Unit 1: Accounting — The Language of Business

1.1 Understanding the Role of Accounting

Accounting is an information system that measures and records business activities. Its role is to identify, record, and measure the transactions of a business so that its performance can be evaluated and its financial health assessed. This information is communicated to stakeholders through financial statements — standardized reports that allow users to make rational economic decisions. These statements are prepared according to a set of accounting rules such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), which ensure consistency across businesses.

The flow of accounting information is cyclical: people make decisions, business transactions occur, companies report their results, and those results inform the next round of decisions. Consider Apple Inc.: the company produces iPhones, customers purchase them, revenues and expenses are recorded in Apple’s quarterly and annual reports, and those results then inform management’s decisions about future product lines and inventory levels. The accounting process begins and ends with people making decisions.

This cycle ultimately produces four financial statements, which must be prepared in a specific order because each one feeds into the next:

1. Income Statement — how the company performed during the period
2. Statement of Retained Earnings — why retained earnings changed during the period
3. Balance Sheet — the company’s financial position at year-end
4. Statement of Cash Flows — how much cash was generated and spent during the period

Users of Financial Information

Financial statements serve six categories of users, each with different information needs:

Managers use accounting information to set goals, evaluate results, and take corrective action. Decisions such as whether to build a new product line, open a new office, acquire a competitor, or extend credit to customers all depend on reliable financial data.

Investors (shareholders) provide capital by purchasing ownership interest. They look for two sources of gain: selling their shares later at a higher price, or receiving dividends. Investors use financial information to assess expected returns on their investment.

Creditors lend money rather than purchasing ownership. A bank, for example, lends funds that must be repaid with interest. Creditors use financial information to evaluate whether a borrower can make required payments.

Government and regulatory bodies such as the Canada Revenue Agency (CRA) use accounting information for taxation and market regulation. The Ontario Securities Commission requires periodic financial disclosures from TSX-listed companies.

Individuals use financial information for daily purchasing decisions and personal budgeting. Even basic budgeting of tuition, rent, food, and transportation is a form of financial decision-making.

Not-for-profit organizations use accounting information in virtually the same way as for-profit entities — for operational decisions, investment choices, and reporting to stakeholders including board members and the CRA.

Financial vs. Management Accounting

Because different users have different needs, accounting splits into two branches. Financial accounting serves both internal users (managers, investors) and external users (creditors, government, the public), and is the focus of this course. Management accounting serves internal users only, providing budgets, forecasts, projections, and detailed product- or department-level information.

Types of Business Organizations

There are three main organizational forms, each with different liability and tax implications:

Feature	Proprietorship	Partnership	Corporation
Owner(s)	Single proprietor	Two or more partners	Shareholders (public or private)
Personal liability	Personally liable	Usually personally liable	Not personally liable
Life of entity	Limited by owner	Limited by owner	Indefinite
Tax structure	Personal taxes	Flows through to personal taxes	Corporate taxes + personal taxes on dividends
Examples	Lawyers, accountants	PwC LLP, KPMG LLP, Deloitte LLP	Apple Inc., Amazon Inc.

1.2 Exploring Financial Statements

Generally Accepted Accounting Principles (GAAP)

Financial statements are prepared according to GAAP, which specifies how financial information must be recorded, measured, and reported. In Canada, GAAP is established by the Chartered Professional Accountants (CPA) of Canada.

Canadian public enterprises (stock-listed corporations) must use IFRS, set by the International Accounting Standards Board (IASB). Canadian Tire, listed on the TSX as CTC.A, uses IFRS for its financial statements.

Canadian private enterprises may use either IFRS or Accounting Standards for Private Enterprises (ASPE). Most private companies choose ASPE because IFRS is more costly and complex to implement.

The Four Financial Statements in Detail

Each financial statement answers a different question:

Question	Statement	Key Elements
How well did the company perform during the year?	Income Statement	Revenues − Expenses = Net Income or (Net Loss)
Why did retained earnings change during the year?	Statement of Retained Earnings	Beg. RE + Net Income − Dividends = Ending RE
What is the company’s financial position at year-end?	Balance Sheet	Assets = Liabilities + Owners’ Equity
How much cash was generated and spent during the year?	Statement of Cash Flows	Operating + Investing + Financing = Change in Cash

Income Statement

The income statement (also called the statement of profit and loss) measures operating performance over a specific period — a month, quarter, or year. It has two main elements:

• Total Revenue: ordinary revenues earned from day-to-day business (e.g., sales revenue, service revenue) plus gains from peripheral activities
• Total Expenses: costs incurred in ordinary operations (e.g., wages, rent, depreciation) plus losses from peripheral activities

If revenues exceed expenses, the result is net income; if expenses exceed revenues, the result is a net loss. Common year-ends vary by industry: most companies use December 31, Canada’s big banks use October 31, and many retailers use January 31.

Statement of Retained Earnings

Retained earnings are the accumulated net income (or losses) since a company’s inception, less any dividends paid to shareholders. The statement of retained earnings bridges the income statement and the balance sheet by showing how net income flows into equity:

Beginning Retained Earnings + Net Income − Dividends = Ending Retained Earnings

When historical income exceeds expenses and dividends, retained earnings carry a positive balance. When losses and dividends exceed income, the result is a deficit (negative retained earnings).

Balance Sheet

The balance sheet (statement of financial position) reports the company’s financial position at a specific date — a snapshot rather than a period summary. It is organized around the accounting equation:

Assets = Liabilities + Shareholders’ Equity

Assets are economic resources controlled by the entity that provide future benefits. Current assets (expected to convert to cash within 12 months) include cash, short-term investments, accounts receivable, inventory, and prepaid expenses. Non-current assets (held longer than one year) include property, equipment, land, buildings, and intangibles.

Liabilities are debts the entity expects to settle in the future. Current liabilities (due within one year) include accounts payable, income taxes payable, and accrued expenses. Non-current liabilities include long-term notes payable and bonds payable.

Shareholders’ equity represents owners’ residual interest in assets after deducting liabilities. It consists of share capital (cash received from shareholders in exchange for shares) and retained earnings (cumulative net income less dividends).

The balance sheet takes its name from the fundamental requirement that assets must always equal (balance with) the sum of liabilities and shareholders’ equity.

Statement of Cash Flows

The statement of cash flows reports cash receipts and payments classified into three activities:

• Operating activities: the main revenue-producing activities — cash from sales, payments to suppliers and employees
• Investing activities: purchase and sale of long-term assets — acquiring PP&E, selling investments
• Financing activities: changes in equity and borrowings — issuing shares, paying dividends, borrowing, repaying loans

The statement of cash flows is based on cash basis accounting, while the income statement uses accrual basis accounting. Because of this difference, net income does not usually equal cash flow from operating activities. The statement of cash flows reconciles these two measures.

All financial statements should be accompanied by notes that describe accounting policies, provide additional detail on line items, and disclose information not captured on the face of the statements.

1.3 Relationships Among the Financial Statements

The four financial statements are linked through three key connections:

Link 1: Net income (or net loss) from the income statement flows into the statement of retained earnings.

Link 2: The ending retained earnings balance from the statement of retained earnings appears in the shareholders’ equity section of the balance sheet.

Link 3: The ending cash balance on the balance sheet equals the ending cash on the statement of cash flows.

This linkage means the statements must be prepared in order: income statement first, then the statement of retained earnings, then the balance sheet, and finally the statement of cash flows.

1.4 The Conceptual Framework of Accounting

IFRS and ASPE are built on a conceptual framework that defines the objective of accounting: to provide financial information that is useful to investors, lenders, and other creditors in making decisions.

To be useful, information must possess two fundamental qualitative characteristics:

• Relevance: information must be capable of making a difference in decisions. It should have predictive value, confirmatory value, and be material.
• Faithful representation: information must be complete, unbiased, and accurate.

Four enhancing qualitative characteristics increase the degree of usefulness:

• Comparability: comparable across time and across companies
• Verifiability: can be checked for accuracy and completeness
• Timeliness: reported in time to influence decisions
• Understandability: clear and concise enough for reasonably knowledgeable users

The conceptual framework also rests on four underlying assumptions:

• Going-Concern: the entity will continue to exist indefinitely
• Separate-Entity: a business is economically separate from its owners
• Historical-Cost: assets are recorded at their purchase price
• Stable Monetary Unit: the dollar’s purchasing power is stable over time

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Unit 2: Recording Business Transactions

2.1 Common Types of Accounts and the Transaction Cycle

In a previous unit, we introduced the accounting equation and its four financial statements. In this unit, we walk through the transaction cycle — from when a transaction occurs, to its recording in accounts, to its eventual reflection in the financial statements. The cycle proceeds as follows: a transaction occurs → it is analyzed → it is recorded in a journal → a trial balance is prepared → adjusting entries are recorded → an adjusted trial balance is prepared → financial statements are prepared → income statement accounts are closed.

A transaction is an event that has a financial impact on a business and can be reliably measured. When a customer purchases an iPad from Apple for $900, both conditions are met: the transaction has a financial impact on Apple, and Apple can reliably assign the dollar amount $900.

Accounts

Every transaction is recorded in an account — a record of activity for a specific asset, liability, or equity item. Accounts on the financial statements aggregate many specific accounts. Apple, for example, keeps separate inventory accounts for each product but combines them into a single “Inventories” line on the balance sheet.

Balance Sheet Accounts

The expanded accounting equation is:

Assets = Liabilities + (Share Capital + Beginning Retained Earnings + Net Income − Dividends)

Asset accounts include: Cash, Short-term investments, Accounts receivable, Notes receivable, Inventory, Prepaid expenses, Long-term investments, Equipment, Buildings, and Land. Assets are economic resources that provide future benefits.

Liability accounts include: Accounts payable, Notes payable, Taxes payable, Deferred revenue, and Long-term debt. Liabilities are debts or obligations that must be satisfied in the future.

Shareholders’ equity accounts include: Share capital (contributed capital) and Retained earnings.

Two especially common groupings: receivables represent future cash inflows (an asset), while payables represent future cash outflows (a liability).

Income Statement Accounts

Revenue is income earned from ordinary business activities. It increases net income and retained earnings, and thus increases shareholders’ equity. Gains are income from peripheral activities. Expenses are costs from ordinary business activities, decreasing net income. Losses are from peripheral activities, also decreasing net income.

Account Numbering Convention

Companies maintain a chart of accounts using a numbering convention: assets typically begin with 1, liabilities with 2, equity with 3, revenues with 4, and expenses with 5. This ensures consistency and ease of reference.

2.2 The Impact of Business Transactions

Two Fundamental Principles

Principle 1 — Duality of effects: Every transaction affects at least two accounts. When ABC Inc. issues shares for $50,000 cash, cash increases (asset) and share capital increases (shareholders’ equity).

Principle 2 — Balance: The accounting equation must remain in balance after each transaction. In the example above: Assets (+$50K) = Liabilities + Shareholders’ Equity (+$50K). ✓

“On Account” Transactions

The phrase “on account” describes transactions where no cash changes hands immediately. There are four key scenarios:

• Performed services on account: earned revenue but not yet received cash → increase accounts receivable
• Collected on account: received cash on an outstanding balance → decrease accounts receivable
• Purchased on account: made a purchase on credit → increase accounts payable
• Paid on account: paid down a balance owed → decrease accounts payable

2.3 Business Transactions and T-Accounts

The Double-Entry System

The double-entry system records every transaction with two sides, affecting at least two accounts, ensuring the accounting equation always balances. This is the foundation of modern bookkeeping.

T-accounts are informal tools used to understand the rule of debits and credits. Every account has two sides: debit = left side and credit = right side.

Rules of Debit and Credit

The normal balance of an account — the side where increases are recorded — follows from the accounting equation:

Account Type	Normal Balance	Increases With	Decreases With
Assets	Debit (left)	Debit	Credit
Liabilities	Credit (right)	Credit	Debit
Share capital	Credit (right)	Credit	Debit
Retained earnings	Credit (right)	Credit	Debit
Dividends	Debit (left)	Debit	Credit
Revenues	Credit (right)	Credit	Debit
Expenses	Debit (left)	Debit	Credit

The key intuition: assets, expenses, losses, and dividends all sit on the left (debit) side of the expanded equation; liabilities, equity, and revenues sit on the right (credit) side. For every transaction, debits must equal credits.

Expenses and dividends are exceptions to the intuitive pattern — although they reduce shareholders’ equity, they increase with debits, because they represent uses or distributions of equity.

2.4 Recording Business Transactions: Journals and the Ledger

The Journal

While T-accounts are informal, journals are the formal record of transactions. The journalizing process follows three steps:

1. Identify the accounts affected and their types
2. Determine whether each account increases or decreases
3. Apply the rules of debit and credit and record the entry

Journal entries list debited accounts first (on the left margin) and credited accounts below and indented to the right. The sum of debits must always equal the sum of credits.

Example: Tara Inc. receives $50,000 and issues shares.

Accounts	Debit	Credit
Cash	$50,000
Common share capital		$50,000

The Ledger

A ledger is a book that contains all of a company’s accounts, each with its own debit and credit sides. After journal entries are prepared, posting transfers the dollar amounts from the journal to the appropriate ledger accounts to update their balances.

The journal provides a chronological record of transactions; the ledger provides a record of each account’s activity and current balance. Both are necessary for accurate reporting.

2.5 The Trial Balance

A trial balance lists all ledger accounts with their balances — assets first, then liabilities, then shareholders’ equity — with columns for debits and credits. It is an internal document prepared at the end of the accounting period to facilitate financial statement preparation.

If the total of all debit balances equals the total of all credit balances, the books are in balance. However, equal totals only prove that debits posted equal credits posted — they do not prove the trial balance is error-free. Errors where debits and credits are equal (e.g., recording a transaction to the wrong account) will not be revealed.

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Unit 3: The Adjusting Process and the Accounting Cycle

3.1 Accrual vs. Cash-Basis Accounting

In this unit, we complete the accounting cycle by learning about adjusting entries — adjustments made at period-end to ensure the financial statements accurately reflect revenues earned and expenses incurred.

Cash-basis accounting recognizes revenues when cash is received and expenses when cash is paid, regardless of when the revenue was earned or the expense incurred. This method records only cash transactions, ignoring important economic realities.

Accrual-basis accounting recognizes revenues when earned and expenses when incurred, regardless of cash timing. Accrual accounting is required under both ASPE and IFRS because it accurately reflects the economic condition of an organization by capturing all transactions, not just cash ones.

Two concrete examples illustrate the difference:

Example 1: Apple sells 10 iMacs on account for $20,000, delivering the products. Under cash-basis, Apple records nothing until cash arrives. Under accrual, Apple records $20,000 in revenue and $20,000 in accounts receivable immediately — because the revenue has been earned (goods delivered) and an asset acquired.

Example 2: Apple purchases $50,000 of inventory from Qualcomm on account. Under cash-basis, nothing is recorded. Under accrual, Apple records $50,000 in inventory (asset) and $50,000 in accounts payable (liability).

3.2 Revenue and Expense Recognition Principles

Revenue Recognition

Revenues are amounts earned from ordinary business activities. Under IFRS, revenue is recognized when all three conditions are met:

1. The business has delivered the goods or services to the customer
2. The amount of revenue can be reliably measured
3. It is probable that cash receipts will be received

Example: You purchase an Apple Watch for $500 and take it home. All three conditions are met (delivered, $500 is measurable, cash received) — Apple recognizes $500 in revenue.

If Apple doesn’t have the watch in stock and you haven’t committed to buying it, conditions 1 and 3 fail — no revenue is recognized.

The Matching Principle (Expense Recognition)

Expenses are recognized when incurred — when costs are consumed to earn revenues in the period, regardless of when cash is paid. This is called the matching principle: resources consumed to earn revenues in a period should be expensed in that same period.

Expense recognition conditions:

1. There has been a decrease in future economic benefit (decrease in an asset or increase in a liability)
2. The expense can be reliably measured

Example continued: Apple sells the watch for $500 and the cost of the watch was $300. Since the inventory decreased (condition 1) and the cost is known (condition 2), Apple records cost of goods sold of $300 in the same period as the $500 revenue.

3.3 Adjusting Entries

Adjusting journal entries (AJEs) are recorded at the end of the accounting period, before financial statements are prepared. They ensure revenues are recognized when earned and expenses when incurred, bringing asset and liability accounts to proper balances.

An important rule: cash is never affected by an adjusting entry. Adjustments are made at period-end, not when cash changes hands.

Type 1: Deferrals

Deferrals occur when cash has already been exchanged but revenue or expense recognition must wait.

A. Deferred (Prepaid) Expenses: Cash is paid before the expense is incurred. Example: paying annual rent in advance. At payment, the amount is recorded as an asset (prepaid rent). At period-end, the portion used is expensed via an AJE: debit Rent Expense, credit Prepaid Rent.

B. Deferred (Unearned) Revenues: Cash is received before revenue is earned. Example: a customer prepays three months of office rent. The landlord records this as unearned revenue (a liability). At period-end, the earned portion is recognized: debit Unearned Revenue, credit Revenue.

Note: one company’s prepaid expense is another company’s unearned revenue.

Type 2: Accruals

Accruals occur when a business has earned revenue or incurred expense without yet exchanging cash.

A. Accrued Expenses: Expenses incurred but not yet paid or billed. Example: employees worked but won’t be paid until next week — the company must accrue salary expense. AJE: debit Salaries Expense, credit Salaries Payable.

B. Accrued Revenues: Revenue earned but not yet billed or collected. Example: an audit firm completes work before invoicing the client. AJE: debit Accounts Receivable, credit Revenue.

Type 3: Depreciation

Property, plant, and equipment (PP&E) — buildings, machinery, furniture — are long-term deferred expenses. A portion of their cost must be allocated to each period as depreciation expense (matching principle).

Accumulated depreciation is a contra asset account: it reduces the carrying amount of PP&E on the balance sheet. Its normal balance is credit, opposite to the debit balance of the companion PP&E account.

Net Book Value = Acquisition Cost − Accumulated Depreciation

At period-end: debit Depreciation Expense, credit Accumulated Depreciation.

Summary of Adjustments

Type	Cash Direction	Balance Sheet Effect	Income Statement Effect
Deferred expense (prepaid)	Cash paid earlier	Asset decreases	Expense increases
Deferred revenue (unearned)	Cash received earlier	Liability decreases	Revenue increases
Accrued expense	Cash to be paid later	Liability increases	Expense increases
Accrued revenue	Cash to be received later	Asset increases	Revenue increases
Depreciation	Non-cash	Contra asset increases	Expense increases

Every AJE affects exactly one balance sheet account and one income statement account. AJEs never affect cash.

3.4 Preparing Financial Statements and Closing Entries

Statement Preparation Order

The income statement is prepared first because net income is needed for the statement of retained earnings. The balance sheet is prepared last because it needs the ending retained earnings balance from the statement of retained earnings.

Income Statement Formats

Single-step: all revenues grouped together, all expenses grouped together. One subtraction yields net income.

Multi-step (most commonly used): shows subtotals that emphasize relationships:

1. Net sales revenue − Cost of goods sold = Gross profit
2. Gross profit − Operating expenses = Income from operations
3. Income from operations ± Non-operating items = Income before taxes
4. Income before taxes − Income tax expense = Net income

Classified Balance Sheet

A classified balance sheet separates current from long-term items, listed in order of relative liquidity (how quickly they convert to cash):

• Current assets: expected to convert within one year or operating cycle (whichever longer)
• Long-term assets: held longer than one year
• Current liabilities: due within one year or operating cycle
• Long-term liabilities: due beyond one year

The most common format is the report format — assets at top, liabilities and equity below.

Closing Entries

Closing entries prepare accounts for the next period by resetting temporary accounts to zero. Temporary accounts (revenues, expenses, dividends) are closed; permanent accounts (assets, liabilities, equity) carry forward.

Closing entries transfer revenue, expense, and dividend balances to retained earnings:

1. Debit each revenue account; credit Retained Earnings for total revenues
2. Credit each expense account; debit Retained Earnings for total expenses
3. Credit Dividends account; debit Retained Earnings for total dividends

This process resets the income statement accounts to zero, ready for the next accounting period — like resetting a scoreboard after a game.

3.5 Evaluating a Company’s Debt-Paying Ability

Three ratios help assess whether a company can pay its obligations.

1. Net Working Capital (Working Capital)

\[\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}\]

A positive working capital indicates liquidity — the company can cover short-term obligations with short-term assets. The “sufficient” threshold varies by industry.

2. Current Ratio

\[\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}\]

A general benchmark is a minimum current ratio of 1.50, though this varies by industry. Higher is generally better.

3. Debt Ratio

\[\text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}\]

A low debt ratio is safer — fewer liabilities mean lower required payments. Most companies maintain a ratio between 0.60 and 0.70 (60%–70%).

Lending agreements often require companies to maintain a minimum current ratio and a maximum debt ratio. To avoid breaching these covenants, companies may increase revenues, decrease expenses, or issue new shares.

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Unit 4: Statement of Cash Flows

4.1 The Cash Flow Statement

In the previous units, we completed the accounting cycle through three financial statements. In this unit, we address the fourth: the statement of cash flows. The statement uses the term “cash” to include both cash and cash equivalents — short-term, highly liquid investments such as treasury bills, money market funds, and savings readily convertible to cash within three months.

Cash is critical because without it a company cannot expand operations, replace assets, pay salaries, repay debt, or pay dividends. A company needs both net income and strong cash flow to succeed.

The balance sheet tells you whether cash increased or decreased between two periods but not why. The income statement offers clues but is prepared on accrual basis — net income is not the same as cash inflow. The statement of cash flows explains exactly what caused the cash balance to change, classifying cash flows into three activities: operating, investing, and financing.

The statement is dated “Year Ended” (covering a period of time), and its ending cash balance must agree with the cash account on the balance sheet.

4.2 Classifying Cash Flows

Operating Activities

Operating activities are the main revenue-producing activities of a business — the core of what the company does day-to-day. Cash inflows include receipts from sales of primary goods and services; cash outflows include payments to suppliers and employees.

Companies must generate sufficient cash from operating activities to fund capital expenditures, pay dividends, and sustain day-to-day operations. Insufficient operating cash flows eventually lead to liquidity and solvency problems.

Investing Activities

Investing activities involve transactions related to resources used to generate future income — specifically long-term assets and investments.

Cash inflows: sales of PP&E, sales of investments, interest and dividends received (in this course), collection of loans made to others.

Cash outflows: purchases of PP&E, purchases of investments, loans made to others.

Note: cash flows from buying and selling inventory are operating activities (inventory is used in day-to-day operations), not investing activities.

Financing Activities

Financing activities involve transactions that change the size and composition of a company’s equity and borrowings.

Cash inflows: issuing shares, proceeds from loans and bonds.

Cash outflows: repaying debt principal, paying dividends, repurchasing shares.

General Classification Rule

A useful heuristic: the section of the cash flow statement corresponds to where the account appears on the balance sheet:

Balance Sheet Section	Cash Flow Section
Current assets / current liabilities	Operating
Non-current assets	Investing
Non-current liabilities / shareholders’ equity	Financing

Note: net income affects retained earnings (shareholders’ equity) but is part of operating activities, since it reflects core operations.

Direct vs. Indirect Method for Operating Activities

There are two methods for presenting operating cash flows. Both produce the same total; only the presentation differs.

Direct method: subtracts cash disbursements from cash collections, explicitly showing cash receipts from customers, cash paid to suppliers, etc.

Indirect method: starts with accrual-basis net income and adjusts for non-cash and non-operating items to arrive at cash from operations. Most companies use this method because it is cheaper to prepare, reveals less competitive information, and highlights the reconciliation between net income and operating cash flow.

4.3 Preparing the Operating Section (Indirect Method)

The indirect method converts accrual net income to cash-basis operating income through three types of adjustments:

1. Depreciation (add back): Depreciation is a non-cash expense. It reduces net income but requires no cash outflow. Add it back to accrual income.

2. Gains and Losses on Long-Term Asset Sales (remove):

• Add back losses (no actual cash loss; actual proceeds appear in investing)
• Subtract gains (no actual cash gain; actual proceeds appear in investing)

3. Changes in Working Capital:

For current assets (other than cash):

• Increase in current asset → subtract (cash tied up, but no impact on income)
• Decrease in current asset → add (cash released)

For current liabilities:

• Increase in current liability → add (expense incurred but not yet paid in cash)
• Decrease in current liability → subtract (cash paid for previously recorded expense)

Summary of indirect method adjustments:

\[\text{Cash from Operations} = \text{Net Income} + \text{Depreciation} + \text{Losses} - \text{Gains} - \Delta\text{Current Assets (non-cash)} + \Delta\text{Current Liabilities}\]

Worked example for accounts receivable: If A/R increased by $5,312M (Apple’s 2018 example), revenues exceeded cash collected — subtract $5,312M. If A/R decreased, cash collected exceeded revenues — add the change.

Worked example for inventory: If inventory decreased by $899M, COGS exceeded cash purchases — add $899M. If inventory increased, cash was spent but no income impact yet — subtract the change.

Worked example for accounts payable: If A/P decreased by $11,646M, cash was paid beyond what was expensed — subtract $11,646M. If A/P increased, expense was recorded but cash not yet paid — add the change.

4.4 Preparing the Investing and Financing Sections

Investing Activities: Key Formulas

For acquisitions and disposals of PP&E:

\[\text{PP\&E Beg.} + \text{Acquisitions} - \text{Depreciation} - \text{Carrying Amount Sold} = \text{PP\&E End.}\]\[\text{Sale Proceeds} = \text{Carrying Amount} + \text{Gain} - \text{Loss}\]

Example: Bradshaw had PP&E (net) of $219K at year-start and $353K at year-end, acquired $206K of new assets, and recorded $18K depreciation and an $8K gain on sale. Carrying amount sold = $219K + $206K − $18K − $353K = $54K. Sale proceeds = $54K + $8K = $62K.

For notes receivable:

\[\text{NR Beg.} + \text{New Loans Made} - \text{Collections} = \text{NR End.}\]

Financing Activities: Key Formulas

For long-term debt:

\[\text{LTD Beg.} + \text{New Borrowings} - \text{Repayments} = \text{LTD End.}\]

For share capital:

\[\text{Share Capital Beg.} + \text{New Shares Issued} - \text{Shares Repurchased} = \text{Share Capital End.}\]

For dividends paid (using retained earnings):

\[\text{RE Beg.} + \text{Net Income} - \text{Dividends Declared} = \text{RE End.}\]

Non-Cash Investing and Financing Activities

Some investing or financing activities involve no cash — for example, issuing shares to acquire land. These must be disclosed in a separate schedule or in the notes, since they do not appear on the statement of cash flows itself.

Free Cash Flow

Free cash flow measures the cash available after maintaining or expanding the capital base:

\[\text{Free Cash Flow} = \text{Net Cash from Operating Activities} - \text{Capital Expenditures on PP\&E}\]

A company with significant free cash flow can invest in growth, acquire other companies, or buy back shares — it has flexibility in managing its business.

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Unit 5: Cash, Bank Reconciliation, and Receivables

5.1 Understanding Cash and Cash Equivalents

Cash and cash equivalents represent a company’s most liquid asset — money that can be used immediately to pay bills, buy products, pay salaries, and service debt. Cash equivalents are highly liquid assets convertible to cash within three months, such as treasury bills, commercial paper, and money market funds. Despite multiple bank accounts in different currencies and geographies, all cash balances are combined into a single line on the balance sheet.

Banks help companies manage cash effectively by protecting against forgery (requiring signature cards), providing deposit slips as proof of deposit, issuing cheques that document payments, and providing bank statements with full transaction histories.

5.2 Bank Reconciliation

Why Reconcile?

A bank reconciliation explains the difference between the cash balance on the bank statement and the cash balance in the company’s general ledger. These two records differ due to timing differences — for example, when Apple writes a cheque to Qualcomm but Qualcomm hasn’t deposited it yet, Apple’s books show the payment but the bank statement doesn’t.

As an internal control, the person who prepares the bank reconciliation should not have other cash duties — otherwise, they could steal cash and conceal it through manipulated reconciliations.

The Reconciliation Process

A bank reconciliation has two sides, each adjusted to a common adjusted balance. After adjustments, adjusted bank balance = adjusted book balance.

Bank side adjustments (items in books but not yet on bank statement):

Adjustment	Effect
Deposits in transit (outstanding deposits)	Add
Outstanding cheques (issued but not yet cleared)	Subtract
Bank errors	Add or subtract

Book side adjustments (items on bank statement but not yet in books):

Adjustment	Effect
Bank collections (e.g., customer e-transfers)	Add
EFT receipts	Add
EFT payments	Subtract
Service charges	Subtract
Interest income	Add
NSF (non-sufficient funds) cheques	Subtract
Cost of printed cheques	Subtract
Book errors	Add or subtract

Journalizing

All book side items require journal entries (they are transactions not yet recorded). Add items → debit Cash; subtract items → credit Cash. Items on the bank side require no journal entries — they are already recorded in the books, just awaiting bank processing.

5.3 Accounting for Receivables and Bad Debts

Accounts receivable (A/R) are amounts owed by customers from sales on account. The A/R account in the general ledger is a control account summarizing all customer balances. Companies also maintain a subsidiary ledger with a separate record for each customer.

Notes receivable are longer-term receivables evidenced by a written promissory note detailing the principal, interest rate, term, and maturity date. A borrower may pledge collateral — assets the lender can claim if the borrower defaults.

Bad Debts

By selling on credit, companies accept the risk that some customers will not pay. Bad debt expense is the cost associated with uncollectible receivables. There are two methods for accounting for bad debts:

1. Direct write-off method: recognize bad debt expense only when a specific account is identified as uncollectible. This fails the matching principle because the expense may be recorded in a different period than the related revenue.

2. Allowance method (required under GAAP): at each period-end, estimate the total expected uncollectible receivables and record bad debt expense in the same period as the related revenue. This satisfies the matching principle.

Under the allowance method, an allowance for doubtful accounts (a contra asset account, credit balance) is established. Accounts receivable are reported at their net realizable value (NRV):

\[\text{NRV} = \text{Accounts Receivable} - \text{Allowance for Doubtful Accounts}\]

NRV is the amount the company actually expects to collect.

5.4 Estimating and Writing Off Bad Debts

Two Estimation Methods

Percentage of credit sales method (income statement approach): multiply total credit sales by an estimated uncollectible percentage.

Example: Apple has $3,000,000 in credit sales and estimates 1.5% will be uncollectible → Bad Debt Expense = $3,000,000 × 1.5% = $45,000.

AJE: Debit Bad Debts Expense $45,000 / Credit Allowance for Doubtful Accounts $45,000.

Aging-of-receivables method (balance sheet approach): classify A/R by how long they’ve been outstanding. Older accounts receive higher uncollectible percentages. The sum across all aging categories is the desired ending balance in the allowance account. The AJE adjusts the allowance from its current balance to the desired balance.

Example: Desired allowance = $6,156; current allowance balance = $346. AJE amount = $6,156 − $346 = $5,810.

Writing Off Uncollectible Accounts

When a specific customer’s account is deemed uncollectible:

Accounts	Debit	Credit
Allowance for doubtful accounts	X,XXX
Accounts receivable		X,XXX

This write-off does not affect total assets (A/R decreases, Allowance decreases by equal amount), net income, or NRV. Bad debt expense was already recorded in the period of the related sale.

Recovery of a Written-Off Account

If a customer later pays after being written off, two entries are needed:

1. Reverse the write-off: Debit A/R, Credit Allowance for Doubtful Accounts
2. Record the collection: Debit Cash, Credit A/R

Computing Collections from Customers

\[\text{Beg. A/R} + \text{Sales on Credit} - \text{Write-offs} - \text{Collections} = \text{Ending A/R}\]

5.5 Notes Receivable

Notes receivable are more formal than accounts receivable. Those due within one year are current assets; those due beyond one year are long-term assets.

Key terms: the creditor (lender) holds the note; the debtor (borrower/maker) signs it. Interest is the cost of borrowing, stated as an annual percentage rate. Principal is the amount borrowed; the maturity date is when the debtor must repay.

Interest formula: \(\text{Interest} = \text{Principal} \times \text{Interest Rate} \times \text{Time (in years)}\)

Example: Canadian Western Bank lends $1,000 on a 6-month, 9% note on July 1. At year-end October 31, the bank accrues 4 months of interest: $1,000 × 9% × 4/12 = $30. When the note matures December 31, the bank collects principal + full interest and clears the interest receivable balance.

5.6 Improving Cash Flows: Credit Cards, Debit Cards, Factoring

Companies accelerate cash collection through several strategies:

Credit card sales: the credit card company charges the retailer 2%–3% of the sale amount. The merchant receives net proceeds immediately. Example: Apple sells a $5,000 iMac on VISA. Cash received = $5,000 minus the fee; Credit Card Expense is recorded for the fee.

Debit card sales: the bank charges a flat fee per transaction. Proceeds transfer immediately to the merchant’s account.

Factoring (selling receivables): a company sells its A/R to a factor (another business) at a discount to receive immediate cash. The disadvantage is a financing expense (the discount) and loss of control over collections.

Example: Apple sells $1,000,000 of A/R for $950,000 cash. The $50,000 difference is recorded as a financing expense.

5.7 Evaluating Liquidity

Current Ratio (review)

\[\text{Current Ratio} = \frac{\text{Total Current Assets}}{\text{Total Current Liabilities}}\]

Acid-Test (Quick) Ratio

A more stringent liquidity measure that excludes inventory and prepaid expenses — assets that are less readily convertible to cash:

\[\text{Acid-Test Ratio} = \frac{\text{Cash + Short-Term Investments + Net Receivables}}{\text{Total Current Liabilities}}\]

Higher is better. Inventory and prepaid expenses are excluded because inventory takes time to sell and prepaid expenses represent advance payments that don’t generate future cash inflows.

Days’ Sales in Receivables

Measures how long it takes to collect the average level of receivables. Shorter is better — faster collection means better cash flow.

Step 1: Compute A/R turnover (how many times per year the company collects its average A/R):

\[\text{A/R Turnover} = \frac{\text{Net Sales}}{\text{Average Net Accounts Receivable}}\]

where Average Net A/R = (Beginning Net Receivables + Ending Net Receivables) / 2.

Step 2: Compute days’ sales in receivables:

\[\text{Days' Sales in Receivables} = \frac{365}{\text{A/R Turnover}}\]

Many companies aim for a 30–45 day collection cycle, though this varies by industry.

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Unit 6: Inventory

6.1 Accounting for Inventory

Inventory is merchandise held for sale to customers — a current asset on the balance sheet. For non-manufacturing companies (the focus of this unit), inventory increases when merchandise is purchased and decreases when it is sold.

Inventory Roll

\[\text{Beginning Inventory} + \text{Net Purchases} - \text{Cost of Goods Sold} = \text{Ending Inventory}\]

Cost of Inventory

Under the cost principle, inventory is recorded at the invoice price plus all costs to bring it to saleable condition:

Included: purchase price, freight-in, insurance in transit, costs to make the inventory ready to sell.

Excluded: advertising, sales commissions, and other operating costs (these are period expenses, not product costs).

Cost of Goods Sold

When inventory is sold, its cost transfers from the balance sheet to the income statement:

Inventory (balance sheet asset) → when sold → Cost of Goods Sold (income statement expense)

Gross profit is the difference between sales revenue and cost of goods sold:

\[\text{Gross Profit} = \text{Sales Revenue} - \text{Cost of Goods Sold}\]

Gross profit is a subtotal on the income statement, not an account.

Shipping Terms (FOB)

FOB Shipping Point: legal title passes when goods leave the seller. The buyer owns goods in transit and pays freight costs.

FOB Destination: legal title passes when goods arrive at the buyer. The seller owns goods in transit and pays freight costs.

Consigned goods are always in the inventory of the company that owns them, regardless of physical location.

Perpetual vs. Periodic Inventory Systems

Perpetual system: maintains a running total of inventory — each purchase and sale is immediately recorded. Used by most modern retailers (barcode scanning).

Periodic system: does not maintain a running total; inventory is counted physically at period-end. Used by very small businesses.

Under the perpetual system, purchasing inventory: Debit Inventory, Credit Cash/A/P. Making a sale requires two entries: (1) record revenue at selling price; (2) record COGS at cost.

Sales Discounts

Credit terms such as “2/10, n/30” mean: the customer deducts 2% if paid within 10 days; otherwise the full amount is due within 30 days.

6.2 Inventory Costing Methods

When unit costs change over time (due to production costs, currency rates, or economic influences), companies need rules to determine which cost to assign to goods sold. Three methods are generally accepted:

1. Specific Identification

Each inventory item has a unique identification number; its specific acquisition cost is recorded as COGS when sold. Appropriate for distinguishable, high-value items (luxury cars, aircraft, custom jewelry). Under IFRS, this method is not allowed for interchangeable items.

2. Weighted-Average Cost

Calculates an average cost per unit after each purchase:

\[\text{Average Cost per Unit} = \frac{\text{Cost of Goods Available}}{\text{Number of Units Available}}\]

where Cost of Goods Available = Beginning Inventory + Purchases.

Then: COGS = Units Sold × Average Cost per Unit; Ending Inventory = Units on Hand × Average Cost per Unit.

Example: Alpha Inc. buys 3 widgets @ $10, 5 @ $12, and 2 @ $15. Average cost = ($30 + $60 + $30) ÷ 10 = $12/unit. Sell 4: COGS = $48; Ending Inventory = $72.

A new average is computed every time inventory is purchased.

3. First-In, First-Out (FIFO)

Assumes the first inventory purchased is the first sold — matching the physical flow of most perishable goods. Oldest costs → COGS; newest costs → Ending Inventory.

Example: Alpha Inc. buys 3 @ $10, 5 @ $12, 2 @ $15. Sell 4: COGS = (3 × $10) + (1 × $12) = $42; Ending Inventory = (4 × $12) + (2 × $15) = $78.

Comparison During Rising Prices

During periods of rising costs, FIFO assigns earlier (lower) costs to COGS, producing higher gross profit than weighted-average. During falling prices, the reverse applies.

6.3 Accounting Standards for Inventory

Companies must apply the same inventory method consistently from period to period. If a change is made (only when it provides more reliable and relevant information), it must be applied retrospectively and disclosed in the notes.

Lower-of-Cost-and-Net-Realizable-Value (LCNRV) Rule

Inventory is initially recorded at historical cost. However, if net realizable value (NRV) falls below cost, inventory must be written down to NRV. This applies on an ongoing basis.

Journal entry for inventory write-down: Debit Cost of Goods Sold; Credit Inventory.

If NRV subsequently recovers, the write-down can be partially reversed — but not above the original historical cost.

6.4 Inventory Ratios and Error Analysis

Gross Profit Percentage

\[\text{Gross Profit Percentage} = \frac{\text{Gross Profit}}{\text{Net Sales Revenue}}\]

Measures the markup on inventory as a percentage of sales. Higher is generally better, though benchmarks vary by industry.

Inventory Turnover

\[\text{Inventory Turnover} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}\]

Indicates how rapidly inventory is sold. Higher turnover means goods sell faster, reducing storage costs and generating profit more quickly.

Effects of Inventory Errors

Errors in ending inventory affect both the balance sheet (inventory) and the income statement (COGS). Critically, errors are self-correcting over two periods — ending inventory of one period is beginning inventory of the next:

Inventory Error	Period 1 COGS	Period 1 Net Income	Period 2 COGS	Period 2 Net Income
Ending inventory overstated	Understated	Overstated	Overstated	Understated
Ending inventory understated	Overstated	Understated	Understated	Overstated

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Unit 7: Long-Lived Assets

7.1 Property, Plant, and Equipment (PP&E)

Property, plant, and equipment consists of long-lived tangible assets actively used in operations to generate benefits beyond one year. The fundamental cost principle: the cost of any asset is the sum of all costs incurred to bring the asset to its location and intended use.

Tangible vs. Intangible Assets

Tangible assets have physical substance and are not intended for sale to customers. They are also called PP&E, fixed assets, capital assets, or long-term assets. Examples: buildings, equipment, land, fixtures.

Intangible assets have no physical form. Examples: patents, copyrights, franchises, goodwill.

Long-lived assets are used up over time. Their cost must be expensed over their useful lives — this allocation is called depreciation (for tangible assets) or amortization (for intangible assets). Land is the sole exception: its usefulness does not decrease, so it is never depreciated.

Acquisition Cost by Asset Type

Land: purchase price + real estate commissions + survey and legal fees + back property taxes paid + cost of grading and removing unwanted buildings. Does not include land improvements (parking lots, fencing) — those are separate depreciable assets.

Buildings: architectural fees, building permits, contractors’ charges, materials, labor, overhead, and interest on construction financing. For purchased buildings: purchase price, brokerage commission, sales taxes, and renovation costs.

Equipment: purchase price (net of discounts), transportation, insurance in transit, sales taxes, installation, and testing costs. After the asset is in service, maintenance and insurance are expenses.

Lump-Sum (Basket) Purchases

When multiple assets are purchased for a single price, the total cost is allocated based on relative fair market values:

\[\text{Cost of Each Asset} = \frac{\text{Fair Market Value of Asset}}{\text{Total Fair Market Value}} \times \text{Total Acquisition Cost}\]

WestJet example: $300K purchase of land ($126K FMV) and building ($189K FMV). Total FMV = $315K. Land: 40% × $300K = $120K; Building: 60% × $300K = $180K.

Capital vs. Immediate Expenditures

Capital expenditures (capitalized as assets): betterments that increase productivity, extend useful life, expand capacity, or improve the asset. Non-recurring. → Debit asset account.

Immediate expenditures (expensed in the period): ordinary repairs and maintenance that maintain normal operating conditions. Recurring. → Debit expense account.

7.2 Depreciation Methods

Depreciation allocates a long-lived asset’s acquisition cost to expense over its useful life. Important distinctions:

• Depreciation is a means of cost allocation, not valuation
• Depreciation is a non-cash deferred expense
• All methods produce the same total depreciation over the asset’s life

Three inputs are required: cost, estimated useful life, and estimated residual (salvage) value.

\[\text{Depreciable Cost} = \text{Acquisition Cost} - \text{Residual Value}\]

At the end of its useful life, a fully depreciated asset’s book value equals its residual value.

1. Straight-Line Method

Equal depreciation expense each year:

\[\text{Annual Depreciation} = \frac{\text{Acquisition Cost} - \text{Residual Value}}{\text{Useful Life (years)}}\]

Example: Equipment costs $62.5M, residual value $2.5M, useful life 3 years. Annual depreciation = ($62.5M − $2.5M) ÷ 3 = $20M. Best for assets that generate revenue evenly over their useful life.

2. Units-of-Production Method

Variable depreciation based on actual usage:

\[\text{Rate per Unit} = \frac{\text{Acquisition Cost} - \text{Residual Value}}{\text{Total Units of Production}}\]\[\text{Annual Depreciation} = \text{Rate per Unit} \times \text{Units Produced This Year}\]

Example: Same equipment, 100,000 total hours. Rate = $60,000K ÷ 100,000 = $600/hour. Year 1 (30,000 hrs): $18M; Year 2 (50,000 hrs): $30M; Year 3 (20,000 hrs): $12M. Best for assets that wear out through physical use.

3. Double-Declining-Balance (DDB) Method

Larger depreciation in earlier years:

\[\text{SL Rate} = \frac{1}{\text{Useful Life}}; \quad \text{DDB Rate} = \text{SL Rate} \times 2\]\[\text{Annual Depreciation} = \text{DDB Rate} \times \text{Beginning Carrying Amount}\]

Ignore residual value in all years except the final year, where depreciation = beginning carrying amount − residual value.

Example: $62.5M equipment, $2.5M residual, 3-year life. DDB rate = 66.7%. Year 1: $62.5M × 66.7% = $41.7M. Year 2: $20.8M × 66.7% = $13.9M. Year 3 (forced): $6.9M − $2.5M = $4.4M.

Best for assets that are more efficient/productive in their early years.

Comparison Summary

Year	Straight-Line	Units-of-Production	Double-Declining-Balance
1	$20M	$18M	$41.7M
2	$20M	$30M	$13.9M
3	$20M	$12M	$4.4M
Total	$60M	$60M	$60M

Cash Flow Impact

Item	Cash Flow Section	Treatment
Depreciation expense	Operating	Added back (non-cash)
Sale of PP&E	Investing	Cash proceeds (inflow)
Purchase of PP&E	Investing	Cash payment (outflow)

Return on Assets (ROA)

\[\text{ROA} = \frac{\text{Net Income} + \text{Interest Expense}}{\text{Average Total Assets}}\]

ROA measures how much the entity earned for each dollar of assets invested by both shareholders and creditors. Higher values indicate more efficient asset utilization.

7.3 Intangible Assets

Intangible assets are long-lived assets with no physical form. They fall into two categories:

• Finite lives: amortized over the shorter of useful life or legal life (straight-line method typically used)
• Indefinite lives: not amortized but tested annually for impairment

Five Major Intangible Asset Types

1. Patents: granted by the federal government, giving exclusive rights to produce and sell an invention for 20 years. Amortized over the shorter of useful life or 20 years.

Example: Apple acquires a patent for $1.7B with a 5-year useful life. Annual amortization = $1.7B ÷ 5 = $340M. AJE: Debit Amortization Expense – Patents $340M; Credit Accumulated Amortization $340M.

2. Copyrights: exclusive rights to reproduce and sell creative works. In Canada, extend 50 years after the creator’s life. Amortized over useful life.

3. Trademarks and Trade Names: distinctive product or service identifiers (™ or ®). Amortized over useful life; not amortized if expected to generate cash flows indefinitely.

4. Franchises and Licenses: privileges to sell a product or service under specific conditions. Often indefinite life; not amortized.

5. Goodwill: the excess of purchase price over the fair market value of the acquired company’s net assets. Arises only from a business acquisition — companies cannot record self-created goodwill.

\[\text{Goodwill} = \text{Purchase Price} - \text{Fair Value of Net Assets Acquired}\]

Apple/Beats example: Apple paid $1.2B for Beats; FMV of net assets = $567.3M. Goodwill = $1.2B − $567.3M = $632.7M.

Goodwill has an indefinite life and is not amortized. Instead it is tested annually for impairment and written down when impaired: Debit Loss on Goodwill Impairment; Credit Goodwill.

Research and Development: research costs must be expensed when incurred. Development costs can be capitalized and amortized only after technical and commercial feasibility of the product is established.

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Unit 8: Liabilities and Bonds

8.1 Current Liabilities: Known Amounts

Liabilities are present obligations arising from past events, the settlement of which will result in an outflow of resources. The classified balance sheet distinguishes:

• Current liabilities: due within one year (or operating cycle, if longer)
• Non-current liabilities: due beyond one year

Known-Amount Current Liabilities

Short-term borrowings: amounts owed to banks (e.g., a line of credit used to manage working capital).

Accounts payable: amounts owed to suppliers for credit purchases. Typically due within 30–60 days.

Short-term notes payable: formal written promises to pay a specified amount plus interest by a specified date. Journal entries involve: (1) recording the note at issuance, (2) accruing interest at period-end, and (3) paying note plus interest at maturity.

Apple example: $75M, 8-month, 5% note payable issued September 1, year-end January 31. Interest accrued (5 months) = $75M × 5% × 5/12 = $1,562,500. Remaining interest (3 months) paid at maturity April 30.

Sales taxes payable: sellers collect GST, PST, or HST from customers and remit periodically to governments. Between collection and remittance, the amount is a liability.

Accrued liabilities: expenses incurred but not yet paid — salaries and wages payable, interest payable, income taxes payable.

Unearned revenues: cash collected from customers before services are delivered. Once earned, debit Unearned Revenue; credit Revenue.

Current portion of long-term debt: the portion of long-term debt due within one year, reclassified from long-term liabilities to current liabilities at each year-end.

8.2 Current Liabilities: Estimated Amounts

When a company knows it has a present obligation but is uncertain of the timing or amount, it records an estimated liability — but only when (1) the amount can be estimated reliably and (2) payment is probable.

Provisions (Estimated Warranty Payable)

A provision is recognized when an entity has a present obligation from a past event, cash or other assets will probably be required, and a reliable estimate can be made.

Warranty liabilities are the most common provision. When products are sold, the company records warranty expense in the same period (matching principle), even though it doesn’t yet know which products are defective.

AJE: Debit Warranty Expense; Credit Estimated Warranty Payable.

When warranty work is actually performed: Debit Estimated Warranty Payable; Credit Inventory/Cash.

Contingent Liabilities

A contingent liability depends on the outcome of an uncertain future event (e.g., lawsuits, environmental obligations). The treatment depends on probability and estimability:

Probability	Amount Estimable?	Treatment
Probable	Yes	Recognize (record) the liability
Probable	No	Disclose in notes
Possible	Yes or No	Disclose in notes
Remote	Yes or No	No recognition or disclosure required

8.3 Bonds Payable: Time Value of Money

Time Value of Money

Time value of money (TVM) — $1 today is worth more than $1 in the future, because money can be invested to earn interest.

Present value (PV) is the current value of a future amount, discounted at the market interest rate.

Future value (FV) is the value of a current investment at a future point in time.

\[\text{PV} \times (1 + i)^n = \text{FV}\]

PV of a single payment:

\[\text{PV} = \frac{\text{FV}}{(1 + i)^n}\]

PV of an annuity:

\[\text{PV of Annuity} = \text{Payment} \times \frac{1 - \frac{1}{(1+i)^n}}{i}\]

Practical example: Three offers for your invention — $1M today, $250K/year for 5 years, or $1.5M in 5 years (5% interest rate). Using PV factors: BlackBerry = $1,082,250; Samsung = $1,176,000. Samsung’s offer is most valuable in present value terms.

Accounting for Bond Issuance

Bonds payable are notes issued to many lenders (bondholders) simultaneously. Each bond has:

• Face value (principal, maturity value, par value): amount due at maturity, typically in $1,000 units
• Coupon rate (stated interest rate): determines periodic interest payments
• Maturity date: when face value is repaid
• Interest payment dates: typically semi-annual

Types: Term bonds (all mature simultaneously) vs. Serial bonds (mature in installments); Secured (mortgage) bonds (backed by specific assets) vs. Unsecured bonds/debentures (backed only by creditworthiness; carry higher interest rates due to greater risk).

8.4 Calculating Bond Price at Issuance

Bond price = PV of face value + PV of interest payments

\[\text{Bond Price} = \text{FV} \times \frac{1}{(1+i)^n} + \text{Annuity Payment} \times \frac{1 - \frac{1}{(1+i)^n}}{i}\]

Where the market interest rate \(i\) determines the PV, and the coupon rate determines the annuity payment.

Three Bond Pricing Scenarios

Relationship	Bond Price	Terminology
Coupon rate = Market rate	= Face value	Issued at par
Coupon rate < Market rate	< Face value	Issued at a discount
Coupon rate > Market rate	> Face value	Issued at a premium

Discount intuition: If the coupon rate is below market, investors demand compensation through a lower purchase price. Premium intuition: If the coupon rate exceeds market, the issuer commands a higher price.

Discount example (coupon 9%, market 10%, semi-annual, 5-year, $100K):

• n = 10 periods; coupon rate semi-annual = 4.5%; market rate semi-annual = 5%
• PV of face value: $100,000 / (1.05)¹⁰ = $61,391
• PV of interest annuity: $4,500 × PV annuity factor = $34,749
• Bond value = $96,140 (discount = $100,000 − $96,140 = $3,860)

Premium example (coupon 9%, market 8%):

• Market rate semi-annual = 4%
• Bond value = $104,056 (premium = $104,056 − $100,000 = $4,056)

Regardless of issue price, at maturity the bond’s carrying amount equals its face value.

8.5 Journal Entries for Bond Issuance and Interest

Case 1 — At Par: Debit Cash; Credit Bonds Payable. Each interest payment: Debit Interest Expense; Credit Cash.

Case 2 — At Discount: Debit Cash, Debit Discount on Bonds Payable; Credit Bonds Payable. Discount on bonds payable is a contra account to bonds payable — it reduces net carrying amount.

\[\text{Net Carrying Amount} = \text{Bonds Payable} - \text{Discount on Bonds Payable}\]

Each interest payment: Debit Interest Expense; Credit Discount on Bonds Payable (amortization); Credit Cash/Interest Payable.

Case 3 — At Premium: Debit Cash; Credit Bonds Payable, Credit Premium on Bonds Payable. Premium on bonds payable is an adjunct account — it increases net carrying amount.

\[\text{Net Carrying Amount} = \text{Bonds Payable} + \text{Premium on Bonds Payable}\]

Each interest payment: Debit Interest Expense, Debit Premium on Bonds Payable; Credit Cash/Interest Payable. (Premium reduces interest expense; discount increases it.)

8.6 Bond Amortization: Effective Interest Rate Method

Effective interest rate method (required under IFRS) allocates discount or premium amortization each period based on the carrying amount and the market rate at issuance:

\[\text{Semi-Annual Interest Expense} = \text{Beginning Carrying Amount} \times \text{Market Rate} \times \frac{1}{2}\]\[\text{Semi-Annual Cash Payment} = \text{Face Value} \times \text{Coupon Rate} \times \frac{1}{2}\]

For a discount bond: Amortization = Interest Expense − Cash Payment (discount decreases each period)

For a premium bond: Amortization = Cash Payment − Interest Expense (premium decreases each period)

As carrying amount changes each period, interest expense also changes. Cash payment remains constant throughout the bond’s life.

Amortization Table Example (Discount Bond, 9% coupon, 10% market)

Period	Cash Payment	Interest Expense	Discount Amortization	Discount Balance	Carrying Amount
Jan 1, 2017	—	—	—	$3,851	$96,149
Jul 1, 2017	$4,500	$4,807	$307	$3,544	$96,456
Jan 1, 2018	$4,500	$4,823	$323	$3,221	$96,779
…	…	…	…	…	…
Jan 1, 2022	$4,500	$4,961	$461	$0	$100,000

At maturity, the discount is fully amortized and carrying amount equals face value.

Journal entry Jul 1, 2017: Debit Interest Expense $4,807; Credit Discount on Bonds Payable $307; Credit Cash $4,500.

At maturity: Debit Bonds Payable $100,000; Credit Cash $100,000.

8.7 A Company’s Debt-Paying Ability

Beyond the ratios covered in Unit 3, additional measures evaluate long-term solvency.

Times Interest Earned measures whether operating income can cover interest obligations:

\[\text{Times Interest Earned} = \frac{\text{Income from Operations (EBIT)}}{\text{Interest Expense}}\]

Higher is better — a ratio of at least 2–3× is typically considered comfortable.

Debt-to-Equity Ratio compares total liabilities to shareholders’ equity:

\[\text{Debt-to-Equity} = \frac{\text{Total Liabilities}}{\text{Total Shareholders' Equity}}\]

A lower ratio indicates less financial leverage and lower risk.

8.8 Other Long-Term Liabilities

Beyond bonds, companies use other long-term financing instruments. Long-term notes payable (mortgages, installment loans) work similarly to short-term notes but mature beyond one year. Lease liabilities arise when companies finance assets through financing leases rather than purchasing them outright. Pension and post-retirement benefit obligations represent commitments to employees for future payments.

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Unit 9: Shareholders’ Equity and Corporations

9.1 The Main Features of a Corporation

Corporations differ from proprietorships and partnerships in six key ways:

1. Separate legal entity: a corporation is legally distinct from its owners and can enter contracts, own property, sue, and be sued in its own name
2. Continuous life and transferability of ownership: shares can be bought and sold; the corporation’s life is not tied to individual owners
3. Limited liability: shareholders are not personally liable for corporate debts — they can lose their investment, but no more
4. Separation of ownership and management: shareholders own but managers operate; an advantage for capital raising, a disadvantage for control
5. Corporate taxation: corporations pay their own income taxes; dividends paid to shareholders are then taxed again at the personal rate (double taxation)
6. Government regulation: subject to securities regulations and reporting requirements

Shareholders’ Equity Components

Shareholders’ equity has four components under IFRS:

1. Share capital: amounts received from shareholders in exchange for shares
2. Contributed surplus: amounts contributed by shareholders in excess of what is allocated to share capital
3. Accumulated other comprehensive income (AOCI): past earnings not included in retained earnings (IFRS-specific)
4. Retained earnings: cumulative net income since incorporation, less net losses and dividends declared

Authorized, Issued, Outstanding Shares

• Authorized shares: maximum shares the corporation may issue (per the corporate charter)
• Issued shares: shares sold to shareholders
• Treasury shares: issued shares repurchased by the corporation
• Outstanding shares: issued minus treasury shares (shares currently held by public shareholders)

Classes of Shares

Common shares: basic ownership interest with four rights — sell shares, vote (one vote per share), receive dividends, receive residual assets on liquidation. Common shareholders bear the most risk and benefit most from success.

Preferred shares: typically non-voting, but receive dividends before common shareholders and have priority in liquidation. Generally pay a fixed dividend amount.

Feature	Common Shares	Preferred Shares	Long-Term Debt
Repay principal?	No	No	Yes
Dividends/interest tax-deductible?	No	No	Yes (interest is)
Obligation to pay?	Only after declaration	Fixed, but after declaration	Yes, at fixed rates

9.2 Accounting for Share Issuance

Three Scenarios of Share Issuance

Case 1 — IPO (Initial Public Offering): first sale of shares to the public. Cash received by the corporation.

Case 2 — SEO (Seasoned Equity Offering): additional share sale after IPO. Cash received by the corporation.

Case 3 — Secondary market trading: one shareholder sells to another. No impact on corporate accounts (separate-entity concept). The corporation is not involved.

Issuance for Cash

Example: A company issues 100,000 shares at $50 each.

Accounts	Debit	Credit
Cash	$5,000,000
Common share capital		$5,000,000

Issuance for Non-Cash Assets

Assets received are recorded at their fair market value. If FMV of assets can’t be determined, use the FMV of the shares given up.

Example: Kahn Corp. issues 15,000 shares for equipment ($4M FMV) and a building ($120M FMV).

Accounts	Debit	Credit
Equipment	$4,000,000
Building	$120,000,000
Common share capital		$124,000,000

Share Repurchases

Companies repurchase shares for several reasons: to fulfill share option commitments, support market price (reducing supply), or prevent hostile takeovers. The journal entry is the opposite of issuance: Debit Common Share Capital; Credit Cash.

9.3 Retained Earnings, Dividends, and Stock Splits

Retained Earnings

\[\text{Retained Earnings} = \text{Cumulative Net Income} - \text{Cumulative Net Losses} - \text{Dividends Declared}\]

A credit balance is normal (earnings exceed losses + dividends). A debit balance is called a deficit.

Important: retained earnings are not a pool of cash. A company may have substantial retained earnings yet insufficient cash to pay a dividend — retained earnings and cash are separate accounts.

Cash Dividends

Before declaring a cash dividend, a corporation must have sufficient retained earnings to declare it and sufficient cash to pay it. Only the board of directors can declare a dividend.

Three key dates:

Declaration date: the board declares the dividend. A legal liability is created.

Debit Retained Earnings; Credit Dividends Payable

Record date: the corporation identifies current shareholders. No journal entry required.

Payment date: cash is distributed.

Debit Dividends Payable; Credit Cash

Stock Dividends

A stock dividend is a proportional distribution of additional shares to shareholders. It conserves cash while rewarding shareholders and can dilute the share base to reduce per-share price.

The value of stock dividends = Number of shares to be issued × Market price per share.

On declaration date: Debit Retained Earnings; Credit Stock Dividends Distributable.

On issuance date: Debit Stock Dividends Distributable; Credit Common/Preferred Shares.

Stock dividends do not change total shareholders’ equity — the increase in share capital is offset by the decrease in retained earnings.

Dividends on Preferred vs. Common Shares

Preferred shareholders receive dividends first. Allocation:

1. Calculate preferred dividend: outstanding preferred shares × annual preferred dividend rate
2. Remainder goes to common shareholders

Cumulative preferred shares: if a company skips (“passes”) a dividend in one year, the dividends in arrears must be paid to preferred shareholders before common shareholders receive anything in future years. Cumulative arrears must be disclosed in the notes.

Non-cumulative preferred shares: passed dividends are lost. Only current-year preferred dividends must be paid before common shareholders receive anything.

Stock Splits

A stock split increases (or decreases) the number of shares outstanding without changing total shareholders’ equity, assets, or liabilities. No journal entry is required.

A 3-for-1 stock split triples shares outstanding and roughly reduces the share price by two-thirds. A 1-for-3 reverse stock split reduces shares and roughly triples the price.

Transaction Summary

Transaction	Total Assets	Liabilities	Shareholders’ Equity
Issuance of shares	Increase	No effect	Increase
Repurchase of shares	Decrease	No effect	Decrease
Declaration of cash dividend	No effect	Increase	Decrease
Payment of cash dividend	Decrease	Decrease	No effect
Stock dividend	No effect	No effect	No effect
Stock split	No effect	No effect	No effect

9.4 Book Value and Fair Value of Shares

Fair value (market price) is what a willing buyer pays a willing seller. For public companies, fair value is observable from market prices. For private companies, professional valuators must determine it.

Book value per share indicates the net asset value attributable to each common share:

When only common shares outstanding:

\[\text{Book Value per Share} = \frac{\text{Total Shareholders' Equity}}{\text{Shares Outstanding}}\]

When preferred shares also outstanding:

\[\text{Book Value per Share} = \frac{\text{Total SE} - \text{Preferred SE}}{\text{Common Shares Outstanding}}\]

Return on Equity (ROE)

\[\text{ROE} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Average Common Shareholders' Equity}}\]

ROE measures how much income was earned for each dollar contributed by common shareholders. In the long run, firms with higher ROE tend to have higher share prices.

Return on Assets (ROA) — revisited

\[\text{ROA} = \frac{\text{Net Income} + \text{Interest Expense (net of tax)}}{\text{Average Total Assets}}\]

ROA measures return regardless of how assets were financed. ROE measures return specifically for shareholders. Comparing ROA and ROE reveals the effect of financial leverage.