Course Materials

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INTRODUCTION TO FINANCIAL STATEMENTS

Learning Objectives

After studying this chapter, a student should be able to:

# explain the purpose and content of the general # journalize transactions, post and trial balance accounting records kept by a business; them and formulate financial statements; and # describe the form and content of financial # understand the relationship between the balance statements and the accounting principles that sheet and income statement. guide their preparation;

Introduction

Financial statements contain information that may be important in negotiating a sale or in evaluating a business's performance. In this chapter and the next, we will examine the accounting concepts and terminology needed to interpret financial statements.

There are several reasons why this knowledge is important:

First, the Real Estate Services Act requires certain financial statements to be made available when a business is sold.

Second, if you have a proper understanding of the financial and profit generating aspects of the business, you will be able to determine its market value.

Third, financial statements and accounting records are required by a brokerage for its own purposes and, in particular, for the requirements of dealing with trust funds. We will review the specific requirements of the Real Estate Services Act, Rules and Bylaws, and provide an introduction to financial statements and accounting concepts.

General Records

Importance and Need for Proper Accounting Control Over Brokerage Transactions

Let's review the obligations imposed by the Real Estate Services Act and Rules with regard to a brokerage's own records. Rule 8-1 provides:

(1) A brokerage must keep such financial records in connection with its business as are necessary to ensure the appropriate and timely accounting of all transactions relating to real estate services provided by the brokerage and its related licensees.

As we saw in Chapter 2, the Rules clearly state what records must be kept by a brokerage for transactions relating to business and trust accounts (Rules 8-2 and 8-3 respectively). The Rules make a distinction between general brokerage accounts and trust accounts, with the latter being subject to even more strict obligations, including separate specific trust ledgers to be made accounting for transactions concerning the brokerage’s trust account. The Rules set out the specific obligations on brokerages to ensure proper books and accounts are kept.

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Regulation 75/61, section 4.01 under the repealed Real Estate Act Regulations gave the following requirement:

Every person who applies for a licence under the Act . . . shall . . . have an appropriate knowledge of the books of account required in the operation of a real estate business.

Although this is no longer made explicit in the legislation, it should generally be assumed to still apply, as the requirements with respect to financial accounting on brokerages are equally extensive under the new Real Estate Services Act as they have ever been. Accordingly licensees should have a firm grasp of what is required of them under the new regulatory framework.

The discussion of accounting records will begin with a review of general business records.

Cash and Bank Records

As for any business, accurate and timely recording of all cash and banking transactions is a must. Depending on the size of the business operation, the records may range from simple handwritten accounts to a full scale computerized system. As a general rule, all cash and cheques received should be deposited in full and on a prompt basis. The deposit book is a useful starting point for any cash record. Take care to keep personal transactions completely divorced from your brokerage business. The brokerage bank accounts, therefore, should be reserved strictly for business purposes.

Expenditures on behalf of the brokerage should always be made by cheque. The paid cheques and the supporting invoices or statements provide a good record of the nature of the transaction and proof of its payment. Sometimes cash must be used to pay for incidental items; in this situation, you should still take care to keep receipts as a record of the payment. Many businesses find a petty cash fund useful for this purpose. The use of the fund should be limited to business purposes and not be seen as a convenient source of "pocket money."

A bookkeeper can readily prepare a summary of the banking transactions using a record known variously as a journal, cash book, synoptic, or book of original entry. No matter what form the record takes, the purpose is the same. The journal provides:

C a complete record of cash receipts and disbursements (cheques); C a breakdown of expenses paid for; C a way to keep a running record of the bank balance; and C a convenient summary for recording transactions in the accounts.

Payroll Records

Whenever a payroll is prepared, it is necessary to keep accurate records for both accounting and tax reporting purposes. A detailed record must be kept for each employee so that proper deductions for income tax, Canada Pension, and Employment Insurance may be made. The government publishes deduction tables to assist in making these calculations. Only when all the necessary deductions have been determined can the actual paycheque be prepared. The details of the cheques could be entered in the journal just described or kept in a separate payroll journal if the size of the business warrants it.

Payroll deductions are due to Canada Revenue Agency by the fifteenth of the following month and payment can be made directly at the bank. Each employer must obtain an account number from Canada Revenue Agency to facilitate this process. It is also necessary to report earnings and deductions for each employee for the calendar year on forms known as T-4s. The T-4 forms have to be completed by the end of February of the following year.

4.2 ©Copyright: 2011 by the UBC Real Estate Division Introduction to Financial Statements

General Ledgers and Financial Statements

From the banking and payroll records an accountant or bookkeeper can summarize the financial activities into general ledger accounts. The general ledger is the group of accounts used to keep a separate record for each item found in the financial statements. In other words, the general ledger contains an account for each asset, liability, owner equity, revenue, and expense. Subject to adjustments necessary to properly match revenues and expenses, it is possible to prepare the actual financial statements for the business from this information. Appendix 1 shows a suggested chart of accounts which could be used for a real estate brokerage.

Trust Accounts

Review Sections 25 to 30 of the Real Estate Services Act and the discussion of Trust Accounts in Chapter 2.

The obligations that these sections impose on the brokerage are easily complied with as long as all funds received are promptly deposited into the trust account and payments to the conveyancer or the brokerage itself are not made prematurely.

A separate record sheet for each client is required. This record should completely describe the nature of the property, the amount of funds received, the names of the parties involved, and the commissions payable on the transactions. Rule 8-1(2) of the Rules refers to the specific provisions.

At any time, the total of funds held in trust must always equal the total of the client accounts. This will be the case as long as all trust funds received and credited to a client are deposited in the trust account and all payments on behalf of a client are withdrawn from the trust bank account.

Examination of Records: Licence Applications

Several provisions in the Real Estate Services Act, Rules and Council Bylaws pertain to the records and accounts of a brokerage. Real estate brokers should be aware of the following sections.

C Section 86(2)(f) (and Rule 7-6) provides for the examination of books of a brokerage by the Real Estate Council without restriction and further prohibits the withholding of information.

C Section 37(3) provides for an inquiry or audit by the Council during which Council can enter the premises of the brokerage, inspect and copy files, as well as require licensees (or directors and shareholders of a real estate brokerage who are not licensees) to meet with investigators and answer inquiries.

C Section 38 allows the Council to apply to Court for an order to impound the books and records of a brokerage where there are reasonable grounds to believe a licensee has committed professional misconduct.

C Real Estate Council Bylaw 4-5(2) requires an application for a brokerage licence to be accompanied by a financial statement in a form approved by the Superintendent which has been verified by the statutory declaration of the proposed managing broker or a certificate issued by a chartered accountant or certified general accountant.

A real estate broker is therefore charged with the responsibility of keeping records in such a way that he or she can readily distinguish the brokerage's transactions from those transactions which affect his or her clients or other parties.

Each of these parties or separate financial units over which the brokerage exercises some degree of control must be accounted for as a separate entity. To conform with legal requirements as well as to measure the progress of each entity, separate records must be kept.

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Because these transactions (i.e., the exchange of assets, obligations, or services) involve dollar amounts, they are usually referred to as financial transactions. The way in which the accountant communicates this financial information is through the process of accounting. Accounting is the language of business and, like any other language, it has its own special vocabulary and its own special way of communicating information. Financial statements are an accountant's way of communicating.

Form and Content of Financial Statements

Accounting

Accounting is the systematic recording, reporting and analysis of financial transactions. It is the medium through which an entity records, summarizes, classifies and communicates its activities and transactions for a given period of time. This information is important as it aids in planning and controlling routine operations, making special decisions, and formulating overall policies and long-range plans.

Nature and Function of Financial Statements

Financial statements may be considered to be the end result of the recording, summarizing, and classifying of the accounting process. They represent the medium through which information about business transactions that occurred over a certain period of time (usually one year) are communicated to interested parties.

Financial statements provide quantitative information about a particular entity which is intended to be useful in making economic decisions. These economic decisions usually involve making rational choices among alternative courses of action. However, not all of the information that is needed will be contained in the financial statements.

Financial reporting should meet the following objectives:

C Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.

C Financial reporting should provide information to help present and potential investors, creditors, and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans.

C Financial reporting should provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners' equity), and the effects of transactions, events, and circumstances that change resources and claims on those resources.

Financial statements are compiled in accordance with Generally Accepted Accounting Principles, described below. In, Canada, the primary course of generally accepted accounting principles is the Accounting Handbook issued by the Canadian Institute of Chartered Accountants.

Generally Accepted Accounting Principles

To understand and interpret financial statements, familiarity with generally accepted accounting principles is important. Generally accepted accounting principles refer to the rules and guidelines followed in preparing financial statements and include the following principles.

With effect from January 1, 2011, there will be two different sets of generally accepted accounting principles in use in Canada. Public companies will be required to report in compliance with the International Financial Reporting Standards (IFRS). Private companies will be able to choose whether their financial statements will comply with the International Financial Reporting Standards or the Canadian Accounting Standards for Private Enterprises (ASPEs). Most private

4.4 ©Copyright: 2011 by the UBC Real Estate Division Introduction to Financial Statements

companies will elect to comply with the ASPEs which are less onerous because there will be insufficient benefit in compliance with IFRS to offset the higher costs incurred. This chapter assumes that the brokerage will elect to comply with the ASPEs.

Cost Principle

Commonly referred to as the historical cost principle, this principle holds that when a business enterprise acquires an asset, the asset's historical cost (the amount of consideration given up for the asset) is the appropriate amount to record in the financial statements of the enterprise. While this seems obvious, it should be pointed out that at times an enterprise may acquire an asset for an amount that is greater or less than the asset's fair market value on the date of the transaction. To conform to the cost principle, it is not appropriate to record the asset at what might be considered its fair market value; the asset should be record at what the enterprise paid for it.

Revenue Recognition Principle

Revenue is usually the amount received or receivable by an entity for the provision of goods or services. The revenue recognition principle holds that revenue should be recognized by an enterprise when it is earned, not necessarily when cash is received. This is referred to as the accrual basis of accounting as opposed to the cash basis. For example, under the accrual method of accounting, a real estate representative would record the commission earned from the sale of a house on their accounting records when the "subject clauses" were removed from the contract of purchase and sale, even though the money for the commission would not be received until the completion date. On the other hand, the cash basis would not allow the commission to be recorded until the cash was actually received. The accrual basis of accounting is more common and will be used throughout the chapter. Revenue then, is considered to be earned when title to goods has passed from the seller to the purchaser. In the case of a service enterprise, revenue is earned when the services are rendered.

Matching Principle

This principle holds that expenses directly associated with particular revenues should be recognized in the same period in which the revenue is recognized. Other expenses should be recognized in the period in which the goods or services are consumed. In other words, insurance costs covering a calendar year should be recognized each month and not all in the month in which the insurance begins or the month in which the premium is paid. Costs which benefit more than one month should, to the extent practical, be recognized over the period benefited by the costs. As with the revenue principle, the matching principle requires the accrual basis of accounting be used for maintaining records of the entity; that is, expenses are recorded when incurred, which is not necessarily when they are paid.

Materiality Principle

During the course of any year, expenses such as the purchase of stationery or cleaning supplies may be incurred which have a relatively low cost but are used up over a period of several months. The effort involved to allocate these costs over the several months that they are used would exceed any conceivable benefit achieved by such an allocation. In determining whether any allocation is significant enough to make, one should consider if it is likely to impact any decisions or judgements made by the users of the financial statements. If the cost is below that threshold, it should be expensed when the stationery or supplies are acquired and not spread over the months in which they are used. Conversely, where a large cost (such as insurance) is incurred which benefits the entire year, the cost should be allocated in accordance with the matching principle.

Objectivity Principle

The objectivity principle holds that all accounting information should be reported on objectively determined and verifiable data. This principle is closely aligned with the cost principle, in that the best way to determine objectivity in accounting transactions is the amount of consideration given up at the date of the transaction. If accounting information is recorded on a cost basis, this information could, if required, be certified by an independent party (such as an auditor, if an audit was performed).

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Consistency Principle

Accounting recognizes that alternatives exist in the recording of transactions, and in certain cases generally accepted accounting principles allow the same transaction to be recorded in more than one way.

The consistency principle holds that once a business enterprise adopts one generally accepted accounting principle from a number of alternatives, the enterprise should follow that principle in the ensuing years. This does not mean that a business enterprise is prohibited from changing from one generally accepted accounting principle to another that is more appropriate. However, if a business enterprise were to do this on a continuous basis, it would render the financial statements virtually meaningless since users would not be able to assess performance from one year to the next. Changes in accounting principles should be made only where the change will result in more relevant information being provided to the users of the financial statements.

Fiscal Year

All taxpayers compute their income and tax liability for taxation years. Individuals use the calendar year as their taxation year. Corporations report their income on the basis of a "fiscal period" that may be different from the calendar year. Self-employed individuals, partners and professional corporations must report their income on a calendar year basis.

Corporations may initially choose any fiscal period, but then must consistently report income for tax purposes on that basis. No taxation year may be longer than 53 weeks, and a change of year end may be made only with the approval of the Minister of National Revenue. There are certain circumstances where a corporation's taxation year may be deemed to end; for example, an amalgamation is deemed to cause the end of a taxation year.

Double-Entry Bookkeeping System

Accounting is concerned with the recording of business transactions. This requires the analysis of each individual economic event of a business which can be measured objectively in terms of dollars.

The double-entry bookkeeping system which underlies the accounting process recognizes the dual nature of each financial transaction – that is, each transaction affects at least two different financial statement items (accounts). The nature of the transaction must be examined in order to determine how it should be recorded. For example, the acquisition of an automobile (an asset) might either decrease another asset (cash), or increase a liability (bank loan payable).

This double-entry system gives rise to the accounting equation which is expressed as:

Assets = Liabilities + Owners' Equity

Assets are items of value that are owned by the entity, whereas liabilities represent the dollar value of the claims that creditors have over the entity. Owners' equity represents the amount of money that the owners have invested in the entity.

You should also note that the accounting equation is the basic formula for the balance sheet. The equation not only shows the different assets owned by the entity, but it also shows the proportional contribution of the assets by the creditors and owners. The balance sheet is discussed in detail in a later section.

Accounts

Accounts are the device used in a bookkeeping system to accumulate changes resulting from business transactions; therefore transactions affecting similar assets or liabilities will be summarized in one account. The way in which the two sides of offsetting transactions are recorded is through the use of two types of entries: debits and credits. Each transaction will be recorded by offsetting debit and credit entries in the accounts which are affected by the transaction. Debits are used to record increases in asset accounts, and decreases in liability accounts and owners' equity accounts. Credits are used to record decreases in asset accounts and increases in liability accounts and owners' equity accounts.

4.6 ©Copyright: 2011 by the UBC Real Estate Division Introduction to Financial Statements

In addition to asset accounts, liability accounts, and owners' equity accounts, there are also two other types of accounts: revenue accounts and expense accounts. Revenue accounts record the price of goods sold and services rendered to customers, while expense accounts record the cost of goods and services used. Increases in revenue accounts are recorded using credits, and increases in expense accounts are recorded using debits.

To summarize: Type of account Increases Decreases Assets Debits Credits Liabilities Credits Debits Owners' equity Credits Debits Revenues Credits Debits Expenses Debits Credits

Appendix 1 lists common examples of the different types of accounts used by real estate brokerages.

Review of Journalizing, Posting, and Trial Balancing

Journalizing

The first step in the accounting process is to record the economic event in a journal, referred to as journalizing. This journal entry designates, in the journal, the accounts that are affected by the economic event. Since the objective of this step is to record, in one place, the essence of each business transaction, the following elements must be entered into the journal:

C the date of the transaction (not the date of entry); C a source code (to enable the accountant to trace any entry back to the source transaction); C the names of the accounts affected; and C the amounts by which each account is increased or decreased.

Illustration 1

For example, two individuals form a partnership to buy houses and rent them. After an agreement is made as to the division of profits and responsibilities of each partner, the partners must then invest some of their own money or assets into the partnership. On January 1, 2010, Mr. Adams invests $80,000 cash and Mr. Brock invests $20,000 in cash as well as an office building which he paid $30,000 for in 1999, but as of January 1, 2010 had a fair market value of $60,000 (i.e., this is what the partnership would have had to pay for that particular office building on that date). It was estimated that the office building would last an additional 10 years and at the end of this period could be sold for $10,000 scrap value (salvage value). The journal entry to record this transaction on the books of the partnership would be:

January 1, 2010 Cash 100,000 Office building 60,000 Adam - capital 80,000 Brock - capital 80,000

Note that it is not necessary to include a heading, "debit", before cash and office building and a heading, "credit", before Adam ) capital and Brock ) capital. Accounts that are debited are listed first and are placed closest to the left column whereas the accounts that are credited are indented to the right. Notice also that the total dollar amount of the debits must always equal the total dollar amount of the credits.

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Adjusting Journal Entries

At the end of each accounting period it is necessary to prepare adjusting journal entries. The matching principle dictates that assets that benefit the enterprise for more than one accounting period may not be expended in one period (unless their cost is immaterial). Since an asset may have been purchased in a previous fiscal year, accountants must remember that, when compiling financial statements, an adjusting entry must be made to record the portion of expense applicable to the current period. For example, if a business enterprise purchases a two year insurance policy for $1,200 at the end of the first year, half or $600 would be expensed as the portion applicable to the current period.

Posting

As can be seen in the illustration just given, when there are numerous transactions it would be difficult to determine the amounts in each account by reference to the journal entries. The next step in the accounting process is to summarize all of the transactions which affect each individual account. This step is referred to as posting. The transactions are transferred from the journal into T-accounts. The T-account is a form of writing the account by placing the title of the account at the top, and drawing a vertical line beneath it in the form of a "T". Journal entries which are debits are recorded on the left hand side of the line, and journal entries which are credits are recorded on the right hand side of the line. Once all the journal entries have been posted to T-accounts, all of the transactions affecting any particular account are recorded together in one T-account. T-accounts display the same information which was recorded by date in the journal and reorganizes it to be presented by account.

Figure 1 Sample T-Account

Title of Account Debits are recorded Credits are recorded on this side on this side

To continue with the illustration, four different accounts are affected by the transaction of January 1, 2010. These are cash, office building, Adam ) capital, and Brock ) capital, shown in Figure 2.

Figure 2 Posting

Cash Adam - Capital

1/1/10 100,000 1/1/10 80,000

Office Buildings Brock - Capital

1/1/10 60,000 1/1/10 80,000

This transaction can also be used to show how the balance sheet equation works, as shown in Figure 3.

4.8 ©Copyright: 2011 by the UBC Real Estate Division Introduction to Financial Statements

Figure 3 Balance Sheet Equation

ASSETS = LIABILITIES + OWNERS' EQUITY 1/1/10 Cash $100,000 Adam - Capital $80,000 Office Bldg. 60,000 Brock - Capital 80,000 $160,000 $160,000

The office building is recorded at its fair market value as of January 1, 2010 (i.e., this is what the partnership would have had to pay for that particular office building on that date). From the point of view of the partnership, it is considered that the office building was acquired from Mr. Brock on January 1, 2010 for its fair market value. On December 31, 2010 if the partnership were to prepare financial statements, and on this date the fair market value of the office building is $100,000, it would not mean that the partnership could record the office building at $100,000. Nor does it mean that Mr. Brock's equity in the partnership has increased by $40,000. In essence, on January 1, 2010 Mr. Brock transferred his rights on the office building to the partnership.

Trial Balance

The posting step in the accounting process is followed by preparation of a trial balance. The purpose of preparing a trial balance is to isolate any errors that might have taken place in journalizing and posting and facilitate the preparation of financial statements. In the preparation of the trial balance, the sum of the debit column and the sum of the credit column of each T-account are calculated, and the lesser of these two sums is subtracted from the greater sum. The difference is the balance for that T-account at the end of the financial period. For example, if the sum of the debit column is greater than the sum of the credit column, then the sum of the credit column is subtracted from the sum of the debit column, and the account will have a debit balance. Similarly, if the sum of the credit column is greater than the sum of the debit column, the account will have a credit balance.

Once the balance is calculated for each account, the account names are listed in a trial balance, and their debit or credit balances are placed in the debit and credit columns respectively. Because of the offsetting nature of the journal entries, the sum of the debit column for all accounts in the trial balance must be equal to the sum of the credit column for all accounts. If the totals of the two columns are not equal, then there has been an error in either the journalizing or posting steps which must be corrected.

Illustration 2

The following detailed example itemizes the activities of the initial partnership over the fiscal year which ends December 31. Remember to consider the entry previously discussed in Illustration 1. Rather than including the date, numbers are used at the end of each transaction description so that you can follow the posting process more easily.

Transactions:

C On January 15, 2010 the partnership purchased office supplies of $800 on credit. At December 31, an inventory count revealed $250 of office supplies left (2) and (12).

C On January 18, they purchased a house and land in Coquitlam for $160,000. It was determined that the fair market value of the house was $120,000 and the lot was $80,000. The partnership was able to purchase the house at a reduced price because the vendors had already purchased another house in Surrey and were unable to keep up the mortgage payments on both houses. The partnership paid for this house by paying down $50,000 cash and taking out a mortgage of $110,000 at 12% per annum, compounded monthly and due January 18, 2023 (3).

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C It was estimated that the house would last 16 years more and at the end of this time would have no scrap value.

C On January 30, the supplies purchased on credit were paid for (4).

C On February 1, the house was rented to Harvey Treefall for $1,500 per month. Terms of the lease were that $500 had to be paid as security deposit with each month's rent payable on the first of each month. Mr. Treefall paid $2,000 in cash for the month of February (5).

C Throughout 2010, Mr. Treefall paid his rent on time except for the months of November and December because he was laid off and was unable to meet his rental payments. Mr. Treefall was a good tenant and the partnership felt that he would be able to find employment in January 2011 when the economy improved (11).

C Utilities expenses for the year on the office building amount to $3,500 which was paid for in cash (6).

C During the year the partnership found it necessary to hire some part-time employees for a total of $12,000. As of December 31, $2,000 of this was not yet paid to the employees (7).

C On February 1, the partnership took out a three year insurance policy on the office building for $3,600. This amount was paid on February 1 (8).

C Property taxes for 2010 on the office building and the rental property amounted to a total of $2,400 of which $2,000 was paid on June 30 and $400 was still unpaid at December 31 (9).

C Interest expense for the year on the mortgage amounted to $12,100. A total of $13,000 was paid to the mortgage company during 2005 (10). In 2010, it was estimated that $3,000 would be paid off the principal of the mortgage. All amounts were paid on time to the mortgage company during 2010.

Illustration of Journalizing

The journal entries to record the above transactions follow.

(1) Cash 100,000 Office Building 60,000 Adam - capital 80,000 Brock - capital 80,000

(2) Office Supplies 800 Accounts Payable 800

(3) Rental property - house 96,000 Land 64,000 Cash 50,000 Mortgage 110,000

In this entry the total cost of the house and land is $160,000, which is less than its fair market value (FMV). In order to comply with the cost and objectivity principles, the house and land must be recorded at cost to the partnership. There is no breakdown of how much of the cost is attributable to the land and how much is attributable to the house. Since the FMV of the house and land are known, these amounts are used to allocate the partnership's cost. The FMV of the house is 60% of the total FMV of both the house and land; therefore, 60% of the total cost is allocated to the house (60% of

4.10 ©Copyright: 2011 by the UBC Real Estate Division Introduction to Financial Statements

$160,000 = $96,000). The FMV of the land is 40% of the total FMV and $64,000 (40% of $160,000) would be allocated to the land.

It is necessary to separate the house and land since the house is depreciable and the land is not. Depreciation can be taken only on the house ) not on the land.

(4) Accounts Payable 800 Cash 800

(5) Cash 2,000 Rental revenue 1,500 Security deposit 500

(6) Utilities expense 3,500 Cash 3,500

(7) Wages expense 12,000 Cash 10,000 Wages payable 2,000

The employees rendered service to the partnership in 2010 in the amount of $12,000. Although only $10,000 was paid in cash as at the end of the fiscal year, the 2010 wages expense is $12,000 and not $10,000 (in accordance with the matching principle which is based on the accrual basis of accounting).

(8) Prepaid insurance 3,600 Cash 3,600

This amount, like Entry (2), is put into an asset account, not an expense account. An adjusting entry will have to be made at the end of the fiscal year to record the amount that has been consumed during 2010 (in accordance with the matching principle).

(9) Property tax expense 2,400 Cash 2,000 Property taxes payable 400

Similar to entry (7)

(10) Interest expense 12,100 Mortgage payable 900 Cash 13,000

(11) Cash 12,000 Rental revenue 12,000

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In practice, Entries (6), (7), (10), and (11) would not be made in the manner illustrated, since these transactions took place over the year, and an entry would be made each month. The method used was adopted solely in the interests of simplification.

In Entries (5) and (11), remember that Mr. Treefall has paid only nine months' rent in 2010 and he should have paid eleven months'. This entry records $12,000 (eight months' rent from March to October). Entry (5) records rent received from Mr. Treefall for the first month of his tenancy ) February.

Illustration of Adjusting Entries

(12) Office supplies expense 550 Office supplies 550

In Entry (2), when the office supplies were purchased, an asset account was debited. At the end of the year the inventory revealed that $550 worth of the supplies were used ($800 purchased less $250 left at the end of the year); thus an adjusting entry must be made to record this.

(13) Rent receivable 3,000 Rental revenue 3,000

This entry records rent earned by the partnership for November and December but not yet paid for by Mr. Treefall. It is necessary to conform to the revenue principle as well as the accrual basis of accounting.

(14) Insurance expense 1,100 Prepaid insurance 1,100

When the insurance policy was paid on February 1, it was for a three year term. Each 12 months the insurance expense used up would be $1,200 (one-third of $3,600). However, in 2010 only 11 months have elapsed since the purchase of the insurance policy; therefore, it is appropriate to record as an expense only 11/12 of the annual amount.

(15) Depreciation expense 10,500 Accumulated depreciation: Office building 5,000 Accumulated depreciation: Rental property 5,500

Depreciation can be calculated several ways. However, this discussion will focus on the straight line method.

Under the straight line method, an estimate is made at the time an asset is purchased (its acquisition date) of how many years the asset will be of economic benefit to the enterprise (the asset's economic life). In other words, for how many years will the asset be beneficial to the enterprise in contributing to revenue? An estimate is also made for the amount that can be realized from the sale of the asset at the end of its useful life (referred to as the salvage value of the asset). Since the enterprise may expect to recover some of the cost of the asset when it is resold, it would be illogical to expense all of the original cost of the asset since not all of its cost will be consumed by the business enterprise. The economic

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life of a building is determined through consultation with experts who can estimate how long a building will last, considering the use to which it is put.

The depreciation expense is then computed by subtracting the estimated salvage value from the cost of the asset and dividing the remaining amount by the estimated number of years the asset will be of use. (Note that it is possible for the estimated salvage value to be zero.) This figure will be the amount of depreciation expense that will be recorded each year as long as the asset is being used to generate revenues.

For this example, the office building's depreciation is arrived at in the following manner:

Original Cost & Salvage Value = Yearly Depreciation Estimated Life

60,000 & 10,000 = $ 5,000 per year 10 years

For the rental property, depreciation expense is calculated as follows:

Original Cost & Salvage Value = Yearly Depreciation Estimated Life

96,000 & 0 = $ 6,000 per year 16 years

However, the rental property was only put to use to generate revenues for 11 months in 2010; thus, 11/12 × $6,000 = $5,500, the depreciation expense recorded for 2010.

The Accumulated Depreciation account which is used in the above journal entry to record the depreciation of an asset is a separate type of account, known as a contra asset account. This accumulated depreciation contra account is shown separately on the financial statements and serves to offset its related asset account (refer to Figure 7). By using a contra account, decreases in the book value of an asset due to depreciation can be accumulated with credit entries, and the credit balance in this account will show the total amount of depreciation in the asset to date. The reason for accumulating depreciation separately in a contra account rather than deducting it directly from the asset account is that doing this allows users to identify the original book value of the asset and the cumulative amount of depreciation claimed with respect to that asset.

Illustration of Posting

Figure 4 illustrates the posting of the above entries into T-accounts.

Illustration of Trial Balance

After the entries have been posted, a trial balance is taken. Each account will first be totalled as illustrated in Figure 4 and then a trial balance will be prepared as shown in Figure 5.

From the trial balance, the financial statements: balance sheet, income statement, and statement of changes in financial position can be prepared. The first two are discussed in this chapter; the final statement is discussed in the next chapter.

4.13 ©Copyright: 2011 by the UBC Real Estate Division Chapter 4

Figure 4 Posting of Entries

4.14 ©Copyright: 2011 by the UBC Real Estate Division Introduction to Financial Statements

Figure 5 Adam and Brock Partnership Trial Balance As at December 31, 2010

DEBIT CREDIT

Cash $ 31,100 $ Office supplies 250 Office building 60,000 accumulated depreciation 5,000 Rental property 96,000 accumulated depreciation 5,500 Accounts payable 0 Rent receivable 3,000 Mortgage payable 109,100 Land 64,000 Security deposit 500 Wages payable 2,000 Property taxes payable 400 Prepaid insurance 2,500 Adam - capital 80,000 Brock - capital 80,000 Utilities expense 3,500 Wages expense 12,000 Interest expense 12,100 Depreciation expense 10,500 Insurance expense 1,100 Property tax expense 2,400 Office supplies expense 550 Rental revenue 16,500 $ 299,000 $ 299,000

The Financial Statements

Information about business transactions is communicated to external users through the medium of three financial statements. The financial statements are the:

C income statement; C balance sheet (or statement of financial position); and C statement of cash flows.

The format of these statements is slightly different depending on the type of business enterprise. Some of these differences include the following:

C The income statement of a partnership and proprietorship would not contain an expense account called income tax expense, whereas it would be included in a corporation's income statement. C The owners' equity accounts of a sole proprietorship and partnership would be placed in one account on the balance sheet; the account name would be the name of the proprietor or each partner. In a corporation, the owners' equity accounts are split into two separate accounts: the share capital account and the retained earnings account.

The Operating Statement (Revenue or Income Statement)

The Operating Statement is a listing of the revenue and expenses of an entity enterprise for a particular period of time, usually one year. This is different from the Balance Sheet, which shows the assets, liabilities, and owners' equity at a particular date. The operating statement may be for any period of time ) for one month, a quarter, six months, or a year. It would not usually be drawn up for a period exceeding one year. The operating statement can be seen as a motion picture covering a period of time. The general format of the operating statement is:

Revenue ! Expenses = Surplus (or Deficit)

Fiscal Year

Financial statements are compiled for a business enterprise at least once a year on the enterprise's fiscal year end. This fiscal year is a period of twelve months chosen by the business as the accounting period. It is not necessary that the fiscal year end be the calendar year end. All business enterprises are free to choose whatever date they wish, but once specified, cannot change it at will.

Income Statement: Revenue and Expenses

Expenses may be defined as the cost of assets consumed in order to produce revenue. When the total revenues for a particular period exceed the total expenses from that period, the difference is referred to as net income. When the reverse is true (total expenses for the period are greater than total revenues for that period) the difference is referred to as net loss.

The amount of the net income or net loss is closed off to the owners' equity account in the balance sheet. In the case of a proprietorship, net income would increase the capital account of the proprietor or partners whereas a net loss would reduce these accounts. In a corporation, the net income or net loss is closed off to the retained earnings account. This then serves as the connecting link between the income statement and the balance sheet. For example if, at the start of the period, the owners' equity account contained $100,000 and the enterprise suffered a loss of $15,000, the owners' equity account would now contain $85,000. If instead of a loss of $15,000 there was net income of $15,000, the owners' equity account would then be $115,000.

Some of the more common types of revenue include the following.

C Sales revenue is revenue realized from the sale of goods. C Service revenue is revenue realized from the rendering of services such as the services rendered by a physician or accountant. C Interest revenue is revenue realized from lending money or placing money in a bank account. C Rental revenue is revenue realized from the renting or leasing of space the business owns.

Some of the more common types of expenses include the following:

C Cost of Goods Sold: In a business enterprise that derives its revenue through the sale of goods, the cost of goods sold would include the cost to the enterprise of purchasing or manufacturing the goods offered for sale. This type of account would not be present in a service enterprise.

This amount is calculated by a simple formula:

Beginning Inventory + Purchases ! Ending Inventory = Cost of Goods Sold (COGS)

When a business enterprise acquires goods for resale it does not expense them until they are actually sold. To treat the cost of these goods as an expense to the enterprise before they are sold would violate the matching principle. Hence, the cost of goods sold account is necessary in order to determine what the cost of the enterprise's revenues is for a given period of time.

C Interest expense is the cost of using borrowed money.

C Depreciation expense is the method used to allocate the cost of assets over a period of time.

Figure 6 illustrates the Income Statement for Adam and Brock Partnership.

Figure 6 Adam and Brock Partnership Income Statement As at December 31, 2010

Rental revenue $ 16,500 Expenses: Utilities $ 3,500 Wages 12,000 Interest 12,100 Depreciation 10,500 Insurance 1,100 Property Taxes 2,400 Office supplies 550 42,150 Net Income (loss) ($ 25,650)

The Balance Sheet (or Statement of Financial Position)

A balance sheet (also known as the statement of financial position or the statement of assets and liabilities) is a listing of the assets, liabilities, and owners' equity of a business enterprise at a specific date. It is analogous to the listing of an inventory at a specific time.

On one hand, the balance sheet shows the assets of the enterprise ) the items of value owned by the enterprise ) and, on the other hand, it shows how these assets have been financed. An entity acquires assets either by borrowing the money from creditors (debt financing) or by using the money provided by the owners for the enterprise (equity). Therefore, there are two sources of financing for the acquisition of assets – creditors and owners. The liabilities of an entity are the items of value owed by the enterprise. The liabilities represent the equity that the creditors have in the enterprise, whereas owners’ equity is, as the name implies, the equity that the owners have in the entity. It follows then, that the total of the assets of an entity must equal a total of its sources of capital.

As you have learned, the relationship between these three elements is expressed by the balance sheet equation:

Assets = Liabilities + Owners' Equity

Another way of looking at the balance sheet is to think that when a business acquires assets, it does so either by borrowing the money from creditors or by using the money provided by the owners of the enterprise. Therefore, there are two sources of financing assets: creditors and owners. It follows, then, that the total of the assets of a business enterprise must equal the total of its sources of capital.

Balance Sheet Classifications

Apart from a listing of the assets, liabilities, and owners' equity in the balance sheet, accountants also attempt to classify assets and liabilities.

Current Assets: Current assets are those assets that will either be converted into cash, sold, or consumed within one year or the normal operating cycle of the business, whichever is longer. Current assets are listed in order of liquidity (the items that are most readily converted into cash would be listed first). Examples of current assets include cash, marketable securities, accounts receivable, rent receivable, inventories, and prepaid expenses.

C Marketable securities are temporary investments of a business enterprise in the securities of another entity. In order for this type of investment to be classified as a current asset, it must meet two criteria: - the investment must be readily convertible into cash; and - management must not intend to keep the investment for more than one year. If the market value of temporary investments is readily available (as, for example, would be the case if the investment was traded on an exchange), the investment should be revalued to market value each time that financial statements are prepared with the revaluation gain or loss being treated as revenue or expense.

C Accounts receivable are amounts due from customers for the sale of goods or rendering of services for which cash has not been received.

C Inventories include items that are held for resale to customers and supplies used in the business.

C Prepaid expenses represent services or rights to services for which cash has been paid but the services have not yet been consumed.

Non-Current (Fixed) Assets: Non-current assets are those that will not be sold or consumed within one year or the normal operating cycle of the business. These include investments that management has no intention of selling within a year as well as property, plant, and equipment.

The assets included under the caption property, plant, and equipment are those assets from which benefit or use can be derived over more than one accounting period. Because the benefits from these assets last more than one accounting period, the matching principle dictates that we cannot charge off in one year the cost of these assets. We must allocate the cost of these assets over the period they will benefit the firm. This allocation is accomplished by recording the depreciation adjusting entry.

A point of caution is required here for those who have had some experience with the tax system of depreciation, known as capital cost allowance. While the subject of income tax is covered in another chapter, it is important to realize that the Income Tax Act only governs how a tax return is computed. It does not dictate what method or amount of depreciation is to be recorded in the accounting records.

Current Liabilities: Current liabilities are those liabilities that the enterprise expects to pay off within a year. Examples of current liabilities would include accounts payable, tenants' deposits, interest payable, property taxes payable, wages payable, and income taxes payable.

C Accounts payable represent amounts owed by the business enterprise to suppliers of goods and/or services which have already been received but not yet paid for in cash.

C Property taxes payable are those taxes which have accrued but have not yet been paid in cash.

C Wages payable are wages owed to employees. Employees are not usually paid in advance. Usually businesses retain employees' wages until after a two week period of work has been done. These wages, for which an employee has rendered service but has not yet been paid, will fall under this category.

C As mentioned, income taxes payable would not be present on the financial statements of a partnership or proprietorship but would appear on the financial statements of a corporation. They represent the amount of income taxes owed.

C Tenants' deposits are amounts paid in advance by the tenants for security purposes. They represent a liability in the hands of the landlord since cash has been received for service not yet rendered.

Noncurrent (Long-term) Liabilities: Noncurrent liabilities are those liabilities that are not expected to be paid within one year. The most common of these from a borrower's viewpoint would be mortgages payable ) the amount still owing on the principal of the mortgage. It is important to note that the amount of the principal owing on the mortgage for the following year is deducted from the noncurrent liabilities and is included in current liabilities. Also note that in the Adam and Brock example, no adjusting journal entry was necessary to reflect the allocation of $3,000 from long term mortgage payable to the current portion of mortgage payable. This is an internal allocation, and will only appear on the balance sheet.

Differences in Accounts of Various Types of Business Enterprises

As mentioned earlier, there are slight differences in the wording of the different types of accounts used by the three different forms of business organization. Regardless of the type of business organization, assets and liabilities would be the same.

However, differences as to the type of account take place in the owners' equity section. In a proprietorship, the equity section would usually be entitled Joe Forsey ) capital. This account would reflect all of the investments made by the owner in the business, profits, and withdrawals.

For a partnership, the equity section would retain a capital account for each of the partners and, as for the proprietorship, investments, profits, and withdrawals made by each partner would be reflected in his or her capital account. In the case of a corporation, the owners' equity is also referred to as shareholders' equity. In the shareholders' equity section there are two major classifications. The first is referred to as share capital and represents the investment made by all of the shareholders of the corporation. The second part is known as retained earnings and represents the accumulation of net income of the corporation from the time of its inception, less any withdrawals paid to the shareholders in the form of dividends.

Figure 7 illustrates the Balance Sheet for Adam and Brock Partnership.

Reference to Figures 5 and 6 is required in order to construct a balance sheet for Adam and Brock Partnership. All items, except owners' equity, are transferred from Figure 5 onto the balance sheet (Figure 7). For a partnership, owners' equity (referred to as owners' capital) is the sum of all capital invested in the property plus net income minus net losses minus cash withdrawals. Because this is an equal partnership, the net loss of $25,650 (see Figure 6) is shared equally. Thus, each partner's original capital of $80,000 is reduced by half of $25,650, or $12,825, resulting in capital for each partner of $67,175 (80,000 ! 12,825).

Figure 7 Adam and Brock Partnership Balance Sheet As at December 31, 2010

ASSETS

Current assets: Cash $ 31,100 Rent receivable 3,000 Prepaid insurance 2,500 Office supplies 250 Total current assets $ 36,850

Noncurrent Assets Office building $ 60,000 ! less accumulated depreciation 5,000 55,000

Rental property 96,000 ! less accumulated depreciation 5,500 90,500 Land 64,000 Total Noncurrent Assets 209,500 Total Assets $ 246,350

LIABILITIES AND OWNERS' EQUITY

Current Liabilities: Wages payable $ 2,000 Security deposit 500 Property taxes payable 400 Current portion of mortgage payable 3,000 Total Current Liabilities $ 5,900

Noncurrent Liabilities: Mortgage payable $ 109,100 ! less current portion 3,000 Total Noncurrent Liabilities 106,100 Total Liabilities $ 112,000

Owners' Equity: Adam - capital $ 67,175 Brock - capital 67,175 134,350

Total Liabilities and Owners' Equity $ 246,350

Comparative Financial Statements

When you look at the annual reports of corporations, you will notice that more than one set of financial statements is presented. These are referred to as comparative financial statements.

The accounting profession feels that the presentation of comparative financial statements enhances the usefulness of the statements and brings out more clearly the nature and trends of current changes affecting the enterprise. What this type of presentation emphasizes is the fact that statements for a series of periods are far more significant than those for a single period and that the accounts for one period are only an installment in what is essentially a continuous history.

As you deal with the analysis of financial statements in the next chapter, you will see how it would be virtually impossible to analyze financial statements if only one period were presented.

Explanatory Notes and Comments

Most sets of published financial statements include explanatory notes. These notes are an integral part of the financial statements, whose purpose is to add clarity to the information conveyed. The notes indicate the actual accounting methods used by the entity and disclose additional information to that which is presented in the three principal statements. A careful reading of the notes which are appended to the financial statements is necessary to obtain an understanding of what is contained in the statements.

Limitations of Financial Statements

Reference was made earlier to the fact that the financial statements do not contain all of the information that is required for users to make decisions. In addition to this, there are other limitations of financial statements:

C They are primarily quantitative in nature. C They are limited to individual business enterprises. C Some of the information contained in them is founded on estimates; for example, depreciation expense. C They are limited to past transactions; they report on what has already taken place; C They do not generally include increases in the market value of assets.

Conclusion

In this chapter we have introduced a number of accounting concepts and terms necessary for the proper interpretation and use of financial statements. While no detailed explanation of the accounting process has been given, most users of financial statements can manage without extensive exposure to these procedures. The next chapter discusses cash budgeting and the various methods used to analyze and interpret financial statements. It also provides information on accounting and bookkeeping software packages.

APPENDIX 1 Chart of Accounts (for a Corporation)

Balance Sheet Accounts 101 to 199 Asset Accounts 300 to 399 Owners' Equity Accounts 101 General Bank Account 310 Common Stock 104 Savings Account 330 Retained Earnings 107 Trust Account 340 Dividends 110 Temporary Investments 350 Income Summary 114 Accounts Receivable 117 Interest Receivable Income Statement Accounts 120 Notes Receivable 124 Representatives' Receivable 400 to 499 Revenue Accounts 128 Prepaid Advertising 410 Residential Commissions 130 Prepaid Insurance 420 Commercial Commissions 132 Prepaid Rent 430 Referral Revenue 140 Supplies Inventory 470 Appraisal Revenue 145 Land 475 Miscellaneous 150 Building 480 Interest 151 Accumulated Depreciation - Building 155 Automobiles 500 to 599 Expense Accounts 156 Accumulated Depreciation - Automobiles 510 Commissions - Representatives 160 Furniture & Fixtures 515 Commissions - Other Brokers 161 Accumulated Depreciation - Furniture 520 M.L.S. Fees & Fixtures 525 Referral fees 165 Leasehold Improvements 530 Service fees 166 Accumulated Amortization - Leasehold 535 Advertising Improvements 540 Equipment Rental 170 Franchise 550 Recruiting 171 Accumulated Amortization - Franchise 555 Promotions 175 Goodwill 560 Interest 176 Accumulated Amortization - Goodwill 565 Maintenance 570 Office Supplies 200 to 299 Liability Accounts 575 Property Taxes 201 Bank Loans 580 Salaries & Wages 210 Business Improvement Loans 585 Telephone 215 Accounts Payable 590 Gas & Oil - Automobiles 220 Interest Payable 595 Repair - Automobiles 225 Salaries Payable 597 Utilities 230 Employees' Withholding Payable 599 Income Taxes 235 Client Trust Liability 240 Commissions Payable 245 M.L.S. Payable 250 Other Brokers' Payable 255 Bonus Payable 260 Utilities Payable 265 Property Taxes Payable 270 Income Taxes Payable - Company

Account numbers can be used to objectively identify accounts in order to avoid confusion between accounts with similar names. Accounts are numbered within ranges to identify their types. For example, asset accounts are all numbered between 101 to 199 above. Note that this is not an exhaustive list.