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ACTG 2010
Alex Garber

Ch2–FINANCIAL STATEMENTS: A WINDOW ON AN ENTITY Balance sheet – how a company was doing at a specific time -controlled by the entity that will obtain the benefits (entity has right to use asset to make money) -be the result of a transaction or event that has already occurred -measureable future benefit -provide a future benefit to the entity and must be probable that this benefit will be realized by the entity (there is not much uncertainty that the benefit will be enjoyed) -CURRENT – used up, sold, converted, within 1 year Type of Asset and What is it? Why is it an Asset? Cash- money Future Benefit-cash can be spent to buy g/s, pay debts and dividends Control-the company can use the cash however it wishes Past Transaction-events in the past, such as the sale of furniture gave rise to the cash Measureable-the amount of cash can be determined by counting Accounts receivable- money owed to Future Benefit-right to receive cash in the company who received g/s but haven’t the future paid for them yet Control-the right to collect cash belongs to the company Past Transaction-accounts recievable arise when goods are sold to customers on credit Measureable-measurability with uncertainty. The exact amount that will be collected isn’t known because some customers may not pay Inventory- merchandise that the Future Benefit-the company can sell the company has available for sale to inventory to customers and receive cash customers Control-the company owns the inventory and can determine how, when, where, and at what price it can be sold Past Transaction-the inventory was purchased in a transaction with the manufacturer Measureable- the cost of the inventory can be determined from invoices Property, plant and equipment- Future Benefit-a building provides a includes land, buildings, equipment, location to operate the business furniture and fixtures, vehicles, computer Control-the company can use the hardware and software, and so on that building in any way it deems appropriate allow the company to sell its merchandise (sell, renovate, rent to others, etc.). to customers. The company doesn’t sell Past Transaction-a building would have these but uses them to operate the been purchased from a previous owner or business built to the company’s specifications Measureable-the cost of the building can be determined from purchase documents or from construction cost details. Page 39, 3 (in notes) LIABILITIES -obligations to pay money or provide goods or services to suppliers, lenders, customers, and government -requirement of some economic sacrifice to settle -be the result of a past transaction or economic event Type of Liability and What is it? Why is it a liability Accounts payable and accrued Obligation-pay for g/s provided by liabilities-amounts owed to suppliers for suppliers g/s purchased on credit. Includes Past transaction or economic event- amounts owed to inventory suppliers, the suppliers have provided the g/s. utilities, property owners, and employees, Economic Sacrifice-in most cases money to name a few. must be paid to settle the liabilities. Customers’ deposits- customers pay in Obligation-provide g/s that have been advance for goods to be provided in future paid for by customers but not yet delivered. Past transaction or economic event- payment has been received from customers for g/s Economic Sacrifice- g/s must be provided Income taxes payable- amounts owed Obligation-pay governments for income to the government for income taxes taxes owed but not paid Past transaction or economic event- income taxes are based on income in earlier years Economic Sacrifice-cash must be paid Deferred warranty plan revenue- Obligation-provide warranty service to amounts paid to company for extended customers as required warranty protection on merchandise Past transaction or economic event- customers have purchased extended warranties Economic Sacrifice- warranty service must be provided (parts and labour) Dividends payable-dividends that have Obligation-pay shareholders dividends been declared by the board of directors declared but not yet paid to its shareholders Past transaction or economic event- dividend has been declared by the board Economic Sacrifice- cash must be paid Page 41, 4(in notes) Page 42 - In order to make sense of information, it is important to have benchmarks (like the company’s information over a number of years, information for similar firms or industry averages) - Different financial ratios will be introduced- but there are no universal rules for evaluating ratios(because of the different norms in different industries) OWNER’S EQUITY -Investment in or “value” of an entity -capital stock -retained earnings (“deficit” if negative) - Owners’ equity (OR shareholders’ equity- owners’ equity of a corporation OR partners’ equity-owners’ equity of a partnership OR owner’s or proprietor’s equity- owner’s equity of a proprietorship) is the amount that owners have invested in an entity. In terms of the accounting equation, owners’ equity represents the amount financed by the owners. o Owners’ investments can be direct or indirect  Direct investments –are made by purchasing shares of a corporation or units in a partnership, or by contributing money to a proprietorship; it is direct because investors contribute their own assets dir ectly to the entity; usually cash, sometimes others assets  Indirect investments- occurs when an entity’s net income or profit isn’t paid to the owners but is ‘reinvested; in the entity; indirect because investors don’t choose to invest and the decision to do so is made by the management or board of directors  in a corporation’s balance sheet the shareholders’ equity section separates direct investments and the reinvestment of net income o common shares (OR share capital OR capital stock)- account reflects the amount of money ( or other assets) that shareholders have contributed to the corporation in exchange for shares; direct investments by shareholders are reported here o retained earnings is the sum of al the net incomes a corporation has earned since its inception, less dividends paid (there are some other adjustments but net income and dividends are the main items). Dividends are payments, usually in cash, by a corporation to its shareholders. If retained earnings is negative, it’s referred to as a deficit. Debt-to-equity ratio Debt-to-equity ratio= liabilities/ shareholders’ equity - it is a measure of how an entity is financed- the higher the ratio, the more debt an entity is using relative to equity- and a measure of risk o the more debt, more risk because debt has a fixed cost associated with it called interest (=is the cost of borrowing money and is usually calculated as a percentage of the amount borrowed); o if an entity doesn’t pay the interest and principle (=the amount originally borrowed), the lenders can take legal action o equity is less risky for an entity as there are no mandatory payments- it doesn’t have to pay dividends at any time and shareholders can’t take legal action if they aren’t paid. o Example: liabilities/equity=160,050/353,358- 0.45; this means that the company is financed with about half as much debt as equity; for every one dollar invested by shareholders; 0.45$ is supplied by creditors; if low ratio- indicates a strong balance sheet- the entity is low risk o Can be attractive reasons for financing with debt o Management must achieve the right balance between debt and equity when deciding how to structure the company’s financing – varies between industries Income statement - Shows the events over a period of time; is the ‘how did we do?’ statement, measuring an entity’s economic activity over a period a period of time, such as a year - Its uses are: to evaluate the performance of an entity and its management, to predict future earnings and cash flows, estimating the value of an entity, determining the amount of tax that must be paid - It can have the significant consequences to entities and its stakeholders like: stock prices often change when a company announces its net income; managers’ bonuses are often based on net income; net income is used to determine income taxes; the selling price of a business can be based on net income; the selling price of a business can be based on net income - It’s challenging to measure an entity’s economic activity- different ways that accountants measure an entity’s activities- the two most common are: o Cash accounting, which reports the cash flow into and out of the entity. Under this method, economic performance represents the change in cash over the period of time. o Accrual accounting, which measures an entity’s economic activity rather than its cash flows - Example to illustrate the difference: - MPB has the following economic activity: 1. MPB started and completed seven painting jobs. It collected $2,500 for these jobs and was still owed $900 by one of its customers. The customer told the company she would pay her on August 15. MPB also collected $500 during July for completed jobs during June 2. MPB paid $1,450 to people hired to paint and owed its employees $250- at the end of July , MPB will pay the amount owed in early August 3. MPB purchased and used 1,550$ of paint for the seven jobs undertaken in July. MPB has credit at the paint store so its didn’t pay for any of the paint purchased in July, but it did pay $900 for paint it bought before July. o An income statement using cash accounting (for July) would look like: Breakdown Total (cash collected) $2,500 for the seven July jobs +3,000$ plus $500 for the jobs completed in June Less: For employees(1,450$ paid to -1,450$ Expenses(cash employees in July) spent) For paint ( $900 paid for paint -900$ purchased in previous months) Net income(cash $650 flow)  MPB had 650$ more in cash at the end of July than it did in the beginning.  Still need to pay bills- limited usefulness (incomplete measure of performance and economic activity. o Accrual accounting attempts to reflect a more complete picture of economic activity by capturing relevant economic events, not just cash flows (like it captures sales made on credit whereas cash accounting does not)  Revenue (or sales or sales revenue)- economic benefits earned by providing g/s to customers  Expenses- economic sacrifices made or costs incurred to earn revenue o Under these definitions, revenue and expenses can be reported before, after, or at the same time as the related cash flow. o Challenge: determining when revenue and expenses occur, and when they should be reported in the income statement Breakdown Total Revenue(cash $2,500 for the seven July jobs +3,400$ collected) that were paid for, plus 900$ for the July job that wasn’t paid for by the end of June Less: For employees(1,450$ paid to -1,700$ Expenses(cash employees for work done by spent) employees in July plus $250 -1,550$ owed for work done in July) For paint ( $1,550 for paint purchased and used in July- this paint won’t be paid for until later. Equipment -0,050$ Net income(cash $100 flow)  This one includes equipment needed for operation- does not get used up during each job (like paint)  Depreciation- the ‘using up’ of the equipment  The net income means that the business enjoyed a net economic gain of 100$ during July because of economic benefits (revenue) exceeded the economic costs (expenses) by 100$; corresponds with an increase in net assets (=assets-liability)  The increase could be sue to more cash, more receivables, more of any other asset or fewer liabilities  Accrual accounting can be very tricky- necessary to decide when economic activity occurs- when revenue and expenses happen and should be recorded in the accounting system.  Reason why accounting standards are flexible, why there are often valid alternatives for recording transactions and economic events, why judgement is so important in accounting and why is it possible for managers to work within accounting standards to pursue their own interests  even though separate from balance sheet- kinda the same thing( just ignoring direct investments and dividends) assets =liabilities+ owners’ equity in the beginning of the period+ revenue- expenses assets =liabilities+ owners’ equity in the beginning of the period+ net income o notice: net income in a period increases owners’ equity- and his wealth; since owners’ equity= assets-liabilities- net income means net assets have increased. Gross Margin and Gross Margin Percentage - gross margin- sales less cost of sales (remember that costs of sales is the cost of the inventory sold) gross margin=sales-cost of sales o is available for covering the others costs of operating the business and for providing profit to the owners. The higher it is the better. Gross margin percentage= (gross margin/revenue)(100%) o gross margin percentage is the percentage of each dollar of sales that is available to cover other costs and return a profit to the entity’s owners.  If a company can increase( perhaps by increasing the selling price of its products) without decreasing sales or increasing other costs, its net income will increase  Makes it easier to compare the performance of different entities and the same entity year to year - PROFIT MARGIN PERCENTAGE = net income/revenue x 100 Statement of comprehensive income - it is an extension of net income; over the years, accounting standard setters decided to exclude certain types of economic events from the calculation of net income ( the items went directly to owners’ equity instead); decided that there should be a measure that captures all transactions and economic events that involve non-owners and that affect equity (remember that revenure and expenses effect equity ) –called comprehensive income net income+ other comprehensive income= comprehensive income - other comprehensive income includes those transactions and economic events that involve non-owners and affect equity but are, for various reasons excluded from the calculation of net income. - [Comprehensive] affects equity section of the balance sheet; other comprehensive income is treated the same way that retained earnings is handled; - in the equity section of the balance sheet, there is an account called accumulated other comprehensive income (which includes all the stuff that was omitted) Statement of shareholders’ equity/ the statement of retained earnings -Presents the changes in each account in the equity section of the balance sheet during a period - Statement of retained earnings- summarizes the changes to retained earnings during a period Retained earnings at the end of the year= retained earnings at the beginning of the year+ net income for the year- dividends declared during the year - occasionally other events (besides net income and dividends) affect retained earnings - dividends aren’t considered expenses when calculating net income o they are distributions of the shareholders’ investment in the business back to the shareholders, not a cost of operating the business, and so aren’t included in the calculation of net income. A dividend doesn’t affect the overall wealth of a shareholder- it simply moves the wealth from the entity (which the shareholder owns) to the shareholder’s bank account Statement of cash flows - cash and net income are not the same thing - statement of cash flows shows how an entity is obtained and used cash during a period and it provides information about how cash was managed; important source of information about an entity’s liquidity - three types: o Cash from/used in OPERATIONS- is the cash an entity generates from or uses in its regular business activities; remember that under accrual accounting, net income measures economic flows, not cash flows, whereas cash from operations simply reflects the movement of cash. o Cash from/used in INVESTING activities- is cash spent buying and receiving from selling property, plants, and equipment; intangible assets; other long term-assets; and investments o Cash from/used in FINANCING activities- is the cash an entity raises from and pays to equity investors and lenders; it includes cash borrowed or raised by issuing shares and cash paid for loan replacements, dividends, share repurchases, and sometimes loan interest. The relationship among the financial statements - more extensive than just cash and equity, many transactions and economic events involve both the income statements and the balance sheet and any transaction that involves cash is included in the cash flows statement. Notes to the Financial Statements - expand and explain the information in the statements and provide additional information that may help stakeholders assess and entity - some financial statement users say that the notes to the financial statements provide more information than the statements themselves - its certainly not possible to understand the financial statements without carefully reading the notes - revenue recognition- explains when the company records a sale in the income statement; is part of the summary of significant accounting policies (which are the methods, principles, and practices used by an entity to report its financial results.) o accounting rules, including IFRS, are flexible and often provide managers with leeway therefore this shows the choices made which influence the results of them o may include a list of the company’s property, plant and equipment.  This gives the stakeholder an idea of the types of property, plan and equipment owned by the company, the cost of the assets in each category, and how much has been amortized (=depreciated) o May include information about the company’s franchise operations; a franchise allows someone to own and operate a store as their own business; the company receives fees (=royalties) from the franchise owner and provides support in return  The amount that is made by franchise stores is not included in the sales report because the company doesn’t own these stores(the royalties are included though) Users of a company’s financial statements - Shareholders- if it’s a public company, shareholders are an important stakeholder group; some of the company’s shareholders may be small investors who don’t have access to information other than what is publically available. - Creditors- even if a company has not borrowed money, it does owe a significant amount to various creditors as shown by the accounts payable and accrued liabilities ( like money owed to suppliers); some creditors will want to examine the financial statements as part of their assessment of how much credit they will offer a company - Canadian revenue agency- any company must file regular tax returns and the general purspoe financial statements are required with this filing - Competitors- industries are competitive and may look to others within the same industry to gain insight into how its operating its business. Format of general purpose financial statements - no one right way - IFRS suggests (doesn’t require) a balance sheet format that is quite different from what Canadian companies have typically used - Its important to recognize that as long as all the information you need it present statements can be reorganized to meet your requirements -“general purpose” – not prepared for a specific stakeholder, purpose -at least once a year -report information for a “fiscal” period -public companies must use IFRS -can general public buy shares? if not, then it is private - Other accounting information - in addition to general purpose- accountants can prepare any type of report to satisfy the needs of stakeholders - the only limitations to this are the entity’s willingness to provide the information and its availability in the accounting system ( it can only provide information that has been entered into it) - special purpose reports- are accounting reports that are prepared to meet the needs of specific stakeholders or a specific purpose. Ch3-ACCOUNTING CYCLE Debit (left side) /// Credit (right side) -Accounting cycle – process of entering transaction and economic event data into accounting system and then processing, organizing, and using it to produce information such as financial statements -Transactional entry – a journal entry triggered by an exchange with another entity -Adjusting entry – entries to an accrual accounting system that aren’t triggered by exchanges with outside entries -are required because revenue and expenses can be recognized at times other than when cash is exchanged -every adjusting entry involves a balance sheet accounting and an income statement account -every adjusting entry is associated with a transactional entry that is recorded before the adjusting entry -adjusting entries are required only when financial statements are prepared -adjusting entries never involve cash. If cash is part of the entry, it is not an adjusting entry -i.e. depreciation expense, accumulated depreciation // license expense Contra-asset acc
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