Section 2.1: Financial Position
Perhaps the most important objective of accounting is to determine the financial position (equity / capital / worth / value) of an individual or business on a particular date.
How do we do this for an individual like yourself?
1. List all of the things that you own with a dollar value (assets)
2. List all of your debts or monies owed to others (liabilities)
3. Subtract your total liabilities from your total assets. This difference is called your net worth or net value (equity)
(In other words, 'financial position' is just another term for equity or worth or value.)
The same three steps above can be used to calculate the financial position of a business on a particular date.
So now we know that total assets minus total liabilities equals owner’s equity for a business. And because this equation is absolutely essential to an understanding of this course, this equation is known as the fundamental accounting equation.
Assets - Liabilities = Owner’s Equity (A - L = OE)
And if we add "L" to both sides of the equation above, the fundamental accounting equation may also be written as:
Assets = Liabilities + Owner’s Equity (A = L + OE)
Assets, Liabilities and Owner’s Equity can all be found on a financial statement known as a Balance Sheet, or Statement of Financial Position under International Financial Reporting Standards (IFRS) which are now in use in Canada.
A balance sheet is used to calculate the net worth or net value or equity or capital of an individual or business on a particular date.
Section 2.2: Balance Sheet
The financial position of a business refers to the net worth or net value or owner's equity or capital of that business at a specific point in time.
The formal method of presenting the financial position of a business is by means of a financial statement known as a balance sheet.
For the record, grade 11 chapter two balance sheets are formally known as account form balance sheets which means that the assets are placed on the left side of the document while the liabilities and owner's equity are placed on the right side of the document. Later in the course you will learn about report-form (or top to bottom) balance sheets which are much more common in business today.
A balance sheet shows the financial position (A = L + OE) of an individual or business on a particular date.
A business balance sheet lists all of the asset and liability and equity accounts of that firm and their balances (current dollar value) on a particular date. It is analogous to taking a picture of that business at a given point in time.
Please note that the personal assets and liabilities of the business owner do not belong on the business's balance sheet (see Business Entity Concept below under GAAP). For example, the owner’s personal vehicle and personal bank loan should not appear on the balance sheet of the owner’s business.
And please note that for the sake of ease and convenience, we will mostly be looking at the balance sheets of service-based sole proprietorships during the first few months of this course.
The individual items seen on financial statements such as balance sheets and income statements are known as accounts.
Accordingly, most businesses have several asset accounts (e.g., Bank Balance, Accounts Receivable, Equipment) and several liability accounts (e.g., Bank Loan, Accounts Payable). Sole proprietorships will only have one equity account though, which is the owner’s name followed by the term Capital (e.g., B. Pitt, Capital). Capital is just another term for equity or worth or value.
Accounts Receivable (Asset) - When customers of our business buy goods or services from us, they often buy them with the understanding that they will not have to pay for them until a later date, known as buying/selling 'on credit' or 'on account'. This debt to our business is considered an asset because it represents money that is owed to our firm. (The assumption made in this class is that all debts owing to another individual or business will eventually be paid.) These debts are included on the balance sheet under an asset account known as Accounts Receivable.
A person or company (likely a customer/client) who owes money to our business is known as a debtor.
Accounts Payable (Liability) - When a business purchases necessary items from one of its suppliers/vendors, it often buys them with the understanding that it will not have to pay for them until a later date, once again known as buying/selling 'on credit' or 'on account'. These purchases represent a debt of the business that must eventually be paid. As such, they are included in a liability account on the balance sheet known as Accounts Payable.
A person or company (likely a supplier/vendor or bank) to whom our business owes money is known as a creditor.
Individual and Commercial Debtors and Creditors under A/R and A/P - Individual debtor customers under Accounts Receivable and individual creditor suppliers under Accounts Payable are usually listed in alphabetical order based on their last names, e.g., B. Gold.
For commercial debtors and creditors though, the first name of the company is used to determine alphabetical order, e.g., Hughes Dry Goods.
Ordering of Assets on Balance Sheet - Liquidity of Assets (Convertibility to Cash or Permanence)
Assets are always listed in order of liquidity on the balance sheet.
Liquidity most often refers to the relative ease and speed with which assets can be converted into cash.
The most liquid assets come first, while less liquid assets come later.
Of course, Cash on Hand and Bank Balance are already in their most liquid forms, while liquidity in relation to Accounts Receivable refers to how quickly such debts will be collected in full from our debtor customers, which is typically 30 days or less.
As for non-monetary assets, liquidity means the relative ease and speed with which such assets can be sold on the open market at or near their fair market value and thereby converted into cash.
(That said, non-monetary assets like Equipment and Building will likely never have to be converted into cash unless the business runs into financial difficulty and is forced to sell off, or liquidate, those long-term assets in order to satisfy the claims of its creditors.)
Alternatively, another way of examining the liquidity of assets on the balance sheet is by way of permanence, or the order in which they will be used up or consumed - those likely to be used up most quickly come first while those likely to last a long time come later. You may notice, however, that listing assets in the order in which they will be used up will likely result in the same ordering of assets as when assets are listed in order of their convertibility to cash.
Liquidity of Assets Exercise
List the following assets in order of liquidity, beginning with the most liquid assets first.
Office Supplies (4)
Accounts Receivable (3)
Land (8)
Building (9)
Equipment (7)
Bank Balance (2)
Cash on Hand (1)
Furniture (6)
Automobile (5)
Ordering of Liabilities on Balance Sheet - Due Date of Liabilities
On the other hand, liabilities are always listed on the balance sheet in the order in which they are due and payable. The earliest due dates come first while the later due dates follow afterwards. In the absence of specific due dates however, common sense must dictate the order in which liabilities are listed on the balance sheet.
Due Date of Liabilities Exercise
List the following liabilities in the order in which they will likely become due and payable, beginning with the earliest due date first.
Mortgage Payable (3)
Accounts Payable (1)
Bank Loan (2)
Summary of Balance Sheet Formatting Rules
When preparing a balance sheet (i) by hand with paper and pencil or (ii) using computerized spreadsheets, please pay particular attention to the following formatting rules:
1. Proper accounting paper (columnar paper) or computerized spreadsheets (MS Excel or Google Sheets) must be used
2. The balance sheet heading is always centred on the top three lines in the following order - who (name of business), what (name of financial statement) and when (date of preparation of balance sheet including month, date and year only)
3. Subheadings (Assets, Liabilities, Owner’s Equity) are underlined and placed on the left margin above the account names
4. Asset accounts are listed in order of liquidity or permanence (see above) directly below the Assets subheading
5. Liability accounts are listed directly below the Liabilities subheading in the order in which they must be paid (due date) unless no due dates are provided, in which case common sense must prevail (AP, BL, MP)
6. Both individual and commercial debtor customers and creditor suppliers are indented and listed alphabetically (individual - last name; company - first name) after dashes under either Accounts Receivable (debtor customers) or Accounts Payable (creditor suppliers) - names of individuals are usually written with first initial and last name, e.g. T. Williams
7. With respect to equity accounts, the sole proprietor’s first initial and last name followed by a comma and “Capital” are always listed directly below the Owner’s Equity subheading, e.g., B. Goldkind, Capital
8. If a column of figures is to be added or subtracted, place a single line below those numbers
9. Figures for Total Assets and Total Liabilities and Equity are double underlined and must appear in the same row at the very bottom of the balance sheet on the left or right side respectively - please note that the single line above and double line below these two figures must remain "closed" (sandwich rule)
10. Typical hand-prepared or computerized balance sheets usually contain five dollar signs (first asset, first liability, three totals)
11. Abbreviations or acronyms should never be used unless the name of a business already contains one, e.g., Apple Inc.
12. Do not use decimals or commas when recording dollar figures on columnar paper, although decimals and commas may be used with computerized spreadsheets where appropriate
13. All lines must be drawn with a ruler on paper and pencil balance sheets and all terms must be written neatly
14. All terms should be capitalized on the balance sheet with some minor exceptions (and, or, etc.)
15. Use a pencil (and not a pen) when preparing financial statements on paper to allow for easy corrections
16. There must be at least one space between the Total Liabilities line and the beginning of the Owner’s Equity section
17. "Total Liabilities" actually appears twice on the right side of the balance sheet - once as Total Liabilities and once as a component of Total Liabilities and Equity
18. A single dash or double zero in the far right money column indicates zero cents and please be consistent in your choice of method although your teacher prefers dashes, but please note that cents are typically not displayed on computerized financial statements
19. Always use the precise names of the various asset, liability and equity accounts provided by your teacher and keep in mind that balance sheet formatting rules are particular to the specific course or textbook or company or teacher under study - in any event, always be consistent in your formatting throughout your document
For a terrific example of a Chapter 2, grade 11 accounting balance sheet, check out the following pdf: ch 2 balance sheet example.pdf
Section 2.3: Who Really Owns the Business - Claims Against the Business Assets
Legally the assets of the business belong to the business itself. But ultimately, who really owns the assets of the business? Is it the owners of the business? Or is it the creditors of the business - the suppliers and banks who provided money to the owners in order to purchase those assets in the first place? The answer to that question is that technically both the owners of the business and the creditors of the business have a claim against the assets of the business - at least from a commercial and/or accounting point of view.
The liabilities section of the balance sheet represents the creditors’ claims against the assets of the business because the creditors (those businesses and individuals to whom the business owes money) will eventually be paid or repaid from the assets of the firm.
Meanwhile, the equity section of the balance sheet represents the owners' claims against the assets of the business.
And if the business closes down operations, who do the assets belong to in that scenario? The answer is simple: The commercial laws of Ontario clearly state that it is the creditors of the business who must always be paid first before the owners can take anything out of a failed commercial enterprise.
Upon dissolution (termination) of the company, the assets must eventually be liquidated (sold, and usually at a loss) and the proceeds of sale (money from the sale of assets) will first be distributed to the creditors, both secured and unsecured. If any money is remaining after the creditors have been paid in full, the remaining funds will then be distributed to the owners. Of course, if the proceeds of sale upon liquidation fail to fully satisfy the claims of the creditors, those creditors will likely bring a lawsuit against the owners of the business to recover any monies still outstanding.
As you have just learned, the process of selling off the assets of a failed business in order to generate as much cash as possible so as to satisfy the claims of the company's creditors is known as liquidation.
Section 2.4: GAAP & IFRS & ASPE
All accountants must adhere to a specific set of rules and procedures when performing their duties.
In Canada these procedures were once known as GAAPs, or Generally Accepted Accounting Principles.
However in this country GAAPs have recently been replaced by IFRS, or International Financial Reporting Standards for public companies (public corporations, financial institutions, etc.) and ASPE, or Accounting Standards for Private Enterprises for private companies (sole proprietorships, partnerships, private corporations, etc.)
That said, most of the former Canadian GAAPs are actually fairly similar to the newer IFRS and ASPE in both tone and substance and so we can still learn from an examination of those older rules.
Four of the more important historical Canadian GAAPs appear below:
1. Business Entity Concept - The accounting for a business should be kept separate and apart from the personal accounting of the business owner and/or the accounting of any other business. In other words, the personal assets and liabilities of the owner should never be included on the balance sheet of his/her business or on the balance sheet of any other business belonging to him/her.
2. Cost Principle - Assets should always be listed on the balance sheet at their original cost or purchase price, i.e., the price paid to purchase those assets in the first place. (For now, we will ignore issues of long-term asset depreciation .)
3. Principle of Conservatism - Accounting for a business should always be truthful and accurate and should never deliberately overstate or understate equity (A - L = OE) or net income (R - E = NI).
4. Going Concern Concept - One should always assume that a business will continue to operate indefinitely (forever) unless clear evidence exists to the contrary, e.g., commencement of bankruptcy proceedings. (This assumption allows businesses to list their asset values at their original purchase prices - or current market values - as opposed to their much lower liquidation values.)
As previously stated, please note that most Canadian companies have already switched from GAAP to IFRS or ASPE.
An excellent summary of IFRS and ASPE prepared by a University of Toronto professor can be found here and here.
Additional Notes on Corporate Balance Sheets and Income Statements
As you know, balance sheets (and income statements which will be introduced in chapter 5 of the textbook) appear in many different forms. In Canada, you can examine the actual financial statements of most publicly-traded corporations (which, by law, must publicly disclose their financial records) using a variety of websites easily accessible by members of the public.
For example, you can search for a Canadian public corporation's annual report (which includes their financial statements) on the sedar.com website.
Alternatively, you can view free annual reports of various Canadian public corporations on the Toronto Stock Exchange's website using the TSX Listed Company Directory.
Of course, if you are searching for the annual reports of public corporations based in Canada or any other country throughout the world, you can always check out the Company Spotlight page on the investopedia.com website.
You can also check out individual company's quarterly and annual financial statements (income statements, balance sheets, cash flow statements) on the Google Finance website by typing in the name of the firm in the search box and then clicking on "Financials" under the "Company" drop down menu on the left side of the screen.
And finally, you may want to visit the individual company website of the public corporation you are researching in order to locate their most recent annual reports and financial documents, e.g., Canadian Tire.