Third Canadian Edition
By Christopher D. Burnley
Prepared by Debbie Musil, FCPA, FCMA

Chapter 2
Analyzing Transactions and their Effects
on Financial Statements
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Learning Objectives (1 of 2)
LO 1 – Identify the accounting standards used by
Canadian Companies.
LO 2 – Identify and explain the qualitative
characteristics of useful financial information
and how the cost constraint affects these.
LO 3 – Explain the difference between cash basis of
accounting and the accrual basis of accounting.
LO 4 – Explain the accounting equation template
approach to recording transactions.

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Learning Objectives (2 of 2)
LO 5 – Analyze basic transactions and record their
effects on the accounting equation.
LO 6 – Summarize the effects of transactions on the
accounting equation and prepare and interpret a
simple set of financial statements.
LO 7 – Calculate and interpret three ratios used to
assess the profitability of a company.

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Accounting Standards
• Broad set of rules and guidelines used in the
preparation of financial statements
o International Financial Reporting Standards (IFRS)
o Accounting Standards for Private Enterprises (ASPE)

• Objective of IFRS and ASPE is to produce financial

reporting that is useful to financial statement users

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Accounting Standards Responsibility
• Canadian Accounting Standards Board (AcSB)
responsible for standards used by Canadian
companies
• IFRS is the responsibility of International Accounting
Standards Board (IASB)

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Conceptual Framework
• The underlying set of objectives and concepts that
guide accounting standard-setting bodies in justifying
new standards and revising old ones

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Development of Conceptual Frameworks
• IASB’s and AcSB’s conceptual frameworks were
developed with the following objectives in mind:
o To assist organizations with developing financial
reporting standards
o To assist accountants in determining how to account
for items where there are no specific standards
o To assist users with interpreting financial statements

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Characteristics of Useful Information
Characteristics and constraints of accounting information
according to the IFRS conceptual framework
Fundamental Qualitative Characteristics Enhancing Qualitative Characteristics
Relevance Comparability
Predictive value Verifiability
Confirmatory value Timeliness
Materiality Understandability
Faithful representation Constraints
Completeness Cost constraint
Neutrality
Freedom from error

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Going Concern Assumption
• Financial statements are normally prepared on a
going concern basis:
o Assumption is that a company will continue operating
for the foreseeable future
o Is essential if a company is to be able to realize its
assets and discharge liabilities in the normal course
of operations

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Cash versus Accrual Basis of Accounting
• Under the Cash Basis:
o Revenues are recorded when the cash is received
o Expenses are recorded when cash is paid

• Under the Accrual Basis:

o Revenues are recorded when they are earned
regardless of whether the related cash was received
by the company
o Expenses are recorded when they are incurred

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Revenue Recognition
• Revenue Recognition:
o Five-step process to determine when revenues
should be recognized in the financial statements
o Generally, companies should recognize revenues
when earned
• that is, when company has satisfied its performance
obligations in the contract by providing goods or
services to its customers

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Basic Accounting Equation
• Accounting Equation

Assets = Liabilities + Shareholders’ Equity

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How to Calculate Retained Earnings

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Template Approach

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Recording Transactions
• Every transaction must affect at least two accounts
• Equation must remain in balance after each
transaction
Assets = Liabilities + Shareholders’ Equity
• Retained earnings will be affected by changes in
revenues, expenses and dividends declared

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Transaction Analysis – Start-Up Period –
Transaction 1
• Sample Company Ltd. (SCL) is formed as a
corporation January 1, 2024, and has the following
transactions for January:
• Transaction 1: Common shares are issued for
$250,000 cash
• Effects:
o Assets (Cash) increased by $250,000
o Shareholders’ Equity (Common shares) increased by
$250,000

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Transaction Analysis - 2
• Transaction 2: Borrowed $100,000 from bank
• Effects:
o Assets (Cash) increased by $100,000
o Liabilities (Bank Loan Payable) increased by $100,000

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Transaction Analysis - 3
• Transaction 3: Paid $1,100 cash for January rent
• Effects:
o Assets (Cash) decreased by $1,100
o Shareholders’ Equity (Retained Earnings) decreased
by $1,100

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Transaction Analysis - 4
• Transaction 4: The company paid $65,000 to
purchase equipment
• Effects:
o Assets (Cash) decreased by $65,000
o Assets (Equipment) increased by $65,000

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Transaction Analysis - 5
• Transaction 5: The company purchased a one- year
insurance policy for $1,800 cash
• Effects:
o Assets (Cash) decreased by $1,800
o Assets (Prepaid Insurance) increased by $1,800

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Transaction Analysis - 6
• Transaction 6: The company purchased land for
$180,000
• Effects:
o Assets (Cash) decreased by $180,000
o Assets (Land) increased by $180,000

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Transaction Analysis - 7
• Transaction 7: The company purchased $23,000 of
inventory on account (SCL will pay for these goods at
a later date)
• Effects:
o Assets (Inventory) increased by $23,000
o Liability (Accounts Payable) increased by $23,000

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Transaction Analysis - 8 (Part 1)
• Transaction 8: Sold products to customers for
$34,000, $21,000 was received in cash, the balance
was on account (SCL’s customers will pay at a later
date). Cost of products sold was $17,000
• Effects:
o Part 1 (to account for the sales revenue)
• Assets (Cash & Accounts Receivable) increased by
$34,000
• Shareholders’ Equity (Retained Earnings) increased by
$34,000

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Transaction Analysis - 8 (Part 2)
• Transaction 8 (Part 2):
• Effects (continued):
o Part 2 (account for the inventory that becomes cost
of goods sold)
• Assets (Inventory) decreased by $17,000
• Shareholders’ Equity (Retained Earnings) decreased by
$17,000

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Transaction Analysis - 9
• Transaction 9: The company received an $11,000
payment from customers for sales made on account
• Effects:
o Assets (Cash) increased by $11,000
o Assets (Accounts Receivable) decreased by $11,000

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Transaction Analysis - 10
• Transaction 10: The company makes a payment to
suppliers for $13,500 for inventory previously
purchased on account
• Effects:
o Assets (Cash) decreased by $13,500
o Liabilities (Accounts Payable) decreased by $13,500

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Transaction Analysis - 11
• Transaction 11: The company paid monthly utility
costs of $1,900
• Effects:
o Assets (Cash) decreased by $1,900
o Shareholders’ Equity (Retained Earnings) decreased
by $1,900

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Transaction Analysis - 12
• Transaction 12: The company paid advertising costs
for the month in the amount of $2,200
• Effects:
o Assets (Cash) decreased by $2,200
o Shareholders’ Equity (Retained Earnings) decreased
by $2,200

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Transaction Analysis - 13
• Transaction 13: The company paid $2,900 in wages
to its employees for the month of January
• Effects:
o Assets (Cash) decreased by $2,900
o Shareholders’ Equity (Retained Earnings) decreased
by $2,900

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Transaction Analysis - 14
• Transaction 14: Dividends in the amount of $400
were declared by SCL’s board of directors and paid
• Effects:
o Assets (Cash) decreased by $400
o Shareholders’ Equity (Retained Earnings) decreased
by $400

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Recording Depreciation on Assets -
(relating to Transaction 15)
• When an asset is used up over time, some of the
cost of the asset should be shown as an expense in
each period in which it is used
• The amount shown as an expense in any period is
called the Depreciation of the asset
• Straight-line depreciation expense

Original Cost  Estimated Residual Value

Estimated Useful Life

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Transaction Analysis - 15
• Transaction 15: Record depreciation expense of $850
on equipment for the month of January
($65,000 – $3,800)/6 years = $10,200 per year
$10,200 × 1/12 = $850 per month
• Effects:
o Assets (Equipment) decreased by $850
o Shareholders’ Equity (Retained Earnings) decreased
by $850

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Prepaid Expenses (relating to
Transaction 16)
• An amount paid in advance of the coverage period is
recorded as an asset (Prepaid Expense)
• As time passes, the coverage is “consumed” and is
then recognized as an expense

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Transaction Analysis - 16
• Transaction 16: Record insurance expense of $150
for January
$1,800 × 1/12
• Effects:
o Assets (Prepaid Insurance) decreased by $150
o Shareholders’ Equity (Retained Earnings) decreased
by $150

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Accrued Expenses (relating to
Transaction 17)
• Expenses that are recognized on the income
statement in the period in which they are incurred,
which is usually prior to the period in which they are
paid in cash

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Transaction Analysis - 17
• Transaction 17: Interest expense on the bank loan is
6% per annum and interest payments are to be made
quarterly.
$100,000 × 6% × 1/12 = $500
• Effects:
o Liabilities (Interest Payable) increased by $500
o Shareholders’ Equity (Retained Earnings) decreased
by $500

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Accounting Equation Template

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Accounting Equation Template
• Major limitations to this approach include:
o The number of columns that can be included within
the template
o Lack of specific information regarding revenues,
expenses and dividend accounts

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Financial Statements
We can use the Accounting Equation Template for SCL
to prepare the financial statements:
• Statement of Income
• Statement of Changes in Equity
• Statement of Financial Position
• Statement of Cash Flows

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Statement of Income
• Calculates profit (net income) by subtracting
expenses from revenues for the period

• Dividends are not expenses

o Are distributions of earnings to shareholders

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Statement of Income

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Statement of Changes in Equity

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Classified Statement of Financial
Position
• Current assets and liabilities are distinguished from
non-current assets and non-current liabilities

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Classified Statement of Financial
Position - Assets

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Classified Statement of Financial
Position – Liabilities & Shareholders’
Equity

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Statement of Cash Flows - Categories
• Measures the net cash position as a result of cash
inflows and outflows in the following three
categories of business activities:
o Operating Activities
o Investing Activities
o Financing Activities

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Statement of Cash Flows

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Statement of Cash Flows (cont.)

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Profitability Ratios – Profit Margin
• Profit Margin Ratio:
Net Income
Sales Revenue

Profit Margin Ratio for SCL:

= $7,400/$34,000
= 0.218 or 21.8%

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Profitability Ratios – Return on Equity
• Return on Equity:

Net Income
Average total shareholder's equity

Return on Equity for SCL:

= $7,400/$257,000*
= 0.0288 or 2.88%
*(no opening balance so not averaged)

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Profitability Ratios – Return on Assets
• Return on Assets:

Net Income
Average total assets

Return on Assets for SCL:

= $7,400/$367,000*
= 0.020 or 2.0%
*(no opening balance so not averaged)

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