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FINANCIAL ACCOUNTING
Fourth Canadian Edition
LIBBY, LIBBY, SHORT, KANAAN, GOWING

Financial Statements and Business Decisions

Chapter 1
Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance
Copyright 2011 McGraw-Hill Ryerson Limited

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Understanding the Business

The Players
Investors Creditors
Managers
1. Purchase materials and labour 2. Manufacture product

The Business Operations

4. Collect cash from customers and pay creditors
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3. Sell products to customers

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Understanding the Business

Business owners (called investors, shareholders or stakeholders) look for two sources of possible gain:

Sell ownership interest in the future for more than they paid.

Receive a portion of the companys earnings in cash (dividends).

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Business Background
Creditors lend money to a company for a specific length of time and gain by charging interest on the money loaned.
Loan

Mels Diner

Interest
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Understanding Business Operations

Manufacturers either make the parts needed to produce its products or buy the parts from suppliers.
Manufacturer Product Customer

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The Accounting System

Collects and processes financial information

Reports information to decision makers

Managers (internal decision makers)

Investors and Creditors (external decision makers)

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The Accounting System

Accounting System

Financial Accounting Reports

Periodic financial statements and related disclosures

Managerial Accounting Reports

Detailed plans and continuous performance reports

External Decision Makers

Investors, creditors, suppliers, customers, etc.

Internal Decision Makers

Managers throughout the organization

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The Accounting System and Decision Makers

An organized format used by companies to accumulate the dollar effects of transactions referred to as the Accounting Records.

Inventory Cash Notes Payable

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Equipment

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Information Conveyed in Financial Statements

When studying the financial statements you should focus on these questions:
1. What categories of items (often called elements) are reported on each of the four statements (What are the four statements?) What type of information does a statement convey, and where can you find it?
2. What time period (monthly, quarterly, annual) is covered by the financial statements? 3. How are the elements within a statement related? These relationships are usually described by an equation that tells you how the elements fit together. 4. Why is each element important to managers, owners or creditors decisions? (How important is the information to decision makers?) Copyright 2011 McGraw-Hill Ryerson Limited

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External Financial Reporting

Financial statements are often referred to as having been prepared using GAAP (Generally Accepted Accounting Principles) In Canada, GAAP can be either:

IFRS: International Financial Reporting Standards (IASB) ASPE: Accounting Standards for Private Enterprise (AcSB)

Companies that trade their securities (debt or equity) in a public market are required to use IFRS Those companies that do not meet the above criteria, have an option of using either IFRS or ASPE (most will chose ASPE because it is less complex)

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The Four Basic Financial Statements-IFRS

1. STATEMENT OF FINANCIAL POSITION (sometimes referred to as the Balance Sheet) reports the amount of assets (resources owned), liabilities (amounts owed), and shareholders equity of an accounting entity at a point in time. 2. STATEMENT OF COMPREHENSIVE INCOME reports the revenues less the expenses of the accounting period AND other gains and losses resulting from re-measuring the value of assets and liabilities. 3. STATEMENT OF CHANGES IN EQUITY reports the way that profit, distribution of profit (dividends), and other changes to shareholders equity affected the financial position of the company during the accounting period. 4. STATEMENT OF CASH FLOWS reports inflows (receipts) and outflows (payments) of cash during the accounting period in the categories of operating, investing, and financing. Copyright 2011 McGraw-Hill Ryerson Limited

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The Four Basic Financial Statements-ASPE

1. BALANCE SHEET reports the amount of assets (resources owned), liabilities (amounts owed), and shareholders equity of an accounting entity at a point in time. 2. STATEMENT OF INCOME reports the revenues less the expenses of the accounting period AND other gains and losses. 3. STATEMENT OF RETAINED EARNINGS reports the accumulation of profits that have not been distributed to shareholders, distribution of profit (dividends) of the company during the accounting period. 4. STATEMENT OF CASH FLOWS reports inflows (receipts) and outflows (payments) of cash during the accounting period in the categories of operating, investing, and financing.

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The Statement of Financial Position

Typical Account Titles

Assets Cash Short-Term Investment Trade Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles
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Liabilities Trade Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable

Shareholders Equity Share Capital Retained Earnings

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The Statement of Financial Position

Elements
Assets Economic resources controlled by the entity as a result of past business events from which future economic benefits may be obtained. Liabilities Debts or legal obligations of the entity that result from past business events. Shareholders Equity Amount of financing provided by owners of the corporation and from earnings over time.
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The Statement of Financial Position The Accounting Equation

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A = L + SE
(Assets) (Liabilities) (Shareholders Equity)
Economic Resources Sources of Financing for Economic Resources
Liabilities: From Creditors Shareholders Equity: From Shareholders

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The Statement of Financial Position

THE NESTLE GROUP Statement of Financial Position At December 31, 2009 (in thousands of CHF) ASSETS Cash and cash equivalents Trade receivables Inventories Prepayments Property, plant, and equipment Other assets Total assets LIABILITIES Trade payables and accrued liabilities Income taxes payable Borrowings Other liabilities Total liabilities SHAREHOLDERS' EQUITY Share capital Retained earnings Other components Total shareholders' equity Total liabilities and shareholders' equity
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5,825 12,309 7,734 589 21,599 62,860 110,916 15,812 1,173 23,404 16,896 57,285 6,248 64,660 (17,277) 53,631 110,916
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The Statement of Comprehensive Income

Typical Account Titles

Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue

Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense

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Statement of Comprehensive Income

THE NESTLE GROUP Income Statement For the Year Ended December 31, 2009 (in thousands of CHF, except for EPS) Revenues Sales revenue Other income Total revenues Expenses Cost of goods sold Distribution expense Marketing and administration expense Research and development expense Interest expense Other expenses Total expenses Profit before income taxes Income tax expense Profit for the year Earnings per share
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107618 1,309 108,927 45,208 8,420 36,270 2,021 1,238 615 93,772 15,155 3,362 11,793 2.92
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Statement of Comprehensive Income

Revenues
Earnings from the sale of goods or services.
Revenue is recognized in the period in which goods and services are sold, not necessarily the period in which cash is received. When will the revenue from this transaction be recognized?
$1,000 sale made on May 25. Cash from sale collected on June 10.

May 2011
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June 2011
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Statement of Comprehensive Income

Revenues
Earnings from the sale of goods or services.
Revenue is recognized in the period in which goods and services are sold, not necessarily the period in which cash is received. When will the revenue from this transaction be recognized? $1,000 revenue recognized in May May 2011
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June 2011
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Statement of Comprehensive Income

Expenses
The dollar amount of resources used up by the entity to earn revenues during a period. An expense is recognized in the period in which goods and services are used, not necessarily the period in which cash is paid. When will the expense for this transaction be recognized?
Paid $75 cash on May 11 for newspaper ad. Ad appears on June 8.

X May 2011
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June 2011
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Statement of Comprehensive Income

Expenses
The dollar amount of resources used up by the entity to earn revenues during a period. An expense is recognized in the period in which goods and services are used, not necessarily the period in which cash is paid. When will the expense for this transaction be recognized?
Advertising expense recognized in June.

May 2011
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June 2011
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Statement of Changes in Equity

Equity, beginning of the period Plus: Profit for the year Plus: Other comprehensive income Less: Dividends Plus/Less: Other changes, net Equity, end of the period

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Statement of Changes in Retained Earnings

Retained Earnings, beginning of the period Plus: Profit for the year Less: Dividends Plus/Less: Other changes, net Retained Earnings, end of the period

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Statement of Changes in Equity

THE NESTLE GROUP Statement of Changes in Equity For the Year Ended December 31, 2009 (in thousands of CHF) Share Capital Balance as at Jan. 1, 2009 Profit for the year Distribution of dividends Decrease in share capital Other comprehensive income (loss) Other changes, net Balance as at Dec. 1, 2009 6,266 Retained Other Earnings Components 58,646 11,793 (5,779) (9,996)

(18) (834) (6,447) (17,277)

6,248

64,660

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Statement of Cash Flows

Because revenues reported do not always equal cash collected. . .

. . . and expenses reported do not always equal cash paid . . .

Profit is usually not equal to the change in cash for the period.

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Statement of Cash Flows

THE NESTLE GROUP Statement of Cash Flows For the Year Ended December 31, 2009 (in thousands of CHF) Operating activities Cash collected from customers Cash paid to suppliers and employees Cash paid to general and administrative Cash paid for interest Cash paid for taxes Net cash flow from operating activities Investing Activities Cash used to purchase equipment Cash received from sale of business Net cash flow from investing activities Financing Activities Cash received from bank loan Cash repayments of borrowings Cash paid to repurchase share capital Cash dividends paid Net cash provided by financing activities Net decrease in cash Cash at beginning of year Cash at end of year $
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110,060 (59,508) (29,294) (566) (2,758) 17,934 (5,837) 438 (5,399) 3,957 (4,002) (6,721) (5,779) (12,545) (10) 5,835 5,825
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Relationships Among the Statements

1.

Profit from the income statement results in an increase in ending retained earnings on the statement of changes in equity.
Income Statement Revenues $ 108,927 Expenses 97,134 Profit $ 11,793

Statement of Changes in Equity Beginning retained earnings $ 58,646 Profit 11,793 Dividends (5,779) Ending retained earnings $ 64,660

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Relationships Among the Statements

2.

Ending retained earnings from the statement of changes in equity is one of the three components of shareholders equity on the statement of financial position.
Statement of Changes in Equity Retained Earnings Beginning retained earnings $ 6,805 Profit 3,300 Dividends (1,000) Ending retained earnings $ 9,105 Statement of Financial Position

Cash Other assets Total assets Liabilities Share capital Retained earnings Other equity components Total liabilities and equity

5,825 105,091 $ 110,916 $ 57,285 6,248 64,660 (17,277) $ 110,916

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Relationships Among the Statements

3.

The change in cash on the statement of cash flows is added to the beginning-of-year balance in cash to arrive at end-of-year cash on the statement of financial position.
Balance Sheet $ 17,934 (5,399) (12,545) $ (10) 5,835 $ 5,825 Cash Other assets Total assets Liabilities Share capital Retained earnings Other equity components Total liabilities and equity $ 5,825 105,091

Statement of Cash Flows Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Change in cash Beginning cash balance Ending cash balance

$ 110,916 $ 16,156 6,248 64,660 (17,277) $ 110,916

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Notes

All financial statements should be accompanied by notes which provide the reader with supplemental information about the financial condition and results of operations of the company.
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Three types . . . Describe accounting rules applied. R Present additional detail about an item on the
financial statements. Provide additional information about an item not on the financial statements.

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Management Uses of Financial Statements

Marketing managers and credit managers use customers financial statements to decide whether to extend credit.

Purchasing managers use suppliers financial statements to decide whether suppliers have the resources to meet the demand for products.

Employees union and human resource managers use the companys financial statements as a basis for contract negotiations over pay rates.
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Responsibilities for the Accounting Communication Process

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Effective communication means that the recipient understands what the sender intends to convey.

Decision makers need to understand accounting measurement rules.

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How are IFRS and Generally Accepted Accounting Principles Determined?

Our accounting system has a long and distinguished history. An Italian monk named Luca Pacioli, published the first elements of double-entry bookkeeping in 1494. Prior to 1933, the management teams of most companies were largely free to choose their own financial reporting practices.

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Generally Accepted Accounting Principles

Securities Act of 1933 Securities and Exchange Act of 1934

The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements in the U.S. The Ontario Securities Commission (OSC) has been given broad powers to determine measurement rules for financial statements in Canada.

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Generally Accepted Accounting Principles

The OSC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP.

Currently, the Accounting Standards Board (AcSB) is recognized as the body to formulate GAAP in Canada.

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Generally Accepted Accounting Principles

Companies incur the cost of preparing the financial statements and bear the following economic consequences . . .

Effects on the selling price of shares. Effects on the amount of bonuses received by managers and other employees. Loss of competitive information to other companies.
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International Perspective
International Financial Reporting Standards

Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).
Examples of jurisdictions requiring the use of IFRS either currently or by 2012 include: European Union Australia and New Zealand Hong Kong, India, Malaysia, and South Korea Israel and Turkey Brazil and Chile Canada and Mexico In the United States, the Securities and Exchange Commission now allows foreign companies whose stock is traded in the U.S. to use IFRS and is considering requiring the use of IFRS for U.S. domestic companies by 2014.
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Management Responsibility and the Demand for Auditing

To ensure the accuracy of the companys financial information, management: Maintains a system of controls. Hires outside independent auditors. Forms a committee of the board of directors to review these two safeguards.

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Independent Auditors
Auditors

express an opinion as to the fairness of the financial statements. Independent auditors have responsibilities that extend to the general public. The CPAB issues detailed auditing standards that auditors must follow.
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Overall, I believe these financial statements are fairly stated.

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Independent Auditors
An audit involves . . . Examining the financial reports to ensure compliance with GAAP. Examining the underlying transactions incorporated into the financial statements. Expressing an opinion as to the fairness of presentation of financial information.

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Accounting Designations

Chartered Accountant = CA Certified Management Accountant = CMA Certified General Accountant = CGA

Certified Public Accountant = CPA* (* in USA only)

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Ethics, Reputation, and Legal Liability

The Canadian Institute of Chartered Accountants requires that all members adhere to a professional code of ethics. The other accounting professions have similar requirements.
Code of Ethics
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Ethics, Reputation, and Legal Liability A CAs reputation for honesty and competence is his/her most important asset.

Like physicians, CAs, CMAs, and CGAs have liability for malpractice.
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Appendix 1A: Types of Business Entities

Sole Proprietorship: owned by a single individual.

Partnership: owned by two or more individuals.

Corporation: ownership represented by shares of stock. Advantages of a Corporation

Limited liability
Continuity of life Ease of transfer of ownership Opportunity to raise large amounts of money Disadvantage of a Corporation Double taxation
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Appendix 1B: Employment in the Accounting Profession Today

Career Opportunities
Public Accounting Audit and Assurance Services Management Consulting Services Tax Services Employment by Organizations Internal accounting External reporting Tax planning Various other functions Employment in the Public and Not-forProfit Sector

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Professional Designations CA CMA CGA

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End of Chapter 1

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