AFM101MidtermExamAid

Chapter 1: Financial Statements and Business Decisions

Four Major Financial Statements (FS)
1) The Balance Sheet
The companys financial position at a point in time
ABC Co.
Balance Sheet
December 31, 2009

Assets
(list all assets)
Total Assets

Liabilities
(list all liabilities)
Owners Equity/Shareholders Equity
(list owners equity components)
Total Liabilities and Owners Equity

$XX
XX
$XX
XX
XX

Assets
Economic resources of the company, i.e. what the company owns
Liabilities
The companys obligations, i.e. what the company owes
Owners Equity/Shareholders Equity
Two parts:
o The amount of financing provided by the owners of the company through
share capital
o The earnings from the business operations from retained earnings
2) Income Statement
How the company operated during the accounting period
ABC Co.
Income Statement
For the Period Ended December 31, 2009
Revenue
(list all sources of revenue)
Total Revenue

$XX
XX

Expenses
(list all Expenses)
Total Expenses
Net Income

$XX
XX
XX

Revenue
Money received from sale of goods, or providing a service
Expenses
Resources used up by the entity to run the business

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3) Statement of Retained Earnings (Statement of Shareholders Equity)

Used to calculate the ending retained earnings number for the balance sheet
ABC Co.
Statement of Retained Earnings
For the Period Ended December 31, 2009
Beginning Retained Earnings
Add Net Income for period
Subtract Dividends paid to owners
Ending Retained Earnings

$XX
XX
XX
XX

When net income is earned every year, the company can choose to:
o Distribute all (or a portion) to shareholders in the form of dividends
o Retain all (or a portion) to continue to run the day to day business
Retained Earnings: the accumulation of all net income NOT distributed as dividends
since the first year of business

4) Statement of Cash Flows

Used to show all inflows and outflows of company cash during the year
Used to calculate the cash balance on the balance sheet
ABC Co.
Statement of Cash Flow
For the Period Ended December 31, 2009
Cash flows from Operating Activities
(list details)
$XX
Cash flows from Investing Activities
(list details)
$XX
Cash flows from Financing Activities
(list details)
$XX
Net Increase/Decrease in Cash
XX
Cash balance (Jan 1, 2009)
XX
Cash Balance (Dec 31, 2009)
XX
5) Notes to the Financial Statements
Required by accounting standards (GAAP)
Further explain the numbers in the financial statements
Explain accounting policies used by the management of the company
Contain supporting schedules and calculations
Additional important non quantitative disclosures

Ratio
Analysis
Price/Earnings Ratio = Market Price / Net Income
Represents the value an investor thinks this company is worth
Investors will multiply the P/E ratio by the companys net income to determine a
price one would pay for the company
The higher the P/E ratio, the greater confidence investors have in this companys
abilities to generate income

AFM101MidtermExamAid

Chapter 2: Investing and Financing Decisions and the Balance Sheet

The Conceptual Framework

The conceptual framework is used to make connections to lead us from the purpose of
financial statements to the components and characteristics of FS and the methods and
assumptions management use to create the FS.
Objectives of Financial Reporting (creating financial statements)
To provide useful information to external users of the financial statements so they
can make business decisions
Elements of the financial statements
Assets, liabilities, shareholders equity, revenue, expenses, etc.
Qualitative Characteristics of good financial statements
Understandability, relevance, reliability, comparability
Underlying Assumptions of accounting information
Separate entity: each business is accounted for as an individual organization
Unit-of-measure: a business accounts for its operations and reports the results using
the monetary unit of the country in which it is operating
Going concern: a business is expected to continue to operate in the foreseeable
future; there is nothing to suggest it will go out of business soon
Basic Accounting Principles (GAAP)
Cost Principle
Revenue Recognition
Matching
Full Disclosure
Constraints of financial reporting
Cost-benefit: sometimes we want to collect as much information as possible, but we
need to view it on a cost-benefit basis; is it worth the costs to collect the extra
information?
Materiality: information from the financial statements that will affect/influence a
users decision is considered material in nature

AFM101MidtermExamAid

Elements of a Classified Balance Sheet

Assets
Economic resources arising from past transactions
Future benefits (i.e. conversion to cash) can be obtained
Current Assets
Assets that can generally be converted to cash within one year very liquid
o Cash and cash equivalents
o Short term investments (i.e. shares in other companies, can sell very easily)
o Accounts receivable (a promise to pay from a customer or another party)
o Note Receivable
o Inventory
o Prepaid expenses (expenses paid before they are actually used)
Non-Current Assets
Assets that are generally converted to cash after more than one year
o Long term investments
o Property, plant, equipment (reported on a net of amortization basis)
o Intangible assets (patents, trademarks, licenses, franchises)
o Goodwill
Liabilities
Debts and obligations owed to other parties, which will be paid off using assets in the
future
Current Liabilities
Obligations that will be paid within one year
o Accounts Payable
o Accrued liabilities (i.e. unearned revenue)
o Current portion of long-term debt
Long Term Liabilities
Obligations that will take longer than a year to pay off
o Long term debt
o Mortgage payable
o Bonds payable
Shareholders Equity
Share Capital
Money received from the company issuing its own shares, purchased by the
shareholders of the company
A form of equity financing, also known as raising money through equity
Retained Earnings
The accumulation of net income not distributed as dividends since the company
began operations
Dividends are paid out of retained earnings and distributed to the shareholders as a
return on their investment in the company

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Example of a Classified Balance Sheet

Ratio Analysis
Debt-to-Equity (D/E) = Total Liabilities / Total Shareholders Equity

Measures how much debt has been used to finance the company (versus financing
through the owners/shareholders of the company
Companies need to pay back debt before they can pay dividends to owners, so a
high debt-to-equity ratio means there is a higher risk that a company may not be
able to meet its financial obligations

E.g. the D/E ratio of the above balance sheet is: 481,000 / 289,000 = 1.66

AFM101MidtermExamAid

Business Transactions and Journal Entries

Business Transactions
Whenever a transaction occurs, it changes the financial position of the company, so
the transaction must be recorded
External events: exchanges of assets and liabilities between the business and other
parties
Internal events: adjustments, unforeseeable events, they do not involve external
parties but must still be recorded as the transactions affect the financial position of
the company
Double Entry Accounting
Every time a transaction occurs, at least two accounts are affected
The total debits = total credits in a transaction
The fundamental accounting equation remains in balance after each transaction

An increase to an asset account is a debit entry

An increase to a liability account is a credit entry
An increase to a shareholders account is a credit entry
Since dividends decrease shareholders equity, thus an increase to dividends is a
debit entry
Debits are always on the left side of a transaction entry
Credits are always on the right side of a transaction entry
Whenever a transaction occurs record in General Journal
Date

Description

Feb 15 Equipment
Accounts Payable
Cash
Feb 28 Rent Expense
Cash

Post.
Ref.

Debit

Credit

10,000
8,000
2,000
5,000
5,000

All transactions are posted to general ledger accounts, or we use t-accounts for simplicity.
The ending balances to each t-account form the balances on the Balance Sheet.

AFM101MidtermExamAid

Chapter 3: Operating Decisions and the Income Statement

The Operating Cycle
The cycle of activities that goes from paying suppliers for goods and materials to

generating inventory to selling the inventory to customers to collecting the cash from
customers (for a manufacturing/merchandising company)
At the end of every operating cycle, a set of year-end financial statements are
made
This supports the periodicity assumption: the operations of a company are reported
in specified periods (usually a year)

Elements of a Multi-Step Income Statement

Results of Continuing Operations
Calculates the income that comes from the running of the business
Revenue/Sales
Results of selling a good or providing a service
A company can have more than one source of revenue; if this is the case, then the
revenue section should have more detailed line items
Cost of Goods Sold
The cost to the company for obtaining the product to sell or providing the service
Gross Profit
Revenue Cost of Goods Sold
Operating Expenses
The expenses incurred to operating the business
o Salaries expense
o Utilities expense
o Administrative expenses
o Rent expense
o Insurance expense
o Amortization expense
Operating Income
Gross Profit Operating Expenses
This number represents the income earned from the day-to-day operations of the
business
Other Income
Other sources of gains and losses
o Gain/loss from sale of land or other capital assets
Other Expenses
Other expenses incurred that do not directly relate to the daily operations of the
business
o Interest Expense
o Investing Expenses
Earnings Before Income Tax
Operating Income +/- other gains and losses other expenses
Income Tax Expense
Calculated by tax professionals
Income from Continuing Operations
Earnings before Income Tax Income Tax Expense
This number is also the Net Income number if the company does not have
discontinued operations and/or extraordinary events

AFM101MidtermExamAid

Results of Discontinued Operations

Sources of gains or losses from segments of the business that are not in operations
This amount (if any) is required to be recorded separately, so that is why it is on a
separate line on the income statement
Extraordinary Events
Sources of gains or losses resulting from events unusual and infrequent in nature
These events are not dependent on the decisions made by management (not
controllable)
o Losses from natural disasters
Net Income
Net Income = income from continuing operations +/- gains/losses from discontinued
operations +/- extraordinary events
Earnings Per Share
Earnings Per Share (EPS) = Net Income / average number of shares outstanding
Required to be disclosed on the bottom of the income statement
Example of a Multistep Income Statement
Example Company
Income Statement
For the period ended December 31, 2009
Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Salaries Expense
Sales and Administrative Expense
Utilities Expense
Rent Expense
Total Expenses
Operating Income
Gain from Sale of Land
Operating Income Before Tax
Income Tax Expense
Income from Operations
Loss from Discontinued Operations
Income before Extraordinary Events
Extraordinary Gain
Net Income

100,000
(60,000)

(1,000)
(500)
(2,000)
(800)

Earnings Per Share (10,000 shares outstanding)

40,000

(4,300)
35,700
5,000
40,700
(16,280)
24,420
(10,000)
14,420
2,000
16,420
$1.642

AFM101MidtermExamAid

Accrual vs. Cash Basis of Accounting

GAAP specifies the Accrual basis of accounting, where revenue is only recorded when
its earned and expenses are recorded when incurred
This timing can be quite different from the Cash basis of accounting, where revenue
is recorded when cash is received and expenses are recorded when cash is paid

Revenue Recognition Principle

Revenue should be recognized on the income statement when the following 3
criterion are satisfied:
o Earnings process is complete or almost complete: the company providing the
good or service must have completed its services
o An exchange of transaction: the customer must have already paid or have
promised to pay in the near future (price agreed upon by both parties)
o Collection of payment is reasonably assured: if the customer has agreed to
pay in the near future, then there is a low risk of default
Matching Principle
Expenses should be recorded in the same period as the revenue it helped to earn
All expenses of a company either directly or indirectly contribute to the companys
abilities to earn revenue; thus, expenses should be recorded when they are used up
**Note: Even if revenue isnt recognized or expenses havent been incurred, we still need to
record any business transaction as a journal entry (it just wont affect a revenue or expense
account yet; thats what adjusting entries are for in chapter 4) **
Comparison of Accrual vs. Cash Basis of Accounting
Cash is paid before expense is incurred
On September 30th ABC Co just made a $3,000 cash payment for the next 6 months of rent
Cash Basis
Accrual Basis
Rent Expense
3,000
Prepaid Rent (Asset)
3,000
Cash
3,000
Cash
3,000
Cash is received before revenue is earned
On Nov 25th TIX Co, a ticketing service agency received $5,000 worth of payments from
customers for a Broadway show later in the year
Cash Basis
Accrual Basis
Cash
5,000
Cash
5,000
Revenue
5,000
Unearned Revenue (L)
5,000
Expenses are incurred before cash is paid
The company received a $500 hydro bill on December 31st, they didnt make the payment
until the next fiscal period
Cash Basis
Accrual Basis
NO ENTRY
Utilities Expense
500
Utilities Payable (L)
500
Revenue is earned before cash is received
You own a lawn-mowing business and youve mowed $200 worth of lawns, yet your clients
have promised to pay within the next week
Cash Basis
Accrual Basis
NO ENTRY
Accounts Receivable (A)
200
Revenue
200
More adjusting entries in Chapter 4

AFM101MidtermExamAid

Ratio Analysis
Asset Turnover = Total Sales / Average Total Assets

Average Total Assets = [last years total assets + this years total assets] / 2
Measures how much sales is generated for every $1 of assets
A high ratio is favourable

Return on Assets = Net Income / Average Total Assets

Measures managements effectiveness at utilizing assets to generate income
A high ratio is favourable

AFM101MidtermExamAid

Chapter 4: Adjustments, Financial Statements and the Quality of Earnings

Unadjusted Trial Balance
A list of ALL of the companys accounts, used for internal purposes
Contains both balance sheet and income statement accounts
The total columns for debits and credits must be equal
After closing entries, all revenue and expense accounts will have zero balances,
leaving only balance sheet accounts
ABC Co.
Trial Balance
December 31, 2009
Debit
Cash
Accounts Receivable
Inventory
.
.
Accounts Payable
Income Tax Payable
Accrued Liabilities
.
.
Share Capital
Retained Earnings
Revenue
Other Revenue
Cost of Goods Sold
Salaries Expense
Rent Expense
.
.

Credit

XX
XX
XX

XX
XX
XX

XX
XX
XX
XX
XX
XX
XX

Totals

XX

XX

Adjusting Entries
Throughout the normal course of business, we record all transactions as journal
entries
Adjusting entries transfer amounts to different accounts, allowing us to properly
recognize revenue and record expenses according to GAAP
Adjusting entries NEVER affect cash
At the end of the business cycle, we record entries to close revenue and expense
accounts, and prepare the final financial statements

AFM101MidtermExamAid

Types of Adjusting Entries

Deferred Revenue (unearned revenue)
Cash was received before revenue is earned
During operations, when cash was received
DR Cash
CR Unearned Revenue (Liability)
Adjusting entry, when revenue is earned
DR Unearned Revenue (erases the liability account)
CR Revenue (recognizes the revenue)
E.g. On Jan 1st, ABC Co signed a contract stating they will provide 2 months of services.
They received $1,200 payment up front.
Jan 1st During Operations
DR Cash
1,200
CR Unearned Revenue
1,200
Jan 31st Adjusting Entry
DR Unearned Revenue 600
CR Revenue
600
First month of revenue is earned
Feb 28thAdjusting Entry
DR Unearned Revenue 600
CR Revenue
600
Second month of revenue is earned
**Note: because we were told the contract was for 2 months of services, we are able to
adjust at the end of every month; usually, we would recognize the revenue and erase
the liability for the entire amount when revenue was deemed earned.
Deferred Expense (Prepaid Expenses)
Cash is paid for expenses to be incurred in the future (specified amount of time)
Includes prepaid rent, prepaid insurance
Adjustments are made at the end of every month when expenses are incurred
During operations, when payment was made
DR Prepaid Expenses (Current Asset)
CR Cash
Adjusting entry, when expenses are incurred
DR Expense
CR Prepaid Expenses (decline in the value of the asset as expenses are incurred)
E.g. On April 30th, ABC Co paid for 8 months worth of insurance for $2,400
April 30th When payment was made
DR Prepaid Insurance
2,400
CR Cash
2,400

AFM101MidtermExamAid

May 31st Adjusting Entry

DR Rent Expense
300
CR Prepaid Insurance
First month of rent expense

300

June 30th Adjusting Entry

DR Rent Expense
300
CR Prepaid Insurance
300
Second month of rent expense
**Same entries made for months 3 8
Accrued Revenue (receivables)
Revenue is earned before payment is received from customer
During operations, when service was performed/product was sold
DR Accounts Receivable (customer has yet to pay)
CR Revenue
Adjusting entry, when cash is received
DR Cash
CR Accounts Receivable (erases the receivable)
E.g. On Mar 1st, ABC Co provided services worth $500, the customer subsequently paid
on Apr 24th
Mar 1st When service was performed
DR Accounts Receivable 500
CR Revenue
500
Apr 24th Adjusting Entry
DR Cash
500
CR Accounts Receivable
500
Payment is received from customer
Accrued Expenses (payables)
Expenses are incurred before the company makes a payment
During operations, when expenses were incurred
DR Expense
CR Accounts Payable (company has yet to pay)
Adjusting entry, when cash is paid
DR Accounts Payable (erases the payable)
CR Cash
E.g. The company pays their employees on a bi-weekly basis. Total salaries expense for
each period is $20,000. The next payday is Jan 2nd. Dec 31st is the companys year end.
Dec 31st Adjusting entry to accrue for expenses at year end
DR Salaries Expense
16,000
CR Salaries Payable
16,000
Expenses must be accrued at year end, but the company has not paid anything yet

AFM101MidtermExamAid

Jan 2nd Entry to record payment of salaries

DR Salaries Payable
16,000 (to erase payable)
DR Salaries Expense
4,000
CR Cash
20,000
Payment is made

Amortization
The matching principle states that a company needs to match expenses to the
revenue it helped generate
Capital assets (machinery, equipment, plant, etc.) are used to help the company
generate revenue
Thus, portions of the assets costs are allocated as amortization expense
The cost principle states that assets must be listed on the balance sheet at their
historical cost (i.e. purchase price)
Therefore, the amortization expense is accumulated in a contra asset account:
accumulated amortization
On the balance sheet, the capital assets are presented in the non-current assets
section at their net value:
Equipment
15,000
Less: Accumulated Amortization Equipment
5,000 10,000
The amount of amortization expense each year:
Annual Amortization Expense = [Cost of Asset Salvage Value] / number of useful years
E.g. On April 1st, ABC Co purchased equipment for 80,000 on account. It was assumed this
equipment would have a salvage value of 8,000 and a useful life of 9 years. Record the
journal entry on purchase date and the requirement adjusting entry at year end.
Annual Amortization Expense = [80,000 8,000] / 9 = 8,000
Amortization expense for this year (9 months) = 8,000 * 9 / 12 = 6,000
Journal Entry to record amortization expense:
Amortization Expense
6,000
Accumulated Amortization Equipment
6,000
Accrued Interest on Bonds or Notes Payable
Companies borrow money by issuing bonds or notes to third parties (creditors)
Before they pay back the amount borrowed, companies need to pay interest on the
amount borrowed
Since interest payment days do not usually correspond with year end dates, accrued
interest must be recorded at each year end
E.g. On April 1st, ABC Co issued a $10,000 bond paying 6% interest semi annually; interest
is paid every September 30th and March 31st
April 1st Company issues the bond (incurs the liability)
Cash
10,000
Bond Payable
10,000
Sept 30th First interest payment
Interest Expense
300
Cash
300
Every 6 months, the company needs to pay 0.06 * 10,000 * 0.5 = $300

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December 31st Year end, need to adjust for the interest expense incurred (but not paid)
Interest Expense
150
Interest Payable
150
March 31st Second interest payment
Interest Expense
150
Interest Payable
150
Cash
300
Closing Entries
Relationship between the Balance Sheet and Income Statement:
o Net Income each year adds to the Retained Earnings account on the Balance
Sheet
At the end of each operating cycle, we need to transfer the net income earned during
the period to Retained Earnings
o This is done through closing entries
Temporary (Nominal) Accounts
Revenue, Expense accounts
Close out to retained earnings at end of fiscal period
Start with $0 balance at beginning of fiscal period
Permanent (Real) Accounts
Accounts on the Balance Sheet (they have a beginning balance at the start of each
operating period
We close Temporary Accounts and do not close Permanent Accounts
The Closing Entry Process
Step 1: Close Revenue Accounts
Sales Revenue
Rent Revenue

Income Summary

XX
XX
XX

The Income Summary is another temporary account that we use only in the closing entry
process. This account itself gets closed out to retained earnings.
Step 2: Close Expense Accounts
Income Summary
Rent Expense
Salaries Expense
Interest Expense

XX
XX
XX
XX

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Step 3: Close Income Summary Account

If there was a net income
Income Summary
XX
Retained Earnings
XX
** Retained earnings increased (credit entry)
If there was a net loss
Retained Earnings
XX
Income Summary
XX
** Retained earnings decreased (debit entry)
Ratio Analysis
Net Profit Margin = Net Income / Total Sales

Measures how much income is generated for each dollar of sales

i.e. For every $1 of sales, how much does the company get to retain?
A higher net profit margin is more favourable

Return on Equity (ROE) = Net Income / Average Shareholders Equity

Average Shareholders Equity = [Beginning SH Equity + Ending SH Equity] / 2

Measures how much income is generated for each dollar of shareholders equity (or
the shareholders investment in the company)
A higher ratio is more favourable

Comprehensive Example (AP4-8)

Accounts given (some with opening balances)
Account Name
Cash
Accounts Receivable
Supplies Inventory
Small Tools Inventory
Equipment
Accumulated Amortization Equipment
Other Assets
Accounts Payable
Notes Payable
Wages Payable
Interest Payable
Income Taxes Payable
Deferred Revenue
Share Capital (15,000 shares outstanding)
Retained Earnings
Service Revenue
Amortization Expense
Income Tax Expense
Interest Expense
Other Expenses
Total

Debit
5,000
4,000
2,000
6,000

Credit

9,000
7,000

15,000
4,000

26,000

26,000

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Transactions during 2007

a) Borrowed $25,000 cash on an 8% note payable, dated July 1, 2007
b) Purchased equipment for $18,000 cash on Jan 1, 2007
c) Sold 5,000 additional shares for $1 cash per share
d) Earned revenue for 2007 of $74,000 including $15,000 on credit
e) Recognized other expenses for 2007 $35,000 including $9,000 on credit
f) Purchased additional small tools inventory, $3,000 cash
g) Collected A/R, $8,000
h) Paid A/P, $11,000
i) Purchased supplies on account, $10,000
j) Received a $3,000 deposit on work to start Jan 15, 2008
k) Declared and paid cash dividend, $12,000
Adjusting Entries
l) Service supplies inventory of $4,000 and small tools inventory of $9,000 were on
hand at year end
m) The equipments useful life is 4 years and salvage value is $2,000
n) Accrued interest on the notes payable has yet to be computed
o) Wages earned since December 24 pay date but not yet paid $4,000
p) Income tax expense payable in 2008, $4,000
Required:
1) Prepare journal entries for transactions during 2007 and post to general
ledger accounts
2) Prepare adjusting entries for 2007 and post to general ledger accounts
3) Prepare an income statement for 2007
4) Prepare closing entries for 2007 and post to general ledger accounts
5) Prepare a balance sheet for December 31, 2007
Journal Entries for transactions during 2007
a) Cash
25,000
Note Payable
25,000
b) Equipment
18,000
Cash
18,000
c) Cash
5,000
Share Capital
5,000
d) Cash
59,000
A/R
15,000
Service Revenue
74,000
e) Other Expenses
35,000
Cash
26,000
A/P
9,000
f) Small Tools Inventory
3,000
Cash
3,000
g) Cash
8,000
A/R
8,000
h) A/P
11,000
Cash
11,000
i) Supplies Inventory
10,000
A/P
10,000
j) Cash
3,000
Deferred Revenue
3,000
k) Retained Earnings
12,000
Cash
12,000

AFM101MidtermExamAid

General Ledger/T-accounts for Posting

Account: Cash
Beginning Balance
Transaction a)
Transaction b)
Transaction c)
Transaction d)
Transaction e)
Transaction f)
Transaction g)
Transaction h)
Transaction j)
Transaction k)
Total

Debit
5,000
25,000

Credit

18,000
5,000
59,000
26,000
3,000
8,000
11,000
3,000
12,000
35,000

Account: Accounts Receivable

Beginning Balance
Transaction d)
Transaction g)
Total

Debit
4,000
15,000

Account: Supplies Inventory

Beginning Balance
Transaction i)
Subtotal
Transaction l)
Total

Debit
2,000
10,000
12,000

Account: Small Tools Inventory

Beginning Balance
Transaction f)
Total

Debit
6,000
3,000
9,000

Credit

Account: Other Assets

Beginning Balance
Total

Debit
9,000
9,000

Credit

Debit

Credit
7,000
9,000

Account: Accounts Payable

Beginning Balance
Transaction e)
Transaction h)
Transaction i)
Total
Account: Share Capital
Beginning Balance
Transaction c)
Total

Credit

8,000
11,000
Credit

8,000
4,000

11,000
10,000
15,000
Debit

Credit
15,000
5,000
20,000

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Account: Retained Earnings

Beginning Balance
Transaction k)
Subtotal
Closing Entry
Total

Debit
12,000
8,000

18,000
10,000

Account: Notes Payable

Transaction a)
Total

Account: Equipment
Transaction b)
Total

Account: Service Revenue

Transaction d)
Closing Entry
Total
Account: Other Expense
Transaction e)
Closing Entry
Total

Credit
4,000

Debit

Credit
25,000
25,000

Debit
18,000
18,000

Credit

Debit

Credit
74,000

74,000
0
Debit
35,000

Credit
35,000

Account: Deferred Revenue

Transaction j)
Total

Debit

Credit
3,000
3,000

Prepare adjusting entries and post to General Ledger accounts

Journal Entries for adjustments at year end
l) Supplies Expense
8,000
Supplies Inventory
8,000
m) Amortization Expense
4,000
Accumulated Amortization 4,000
n) Interest Expense
1,000
Interest Payable
1,000
o) Wages Expense
4,000
Wages Payable
4,000
p) Income Tax Expense
4,000
Income Tax Payable
4,000
Account: Supplies Expense
Transaction l)
Closing Entry
Total

Debit
8,000

Credit
8,000

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Account: Amortization Expense

Transaction m)
Closing Entry
Total

Debit
4,000

Credit
4,000

Account: Accumulated Amortization Equipment

Transaction m)
Total

Debit

Credit
4,000
4,000

Account: Interest Expense

Transaction n)
Closing Entry
Total

Debit
1,000

Credit

Account: Interest Payable

Transaction n)
Total

Debit

Credit
1,000
1,000

Debit
4,000

Credit

Account: Wages Expense

Transaction o)
Closing Entry
Total

1,000
0

4,000
0

Account: Wages Payable

Transaction o)
Total

Debit

Credit
4,000
4,000

Account: Income Tax Expense

Transaction p)
Closing Entry
Total

Debit
4,000

Credit

Account: Income Tax Payable

Transaction p)
Total

Debit

Credit
4,000
4,000

Account: Income Summary

Closing Entries
Closing Entries
Closing Entries
Total

Debit

Credit
74,000

4,000
0

56,000
18,000
0

AFM101MidtermExamAid

Post-Adjustment Trial Balance

Account Name
Cash
Accounts Receivable
Supplies Inventory
Small Tools Inventory
Equipment
Accumulated Amortization Equipment
Other Assets
Accounts Payable
Notes Payable
Wages Payable
Interest Payable
Income Taxes Payable
Deferred Revenue
Share Capital (15,000 shares outstanding)
Retained Earnings
Service Revenue
Amortization Expense
Income Tax Expense
Interest Expense
Other Expenses
Supplies Expense
Wages Expense
Total

Debit
35,000
11,000
4,000
9,000
18,000

Credit

4,000
9,000
15,000
25,000
4,000
1,000
4,000
3,000
20,000
8,000
74,000
4,000
4,000
1,000
35,000
8,000
4,000
150,000

ABC Co.
Income Statement
For the Period Ended December 31, 2007
Service Revenue

74,000

Expenses
Amortization Expense
4,000
Interest Expense
1,000
Supplies Expense
8,000
Wages Expense
4,000
Other Expenses
35,000
Income Tax Expense
4,000
Net Income
Earnings Per Share (18,000 / 20,000)

56,000
18,000
$0.9

150,000

AFM101MidtermExamAid

Closing Entries
Service Revenue
Income Summary
Income Summary
Amortization Expense
Interest Expense
Supplies Expense
Wages Expense
Other Expenses
Income Summary
Retained Earnings

74,000

74,000

56,000
4,000
1,000
8,000
4,000
35,000
18,000

18,000

Post closing entries to account ledgers.

ABC Co.
Balance Sheet
December 31, 2007
Assets
Cash
Accounts Receivable
Supplies Inventory
Small Tools Inventory
Equipment
Accumulated Amortization Equipment
Other Assets
Total Assets
Liabilities and Shareholders Equity
Liabilities
Accounts Payable
Notes Payable
Interest Payable
Income Tax Payable
Wages Payable
Deferred Revenue
Total Liabilities
Shareholders Equity
Share Capital
Retained Earnings
Total Shareholders Equity
Total Liabilities and Shareholders Equity

35,000
11,000
4,000
9,000
18,000
4,000

15,000
25,000
1,000
4,000
4,000
3,000

14,000
9,000
82,000

52,000

20,000
10,000
30,000
82,000

AFM101MidtermExamAid

Chapter 5: Reporting and Interpreting Cash Flows

The Need for a Cash Flow Statement
Due to the accrual basis of accounting:
o Cash received Revenue
o Cash paid Expenses
Knowing how much cash is available for use in the company is very important
o If a company wants to purchase items or expand operations, cash is needed
A company can have lots of assets on their Balance Sheet, but if none of them can
be converted to cash easily, then the company will have difficulty continuing
operations
The Cash Flow Statement
Separated into 3 sections:
o Operating
o Investing
o Financing
Summarizes the inflows and outflows of cash
We can determine the ending cash balance on our Balance Sheet by adding the
inflows and outflows of cash to the beginning cash balance
o Cash (Beginning) +/- Increase or Decrease of Cash = Cash (Ending)
Cash Flows from Operating Activities
Cash inflows and outflows relating to the day to day operations of the business
Cash inflows: (money received from)
o Making sales
o Receiving dividend or interest revenue
Cash outflows: (money paid for)
o Operating expenses (salaries, utilities, rent)
o Interest expense, income tax expense
Cash Flows from Investing Activities
Cash inflows and outflows relating to the purchase or sale of capital assets or the
purchase or sale of investments in other companies
Cash inflows (money received from)
o Sale of plant, property, or equipment
o Sale of investments
Cash outflows (money paid for)
o Purchase of plant, property, or equipment
o Purchase of investments
Note: the cash flows are categorized as investing activities when it relates to the
initial purchase or final sale of investment in other activities. If we receive interest of
dividend revenue on the investment, that cash flow is considered an operating
activity
Cash Flows from Financing Activities
Cash inflows and outflows related to external parties (owners and creditors) in order
to finance (or generate cash) for the company
Cash inflows (money received from)
o Issuing shares of your own company (money is received from shareholders)
o Issuing debt or notes payables (money is received from debt-holders or
creditors)
Cash outflows (money paid for)

AFM101MidtermExamAid

o
o
o

Buying back your own shares from existing shareholders

Paying back the debt or note payable to debt-holders or creditors
Paying dividends to existing shareholders

Accounts and Types of Activities (General Guideline)

Very general guideline for each transaction affecting cash flows

Identify the accounts that are affected
o Current assets or current liabilities operating
o Non-current asset (i.e. plant, property, equipment, or long term investments)
investing
o Long term liabilities or Shareholders Equity (i.e long term debt or bonds,
commons shares) financing

Examples
Receiving interest on investments held
A: operating
Balance Sheet account affected (other than cash): None so this example does not
follow the general guideline
Sale of a piece of land and related building
A: investing
Balance Sheet account affected: Land, Building
Investing in common stock in another company
A: investing
Balance Sheet account affected: Investments (assume long term asset, but could be
current asset as well)
Cash payment of a Note Payable
A: financing
Balance Sheet account affected: Note Payable (assume long term liability, but could
be short term liability as well)
Purchasing a new supply of inventory
A: operating
Balance Sheet account affected: Inventory
Issuing Common Shares to new shareholders
A: financing
Balance Sheet account affected: Common Shares
Paying dividends to shareholders
A: financing
Balance Sheet account affected: Dividends (which affects retained earnings)
Issuing a bond to generate cash for a company
A: financing
Balance Sheet account affected: Bond Payable

AFM101MidtermExamAid

Two Methods to Prepare Cash Flows from Operations section

1) Direct method record all the actual movements of cash that occurred in the
period
2) Indirect method start with net income and adjust for any non-cash items or
items that will be accounted for in the investing or financing sections
Both methods give the same cash flow from operations number
Indirect Method: Operating Cash Flows
Net Income
- Increases in current assets
+ Increases in current liabilities
+ Non cash expenses, losses
- Non cash revenues, gains
= Cash Flow from Operations
We want to get from Net Income to Net Cash Flows
Revenue
Cash Received
- Expenses
- Cash Paid
= Net Income
= Net Cash Flows
So therefore, we need to make adjustments for differences between revenue and cash
received and expenses and cash paid
You will be given a balance sheet showing balances for this year and the previous year
Current Assets
Subtract increases in current assets (A/R, Inventory, Prepaids, etc.)
Add decreases in current assets
Why? Illustrate with A/R
We know:
Beginning A/R + Revenue Cash Collected = Ending A/R
If there was an increase in A/R then:
Revenue Cash Collected > 0
Revenue > Cash Collected
Thus our cash collected was less than actual revenue, and we should subtract this
difference (i.e. the increase in A/R) from net income to account for the actual cash collected
If there was a decrease in A/R then:

Revenue Cash Collected < 0

Revenue < Cash Collected
Thus our cash collected was more than actual revenue, and we should add this difference
(i.e. the increase in A/R) to net income to account for the actual cash collected
Current Liabilities
Add increases in current liabilities (A/P, Interest Payable, Income Tax Payable, etc.)
Subtract decreases in current liabilities
Why? Illustrate with A/P
We know:
Beginning A/P + Expenses Cash Paid = Ending A/P
If there was an increase in A/P then:
Expenses Cash Paid > 0
Expense > Cash Paid

AFM101MidtermExamAid

Thus our expenses were greater than the cash paid. Since we subtract expenses to arrive at
net income and our cash flow was less than expenses, we should add the difference back to
net income to account for the actual cash paid.
If there was an decrease in A/P then:

Expenses Cash Paid < 0

Expense < Cash Paid
Thus our expenses were less than the cash paid. Since we subtract expenses to arrive at
net income and our cash flow was more than expenses, we should subtract the difference
from net income to account for the actual cash paid.
Non cash expenses and losses

Add expense amounts on the income statement that do not affect cash
o
Depreciation expense,
future income tax expense

Add losses on sale of assets or investments

o
Accounted for in the
investing section

Add losses on repayment of long term debt or bonds

o
Accounted for in the
financing section
Since these expenses do not affect cash and the losses are accounted for in other sections
of the cash flow statement, we need to add these amounts back so the net effect on net
income is zero.
Non cash revenues and gains

Subtract revenue amounts on the income statement that do not affect cash

Subtract gains on sale of assets or investments

o
Accounted for in the
investing section

Subtract gains on redemption of long term debt or bonds

o
Accounted for in the
financing section
Since these revenues do not affect cash and the gains are accounted for in other sections of
the cash flow statement, we need to subtract these amounts so the net effect on net income
is zero.

AFM101MidtermExamAid

Example: Prepare the statement of cash flows for SOS Limited for 2009 using the indirect
method.

Cash
Accounts receivable
Inventories
Prepaid expenses
Equipment
Accumulated amortization, equipment
Amortization expense, equipment
Land
Accounts payable
Interest payable
Notes payable
Bonds payable
Mortgage payable
Capital stock

2008
$10,000
17,000
14,000
3,500
50,000
19,000
11,000
80,000
13,000
550
31,000
50,000
40,000
210,000

2009
$20,200
21,000
18,400
1,000
65,000
27,000
14,000
120,000
19,000
1,150
44,000
30,000
40,000
217,000

The following information relates to activities for SOS Limited for 2009.
a) Net income for the year ended December 31, 2009, was $22,500.
b) The company borrowed $20,000 on a long-term note from the bank. Interest is
payable annually and the interest expense of $3,000 is included in net income.
c) An additional piece of land was purchased on November 30, 2009. The seller of the
land accepted a mortgage as full payment.
d) During the year, a piece of equipment was sold for $15,000, paid in cash. Any gain
or loss on the sale was included in net income. A new piece of equipment costing
$28,000 was purchased in June. The purchase price was paid in cash.
e) Dividends of $6,000 were paid in cash.
f) Capital stock was issued in exchange for the retirement of $7,000 of long-term notes
payable.
g) A portion of the bonds matured during 2009 and the company paid cash to redeem
these bonds.

AFM101MidtermExamAid

Solution
First, identify the changes in current asset and current liability accounts for the
cash flow from operating activities section and any non cash expenses and
revenues:
2008

2009

Cash

$10,000 $20,200

Accounts receivable

17,000

21,000

4,000

Inventories

14,000

18,400

4,400

Prepaid expenses

3,500

1,000

(2,500)

Equipment

50,000

65,000

Accumulated amortization, equipment

19,000

27,000

Amortization expense, equipment

11,000

14,000

Land

80,000

120,000

Accounts payable

13,000

19,000

6,000

Interest payable

550

1,150

600

Notes payable

31,000

44,000

Bonds payable

50,000

30,000

Mortgage payable

40,000

40,000

Capital stock

210,000 217,000

Cash flows from operating activities

Net Income
Adjustments:
Increase in A/R
Increase in Inventory
Decrease in Prepaid
Increase in A/P
Increase in Interest Payable
Amortization Expense

22,500
(4,000)
(4,400)
2,500
6,000
600
14,000

Next, use the additional information to start constructing the cash flows from
investing activities section:
An additional piece of land was purchased on November 30, 2009. The seller of the land
accepted a mortgage as full payment.

No effect on cash, but should be disclosed as a non cash investing activity

AFM101MidtermExamAid

During the year, a piece of equipment was sold for $15,000, paid in cash. Any gain or loss
on the sale was included in net income. A new piece of equipment costing $28,000 was
purchased in June. The purchase price was paid in cash.

Cash received for sale of equipment: 15,000

Cash paid for new equipment: 28,000

Cash flows from investing activities
Cash paid for purchase of new equipment
(28,000)
Cash received for sale of equipment
15,000
Net Cash Flows from Investing Activities
(13,000)
Next, since there was a sale of equipment, we need to figure out the gain or loss
and back that out of net income in the operating activities section
Equipment Account:
Beginning Balance + Cost of Purchases Cost of Equipment Sold = Ending Balance
**Here, the historical cost of any equipment sold is removed from the equipment account
Using the balances provided, we see that
50,000 + 28,000 Cost of Equipment Sold = 65,000
Cost of Equipment Sold = 13,000
To determine the gain or loss on sale of asset, we need the Net Book Value of the
equipment that was sold.
Net Book Value = Cost of equipment Accumulated Amortization (of that equipment)
Accumulated Amortization Account:
Beginning Balance + Amortization Expense of the Year Accumulated Amortization amount
for any equipment that was sold = Ending Balance
19,000 + 14,000 Accum Amort for equipment sold = 27,000
Accum Amort for equipment sold = 6,000
Therefore Net Book Value of equipment sold = 13,000 6,000 = 7,000
Gain on Equipment Sold = Sale Price Net Book Value = 15,000 7,000 = 8,000
Thus this gain needs to be subtracted from net income in the operating activities section
Our finished operating and investing sections:
Cash flows from operating activities
Net Income
Adjustments:
Increase in A/R
Increase in Inventory
Decrease in Prepaid
Increase in A/P
Increase in Interest Payable
Amortization Expense
Gain on Sale of Equipment
Net Cash Flows from Operating Activities
Cash flows from investing activities

22,500
(4,000)
(4,400)
2,500
6,000
600
14,000
(8,000)
29,200

AFM101MidtermExamAid

Cash paid for purchase of new equipment

Cash received for sale of equipment
Net Cash Flows from Investing Activities

(28,000)
15,000
(13,000)

Next, use the additional information to start constructing the cash flows from
financing activities section:
The company borrowed $20,000 on a long-term note from the bank. Interest is payable
annually and the interest expense of $3,000 is included in net income.

Cash received from borrowing of 20,000

Dividends of $6,000 were paid in cash.

Cash paid for dividends of 6,000

Capital stock was issued in exchange for the retirement of $7,000 of long-term notes
payable.

Not a cash item, should be disclosed as a non cash financing activity

A portion of the bonds matured during 2009 and the company paid cash to redeem these
bonds.

Looking at the B/S, bonds payable decreased by 20,000 so $20,000 was paid to
redeem these bonds
Adding the financing section, we have our finished statement of cash flows:
Cash flows from operating activities
Net Income
Adjustments:
Increase in A/R
Increase in Inventory
Decrease in Prepaid
Increase in A/P
Increase in Interest Payable
Amortization Expense
Gain on Sale of Equipment
Net Cash Flows from Operating Activities

22,500
(4,000)
(4,400)
2,500
6,000
600
14,000
(8,000)

29,200

Cash flows from investing activities

Cash paid for purchase of new equipment
Cash received for sale of equipment
Net Cash Flows from Investing Activities

(28,000)
15,000
(13,000)

Cash flows from financing activities

Cash received from issuance of N/P
Cash paid for dividends
Cash paid for redemption of bonds
Net Cash Flows from Financing Activities
Net Increase in Cash
Cash (Begin)
Cash (End)

20,000
(6,000)
(20,000)
(6,000)
10,200
10,000
20,200

The ending cash balance of $20,200 matches with the cash balance on the balance
sheet for 2009.

AFM101MidtermExamAid

Ratio Analysis
Quality of Income = [Cash Flow from Operating Activities] / Net Income

Measures portion of income generated in cash

A higher ratio indicates greater ability to finance operating activities from cash
inflows, and less likely to be using aggressive accounting

Capital Acquisitions Ratio = [Cash Flow from Operating Activities] / Cash paid for PPE

Measures the ability of company to pay for Property, Plant, and Equipment (PPE)
using operating cash flows
The alternative way for company to buy PPE is to borrow money via debt or
equity
Preferable to have Ratio above 1: greater ability to finance growth/ expansion
with internal funds

AFM101MidtermExamAid

Chapter 6: Interpreting and Communicating Accounting Information

Players in the Accounting Communication Process
Remember the end goal: companies want to produce reliable financial statements for
the public to view
Along the way, many questions arise:
o How is management going to record their accounting information?
o Who is going to ensure the information is accurate and appropriate?
o Who decides what set of principles or rules govern how companies can report
their financial information
Regulators
Financial information reported by public companies is subject to strict rules and
standards
These standards are set by different organizations on different levels (provincial,
national, etc.)
Regulators work to create a set of standards regarding how to report financial
information to create consistency and comparability for all companies
Management (CEO, CFO, Senior Executives)
These are the people running the business
Top management chooses which accounting methods to use when recording their
financial information
The methods must still comply with standards set by the regulators, but in lots of
situations, a choice can be made between which method to use
Board of Directors
The board is supposed to be independent from management and is the voice for
the shareholders of the company
They are responsible for ensuring the integrity of the accounting records (no fraud,
theft, scandals)
However, its very common to have the CEO, CFO also on the Board, which creates
perceived independence issues
External Auditors
Independent third parties that come to companies to ensure their financial
statements comply with standards
They spend weeks gathering evidence provided by management in order to produce
an auditors report
The auditors report will state whether the company is in compliance with accounting
standards
The auditors report will be a part of the companys annual report
The annual report displays company goals, vision, mission, product lines, and of
course, the set of financial information that has been audited by external auditors
Auditors do not make any opinions on the financial wealth of the company; they are
merely there to ensure accounting records are in compliance with standards

AFM101MidtermExamAid

Financial Analysts
FA use information available to the public to analyze the financial health of a
company
They make recommendations on whether to buy, sell, or hold the companys shares
Communicating Useful Information
Financial statements are made public in order to provide information to the users of
the statements
It is up to management to provide information that is actually useful to both internal
and external parties
Characteristics of useful information
o Relevant: the information can influence the users decision. The information
is predictive (i.e. information is presented in the proper sections; you can find
what youre looking for) and timely
o Reliable: the information is verifiable, unbiased and accurate.
Verifiable: independent accountants from different firms can agree on
the companys accounting records
Unbiased: the way accounts and transactions are measured or
presented on the financial statements is not meant to influence a
particular user
Accurate: whats stated in the account balances are correct!
o Comparable: users can compare companies in the same industries or
compare the company to its historical records
o Consistent: the use of accounting methods is consistent over time and any
changes are disclosed properly
Constraints of Accounting Measurement
Having accurate, up to date information is extremely important, but costly
3 properties showcase the constraints of accounting records
o Materiality: items that are small or insignificant do not have to be accounted
for using specific accounting guidelines, as these accounts will not affect a
users decision
o Cost-benefit: companies must make a decision on how much accounting
information they are willing to produce to improve their accuracy. They need
to understand their ability to provide timely, accurate information with the
costs involved. Sometimes the costs of producing extra information will
outweigh the benefits.
o Conservatism: its better to understate assets and overstate liabilities (i.e.
be perceived in a worse position that the company is actually in)