AFM 101 Textbook Notes

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Department
Accounting & Financial Management
Course
AFM 101
Professor
Donna Psutka
Semester
Fall

Description
Chapter 1: Financial Statements and Business Decisions September-10-12 11:30 AM Understanding the Business The Players - Commonin new businesses -> the founder = manager of the business (owner-manager) - Lenders = creditors - Investors: individuals who buy small percentages of large corporations.They hope to receive a portion of what the companyearns in the form of cash payments (dividends),and they hope to eventually sell their share of the company at a higher price than they paid. - Creditors lend money to a companyfor a specific length of time. They gain by charging interest on the money they lend. - Financingactivities: exchanging money with lenders and owners - Investing activities: buying or selling property The Business Operations - Suppliers:who companies purchase ingredients and accessoriesfrom - Companies sell products to retail stores, customers, or through wholesale distributors. - Diagram (p.2) The Accounting System - Accounting: a system that collects and processes (analyzes, measures, and records) financial information about an organization and reports that information to decision makers. - Parties within the firm = internaldecisionmakers (e.g. managers) • Internal managers typically require continuous detailed informationbecause they must plan and manage the day-to-day operations of the organization. Developingaccounting information for internal decision makers is called managerialor managementaccounting. - Parties outside the firm = external decision makers (e.g. creditors, investors,suppliers, customers) • Accounting for external decision makers is called financialaccounting - Exhibit 1.1 (p.3) • Financialaccountingsystem: periodic financial statements and related disclosures • Managerialaccounting system: detailed plans and continuous performancereports - 2 primary users of statements:investors (owners) and creditors (lenders) The Four Basic Financial Statements: An Overview - The statementof financial position, statement of comprehensiveincome, statementof changes in equity, and statementof cash flows - These basic statementsare normally prepared by for-profit corporations.Statements are intended primarily to inform investors,creditors, and other external decision makers. They summarizethe financial activitiesof the business. They can be prepared at any point in time and can apply to any time span. - Quarterly reports: reports prepared at the end of each quarter - Annualreports: reports prepared at the end of the year The Statement of Financial Position (Balance Sheet) - Reports the financial position (assets, liabilities, and shareholders' equity) of an accounting entity at a point in time Structure - Heading of the statement: • Name of the entity - The Nestlé Group • Title of the statement - Statement of Financial Position • Specificdate of the statement - At December31, 2009 • Unit of measure - (in millions of Swiss francs) - Exhibit 1.2 (p.5) - Accountingentity: the organization for which financial data are to be collected. It must be precisely defined and is often called the business or the corporation.On the statementof financial position, the accounting entity itself, not the business owners, is viewed as owning the resources it uses and the accounting entity itself, not the business owners, is viewed as owning the resources it uses and as owing its debts. - a financial snapshot clearly stating the entity's financial position at a specific point in time - first lists the company'sassets, liabilities, and then shareholders' equity. Assets are the sources of financing or claims against the company's economicresources. Financing provided by creditors creates a liability. Financing provided by owners creates owners' equity. - Assets = Liabilities+ Shareholders' Equity - Financialposition: the economicresources that the company owns and the sources of financing for those resources Elements - Assets are economicresources controlled by the entity as a result of past business events and from which future economicbenefits can be obtained. Assets can vary depending on the nature of a company's operations. - cash, land,plantand equipment,prepayments, inventories,investments - Trade receivables: selling products on credit and receiving promises to pay (cash is collected later) - Intangibleassets do not have physical existence. - Every asset on the statementof financial position is initially measured at the total cost incurred to acquire it. Their values reflect the benefits that the companyexpects to realize from these assets through use or sale. - Liabilitiesare the entity's legal obligations that result from past business events. They arise primarily from the purchase of goods or services on credit and through cash borrowings to finance the business. - The trade payables arise from the purchase of goods and services from suppliers on credit, without a formal written contract (or note). Short-termborrowingsrepresent amounts borrowed from banks and other creditors, to be repaid in the near future. The incometaxes payable represent an amount due to the government'stax authorities as a result of the company'sprofitable operations. The accrued liabilities are amounts owed to suppliers of various types of services, such as rent and utilities. - Long-termborrowingsresult from cash borrowings based on formal written debt contracts with lending institutions such as banks. The provisionsare estimated amounts payable in the future, but the exact amount and timing of the payment depends on actual future events. - Shareholders' equity indicates the amount of financing provided by owners of shares in the business and the earnings over time. • Shareholders' equity arises from 3 sources: 1. Share capital or the investmentof cash and other assets in the business by the owners in exchange for shares 2. Retainedearnings or the amount of earnings reinvested in the business (not distributed to shareholders in the form of dividends) 3. Other components that essentially reflect the changes in the values of assets and liabilities over time - Total shareholders' equity is the sum of the proceeds received on issuing shares to owners, plus the retained earnings, and the valuation adjustments to the company's assets and liabilities at year-end. A Note on Format - Assets may be listed in either increasing or decreasing order of their convertibility of cash. Liabilities may be listed by either increasing or decreasing order of maturity (due date). - Most statementsinclude the $ beside the first amount in a group of items. A single underline is placed below the last item in a group before a total or subtotal. A double underline is placed below group totals. The Statement of ComprehensiveIncome Structure - Reports the change in shareholders' equity, during a period, from business activitiesexcluding exchanges with shareholders. It includes all changes in equity during a period except those resulting from investmentsby owners (such as the issuance of shares) and distributions to owners (such as dividends). - 2 parts: 1. Reports the accountant's primary measure of a company's performance(profit): revenues generated less expenses incurred during the accounting period 2. Other comprehensiveincome (income and expense items that are not recognized in the income 2. Other comprehensiveincome (income and expense items that are not recognized in the income statementin accordance with IFRS) - Incomestatement: reports the revenues less the expenses of the accounting period - Items of income and expenses can be presented in 1 or 2 statements -> an incomestatement reporting the revenues and expenses that have already affected profit, and a statementof comprehensiveincomereporting income and expense items that will affect profit in the future - Heading: name of the entity, title of the statement,and unit of measure used - Reports information for a specified period of time (accountingperiod: time period covered by the financial statements) - Revenues - Expenses = Profit Elements - Revenues: earned from the sale of goods and services to customers whether or not they have been paid for - Expenses: represent the monetary value of resources the entity used up, or consumed, to earn revenues during the period - Cost of sales (cost of goods sold): total cost to produce products sold to customersduring the year - Depreciation - Distributionexpenses include a varietyof expenses such as the salaries of sales staff and expenses related to distribution of the company's products. Marketing and administrativeexpenses include items such as the salaries of marketing and managementpersonnel, promotionof the company's products through print and electronic media, rental of office space, insurance, utilities, plus other general costs of operating the company not directly related to production. Research and developmentexpenses relate to the research and developmentof new products. The other expenses consist of a variety of expenses that are not included in the previous categories. - Interest expense: reflects the cost of using borrowed funds - Incometax expense - Expenses may require immediatepayment of cash, payment of cash at a future date, or use of some other resource, such as an inventory item, that may have been paid for in a previous period. For accounting purposes, the expense reported in one accounting period may actually be paid for in cash in another accounting period. Nevertheless, the company recognizes all expenses (cash and credit) incurred during a specific accounting period regardless of the timing of the cash payment. - Profit (net income/net earnings): the excess of total revenues over total expenses incurred to generate revenue during a specific period. (Lossesare normally noted by () around the reported figure.) - Profit normally does not equal the net cash generated by operations. The Statement of Changes in Equity Structure - Reports all changes to shareholders' equity during the accounting period - Exhibit 1.4 (p.12) - Covers a specific period of time (the accounting period) - Reports the way that profit, distribution of profit (dividends), and other changes to shareholders' equity affected the company's financial position during the accounting period - Retainedearnings reflect the profits that have been earned since the creation of the company but not distributed yet to shareholders as dividends. The declaration of dividends to the shareholders decreases retained earnings. - Beginning retained earnings + Profit - Dividends = Ending retained earnings Elements - Shows how the incomestatement and the statementof financial position are linked through the retained earnings section of shareholders' equity The Statement of Cash Flows Structure - Reports cash inflows (receipts) and outflows (payments)that are related to operating, investing, and financing activities during the accounting period - Covers a specified period of time (the accounting period) - Describes the causes of the change in cash reported on the statementof financial position from the end of the last period to the end of the current period: end of the last period to the end of the current period: +/- Cash flows from operating activities +/- Cash flows from investingactivities +/- Cash flows from financing activities Change in cash Elements - Exhibit 1.5 (p.14) - Cash flows from operatingactivities are cash flows that are directly related to earning income. - Cash flows from investing activities include cash flows related to the acquisition or sale of the company's productive assets (e.g. purchase of additional property, purchase of intangible assets, acquisition of other businesses, selling businesses and old equipment, etc.) - Cash flows from financingactivities are directly related to the financing of the company itself and involves both receipts and payments of cash to investors and creditors. Relationships among the Four Financial Statements - Profit from the income statement results in an increase in ending retained earnings on the statementof changes in equity. - Ending retained earnings from the statementof changes in equity is one of the three componentsof shareholders' equity on the statementof financial position. - The change in cash on the statement of cash flows added to the cash balance at the beginning of the year equals the balance of cash at the end of the year, which appears on the statementof financial position. - As external users, we can think of the income statement(and the statementof comprehensive income) as explaining, through the statementof changes in equity, how the operations of the company changed its financial position during the year. The statement of cash flows explains how the operating, investing, and financing activitiesof the companyaffected the cash balance on the statementof financial position during the year (Exhibit 1.6 (p.16)). Notes to Financial Statements - Provide supplemental information about the financial condition of a company,without which the financial statementscannot be fully understood - "The notes are an integral part of these financial statements." - 3 basic types of notes: • Descriptions of the accounting rules applied in the company's statements • Presents additional detail about a line on the financial statements • Presents additional financial disclosures about items not listed on the statementsthemselves Summary of the Four Basic Financial Statements - Exhibit 1.7 (p.18) - Competitors'P/E ratio often serve as a stating point in analyzing the price that should be paid for a company or its shares. - Price/Earningsratio = Market Price ÷ Earnings per share (EPS) - Market (Purchase)price = P/E ratio × EPS Responsibilitiesfor the Accounting CommunicationProcess - Effective communication means that the recipient understands what the sender intends to convey. - Measurement rules are based on InternationalFinancialReporting Standards(IFRS) (guidelines for the measurementrules used to develop the informationin financial statements).These encompass broad principles, specific rules, practices, and conventionsof general application that are used by organizations to record transactions and report financial statementinformation to interested users. International Financial Reporting Standards (IFRS) How are Accounting Standards Determined? - Securities and ExchangeCommission(SEC): the U.S. governmentagency that determines the financial statementsthat public companies must provide to shareholders and the measurement rules that they must use in producing those statements - Ontario SecuritiesCommission(OSC): the most influential Canadian regulator of the flow of financial - Ontario SecuritiesCommission(OSC): the most influential Canadian regulator of the flow of financial information provided by publicly traded companies in Canada. - In Canada, provincial securities legislation created securities commissions,most notably OSC, to regulate the flow of financial information provided by publicly traded companieswhose shares trade on Canadian stock exchanges. - Similar to the SEC, the OSC plays an influential role in promotion,surveillance, and enforcementof sound accounting practices by publicly traded companies. The OSC is one of the 13 securities regulators of Canada's provinces and territories. These regulators have formed the Canadian Securities Administrators,which coordinates and harmonizes regulation of the Canadian capital markets among them. - These securities commissionshave worked with organizations of professional accountants to establish groups that are given the primary responsibilities to work out the detailed rules that becomeGAAPs. - AccountingStandardsBoard (AcSB): the private-sectorbody given the primary responsibility to work out the detailed rules that becomeaccepted accounting standards. It is responsible for establishing standards of accounting (in the CICA Handbook) and reporting by publicly accountable enterprises, private enterprises, governmentorganizations, and not-for-profit organizations. For public companies, the AcSB's objective is to moveto a single set of globally accepted high-quality standards (best accomplished by converging Canadian GAAP with IFRS). It implementedits plan by requiring all publicly accountable enterprises to use IFRS in reporting their financial statementsfor fiscal years (annual accounting periods) that start on or after January 1, 2011. - InternationalAccountingStandardsBoard (IASB): an independent standard-setting board that is responsible for the developmentand publication IFRS. It cooperateswith national accounting standard-setters to achieve convergencein accounting standards around the world. The IASB initially issued International Accounting Standards (IAS). New IAS are known as IFRS. Why are Accounting Standards Important to Managers and External Users? - IFRS provide guidance to companiesin selecting the accounting methods that best reflect the results of their operations and financial situation. They prevent managers from deliberately manipulating and reporting values that serve their personal interests by using accounting practices not in conformitywith IFRS. Widely divergent accounting practices reduce the comparability of financial information from different companiesoperating in the same line of business. IFRS enhances the comparabilityby limiting the number of acceptable alternativeaccounting methods across companies and over time. It enables external users to assess the quality of the information presented in the financial statementsand related notes. - Companies, their managers, and their owners are most directly affected by the information presented in the financial statements. Companiesincur the cost of preparing the statementsand bear the major economicconsequencesof their publication. These economicconsequencesinclude: 1. Changes to the selling price of a company's shares, 2. Changes to the amount of bonuses receivedby managementand employees,and 3. Loss of competitiveadvantage over other companies. - Changes in accounting standards can affect the price buyers are willing to pay for companies. Management Responsibility and the Demand for Auditing - Primary responsibility for the accuracy of financial statements -> management - Steps to assure investors that the company's records are accurate: 1. System of Controls 2. External Auditors 3. Board of Directors - Report to management(managementcertification): indicates management's primary responsibility for financial statementinformationand the steps to ensure the accuracy of the company's records - Auditreport (report of independentauditors): describes the auditor's opinion of the fairness of the financial statements,and the evidence gathered to support that opinion - The main difference between the report of managementand the report of the independent auditors concerns the responsibility for the financial informationincluded in the company's annual report. As the report of the independent auditors indicates, the auditor's responsibility is to express an opinion on financial statementsthat have been prepared by its accounting personnel and reviewedby the auditcommittee of the boardof directors, which assumes responsibility for the quality of the content of these financial statements. content of these financial statements. - In Canada, an accountant may be designated as a CharteredAccountant(CA), a Certified General Accountant(CGA),or a Certified ManagementAccountant(CMA). Only CAs and CGAs (in most Canadian provinces) are permitted to issue audit reports of publicly traded companiesbecause they have certain responsibilities that extend to the general public as well as to the specific business that pays for their services. - Audit: an examination of the financial reports to ensure that they represent what they claim and conformwith IFRS. The independent auditor examines the underlying transactions (but not each one) and the accounting methodsused to account for these transactions. Ethics, Reputation, and Legal Liability - The three Canadian professional accounting organizations require all of their members to adhere to professional codes of ethics. - Financial statementfraud is a fairly rare event. Such frauds are first identified by the firm's accounting staff or its external auditors (whistle blowers). Independent auditors may be held liable for losses suffered by those who relied on the audited financial statements. Appendix 1A: Types of Business Entities - Exhibit 1.9 (p.28) - Sole proprietorship:an unincorporated business owned by 1 person; it usually is small in size and is commonin the service, retailing, and farming industries. Often, the owner is the manager. Legally, the business and the owner are not separate entities. Accounting views the business as a separate entity that must be accounted for separately from its owner. - Partnership:an unincorporated business owned by 2 or more persons known as partners. Some partnerships are large in size (e.g., international public accounting firms and law firms). The agreementsbetween the owners are specified in a partnership contract that deals with matterssuch as division of profit among partners and distribution of resources of the business on termination of its operations. A partnership is not legally separate from its owners. Legally, each partner in a general partnership is responsible for the debts of the business (each general partner has unlimited liability). The partnership is a separate business entity to be accounted for separately from its several owners. - Corporation:a business incorporated federally under the Canada Business Corporations Act or provincially under similar provincial acts. The owners are called shareholders or stockholders. Ownership is represented by shares of capital that usually can be bought and sold freely. When an approved application for incorporation is filed by the organizers, a charter is issued by either the federal or the provincial government.This charter gives the corporation the right to operate as a legal entity, separate from its owners. The shareholders enjoy limited liability. The corporatecharter specifies the types and amounts of share capital that can be issued. The shareholders elect a governing board of directors, which employs managers and exercises general supervision of the corporation. - Because a corporationis considered a legally separate entity, directors and executivesmay find themselvesbeing sued for damages by their former employer.Accounting also views the corporationas a separate business entity that must be accounted for separately from its owners. - In terms of economicimportance, the corporationis the dominant form of business organization in Canada. This dominance is caused by many advantages of the corporateform: 1. Limited liability for the shareholders 2. Continuity of life 3. Ease in transferring ownership (shares) 4. Opportunities to raise large amounts of money by selling shares to a large number of people - Primary disadvantages of a corporationare: 1. Loss of control by shareholders 2. Complex reporting procedures for a variety of governmentagencies 3. Potential for double taxation of profit (it is taxed when it is earned and again when it is distributed to shareholders as dividends) Appendix 1B: Employment in the Accounting Profession Today - The 3 Canadian accounting designations are granted only on completionof requirements specified by the respectiveprofessional organizations. They include a university degree with a specified by the respectiveprofessional organizations. They include a university degree with a specified number of accounting courses, good character, a minimum of 2 years of relevant professional experience, and successful completion of a professional examination. Currently, all accountants must be licensed by the governmentto engage in professional practice and they must meetongoing tests of competenceto retain their licences. The Certified Public Accountant (CPA) designation exists in the U.S. - Accountants are usually engaged in professional practice or are employedby business, government entities, and not-for-profit organizations. There is a demand for value-added accounting services (e.g., financial analysis, evaluation and implementationof new informationtechnology and business processes, managementadvisory and consulting services, forensic accounting, and environmental accounting). Practice of Public Accounting - Usually 2 or more individuals organize an accounting firm in the form of a partnership (in many cases, a limited liability partnership, or LLP). Accounting firms vary in size from a one-person office to regional firms, to the "Big Four" firms (Deloitte& Touche, Ernst & Young, KPMG,and PricewaterhouseCoopers),which have hundreds of offices worldwide. Accounting firms usually render three types of services: assurance services,management consulting services, and tax services. Assurance Services - Are independent professional servicesthat improvethe quality of information, or its context, for decision makers - Most important assurance service -> financial statementauditing - The audit's purpose is to lend credibility to the financial reports/to ensure that they fairly represent what they claim. - Other areas include integrity and security of electronic commerceand reliability of information systems. Management Consulting Services - Are usually accounting-based and encompass such activitiesas the design and installation of accounting, data processing, and profit-planning and control (budget) systems;financial advice; forecasting; internal controls;cost-effectivenessstudies; and operationalanalysis - Availability of such services might have caused large accounting firms to separate their consulting practice from their audit function Tax Services - Services include tax planning as a part of the decision-making process and the determination of the income tax liability (reported on the annual incometax return) - Because of the increasing complexity of provincial and federal tax laws, a high level of competenceis required, which accountants specializing in taxation can provide. - The accountant's involvementin tax planning often is quite significant. Most major business decisions have significant tax impacts; tax-planning considerationsoften govern certain business decisions. Employmentby Organizations - Many accountants, including CAs, CGAs, and CMAs, are employedby profit-making, not-for-profit and governmentorganizations. An organization, depending on its size and complexity,may employ from a few to hundreds of accountants. In a business enterprise, the chief financial officer (usually a vice-president or controller)is a memberof the management team. This responsibility usually entails a wide range of management,financial, and accounting duties. - In a business entity, accountants typically are engaged in a wide variety of activities, such as general management,general accounting, cost accounting, profit planning and control (budgeting), internal auditing, and computerized data processing. A primary function of the accountants in organizations is to provide data that are useful for internal managerial decision making and for controlling operations. The functions of external reporting, tax planning, control of assets, and a host of related responsibilities normally are also performed by accountants in industry. Employmentin the Public and Not-For-ProfitSectors - The vast and complexoperations of governmentalunits, from the local to the international level, create a need for accountants. The same holds true for other not-for-profitorganizations. create a need for accountants. The same holds true for other not-for-profitorganizations. Accountants employed in the public and not-for-profitsectors performs functions similar to those performed by their counterparts in private organizations. Chapter 2: Investing and Financing Decisions and the Statement of Financial Position September-17-12 11:30 AM Overview of Accounting Concepts - Exhibit 2.1 (p.48) Concepts Emphasized in Chapter 2 Objective of Financial Reporting - primary objectiveof external financial reporting: to provide useful economicinformationabout a business to help external parties make sound financial decisions in their capacity as capital providers Accounting Assumptions - Separate-entityassumption: business transactions are separate from the transactions of the owners - Unit-of-measureassumption: accounting information should be measured and reported in the national monetaryunit (dollars in Canada, euros in EU countries, etc.) - Accountants assume that the unit of measure has a stable value over time. The stable monetaryunit assumption allows accountants to combine different amounts, even though the purchasing power of the monetaryunit has changed over time. - Continuity(going-concern)assumption:businesses are assumed to continue to operate into the foreseeablefuture • Violation of this assumption means that assets and liabilities should be valued and reported on the statementof financial position as if the companywere to be liquidated. Basic Accounting Principle - Historical cost principle -> the cash equivalent cost needed to acquire an asset (the historical cost) should be used for initial recognition (recording) of all financial statementelements - Cost principle:requires assets to be recorded at the historical cash-equivalent cost (cash paid + current monetaryvalue of all non-cash considerationsalso given in the exchange) on transaction's date - Pro: many assets are acquired according to legal contracts that clearly state the acquisition cost. For example, if you trade your computer plus cash for a new car, the cost of the new car is equal to the cash paid plus the market value of the computer. Thus, cost is relatively easy to determine and can be verified. - Con: subsequent to the date of acquisition, the continued reporting of historical cost on the statementof financial position does not reflect any change in market value, usually because market value is less verifiable measure than historical cost. Elements of the Classified Statementof Financial Position - Assets: economicresources controlledby an entity as a result of past transactions or events and from which future economicbenefits may be obtained (2 subgroups: current & non-current) - Classifications of info are included in the financial statements - Exhibit 2.2 (p.51) • Consolidated: classified elementsof statementof financial position are combined with those of other companies under its control • Column/report format - Account format(assets on left, liabilities & shareholders' equity on right) - Typical assets: 1. Current assets (short-term):cash and cash equivalents (mostliquid), short-term investments,trade and other receivables, inventories, prepayments,other current assets 2. Non-current assets (long-term):property, plant, and equipment (at cost less accumulated depreciation), investmentassociates, financial assets, goodwill, intangible assets, other (miscellaneous)assets - Current assets: assets that will be used or turned into cash, normally within 1 year - In order of liquidity: order in which assets can be transformed into cash - Each of the items reported on the statement is a combinationof a number of similar items. - Short-term investments: reported values for shares of other companies and other financial instruments purchased as investmentsof excess cash - Trade and other receivables consist primarily of trade receivables: amounts owed by customerswho purchased products & services on credit, are normallycollected within 1 year of statement's date - Notes receivable: written promises by customersand others to pay fixed amounts by specific dates - Notes receivable: written promises by customersand others to pay fixed amounts by specific dates - Inventories:goods that are held for sale to customersin the normal course of business or are used to produce goods/servicesfor sale, always considered a current asset no matter how long it takes to produce & sell - Prepayments: available benefits that the company will use within 1 year - Other current assets will include a # of assets with smaller balances that are combined. - Non-current assets will be used or turned into cash over a period longer than the next year. - Property, plant,and equipment includes all land, buildings, machinery,and equipment that will be used for the production, packaging, and storage of products -> fixed/capital assets, tangible (physical form) - Investmentin shares -> objective:investment in associates - Financialassets: investmentsin shares/debt instruments issued by other companies(kept for > 1 year) - Goodwill:intangible asset that arises when a companypurchases another business to control its operating, investment,and financing decisions • reflects assets that are not easily identifiable & measured (e.g. customerconfidence) - Intangibleassets: no physical substance but have a long life, usually are not acquired for resale but are directly related to the operations of the business (e.g. goodwill, franchises, patents, trademarks, etc.) • Values arise from the legal rights and privileges of ownership, which is recognized if purchased from external parties or as a result of internal development - Liabilities:present debts/obligationsof the entity that result from past transactions, which will be paid with assets/services(2 subgroups: current & non-current) • Future outflows of assets (mainly cash)/servicesto the creditors that provided the corporationwith the resources needed to conduct business • Creditors receive the full payment of the amount owed to them & the interest on borrowed amount. - Typical liabilities: 1. Current liabilities (short-term): trade payables, short-termborrowings, income taxes payable, accrued liabilities, other current liabilities 2. Non-current liabilities (long-term): long-term borrowings, deferred income tax liabilities, provisions, other liabilities - Order of time of maturity: how soon an obligation must be paid - Current liabilities: obligations that will be paid in cash/current assets or satisfied by providing service within the coming year - Trade payables:the total amount owed to creditors - Short-term borrowings:short-term loans from banks - Incometaxes payable: an estimate of the amount of taxes expected to pay taxation authorities - Accrued liabilities: total amount owed to creditors for various types of services (e.g. payroll, rent, etc.) - Non-currentliabilities: a company's debts that have maturities extending beyond 1 year from the date of the statementof financial position - Long-termborrowings-> from banks and other lenders - Deferred income tax liabilities: arise from temporarydifferences between the profit measured in accordance with IFRS and taxable profit that is determined in conformitywith applicable tax laws - Provisions:estimated liabilities characterized by uncertainty about the exact amount to be paid & timing of payment - Shareholders' equity (owner's equity,stockholders'equity): financing provided by the owners & operations of the business - Creditors are entitled to settlementof their legal claims on the corporation'sassets before the owners receive a penny. Owners have a residual claim on the corporation's assets. - Owners invest (purchase shares) because they expect to receive 2 types of cash flow: dividends (distribution of the corporation's earnings, a return on shareholders' investment)& gains from selling their shares for more than they paid (capitalgains). - Typically, the shareholders' equity of a corporationincludes: 1. Share capital (or capital stock) 2. Retainedearnings (accumulated earnings that have not been declared as dividends) 3. Other components - Share capital: from owners providing cash (& sometimesother assets) to the business, proceeds received when the corporation issued the shares - Contributedsurplus: when shareholders contribute in excess the amount allocated to share capital (e.g. premiums on shares issued) - Contributedcapital: share capital + contributed surplus - Contributedcapital: share capital + contributed surplus - When a company does not own all the voting shares issued, its shareholders' equity is divided between the controlling (parent) and non-controlling (or minority) shareholders (non-controllinginterest). What Type of Business ActivitiesCause Changes in Financial Statement Amounts? Nature of Business Transactions - Transaction:an exchange between a business and one or more external parties to a business or a measureable internal event, such as adjustments for the use of assets in operations • 2 types of events: 1. External events are exchanges of assets, goods, or services by one party for assets, services,or promises to pay (liabilities) to 1 or more parties. 2. Internalevents include certain events that are not exchanges between the business and other parties but neverthelesshave a direct and measurable effect on the accounting entity (e.g. using up insurance paid in advance) - Signing a contract -> only the exchange of promises (not included in statements) Accounts - A standardized format that organizations use to accumulate the monetaryeffects of transactions on each financial statementitem - result of all transactions that affect a specific account (ending balance) on respectivestatement - To facilitate recording of transactions -> chart of accounts: list of accounts & unique numeric codes (organized by financial statementelement, with asset accounts listed first (by order of liquidity), followed by liabilities (by order of time to maturity),shareholders' equity, revenue, expenses - "receivable" -> assets, representing amounts owed to the corporationby customersand others, to be collected in the future - "payable" -> liabilities, representing amounts owed by the corporation to be paid to others in the future - Accounts in financial statementsare summations/aggregationsof a # of specific accounts How Do Transactions Affect Accounts? Principles of Transaction Analysis Transactionanalysis: process of studying a transaction to determine its economiceffect on the entity in - terms of the accounting equation (A = L + SE -> fundamental accounting model) - 2 concepts: 1. Every transaction affects at least 2 accounts; it is critical to correctlyidentify the accounts affected & the direction of the effect (increase or decrease). 2. The accounting equation must remain in balance after each transaction. Dual Effects - Dual effects: every transaction has at least 2 effects - Purchasing on credit -> the eventual payment Balancing the Accounting Equation - Step 1: Identify and classify accounts & effects. (Identify the accounts affected (by their titles). Classify each type of account. Determinethe direction of the effect.) - Step 2: Verify that the accounting equation, A = L + SE, remains in balance. Analyzing Nestlé's Transactions - Financing transactions -> Companies that need cash for investing purposes often seek funds by selling shares to investorsor borrowing from creditors. How Do Companies Keep Track of Account Balances? - Companies establish accounting systemsthat follow a cycle: accounting cycle (Exhibit 2.4 (p.64)). - Transactions are recorded in the general journal in chronological order, and the related accounts are updated in the general ledger. These formal records are based on journal entries & T-accounts. The Direction of Transaction Effects - T-account:a tool for summarizing transaction effects for each account, determining balances, and drawing inferences about a company's activities(2 sides: debit & credit side) - Debit: left side of an account - Credit: right side of an account - Credit: right side of an account - Exhibit 2.5 (p.65) • Asset accounts increase on the debit side (have debit balances). • Liabilities and shareholders' equity accounts increase on the credit side, creating credit balances. - Debits = credits for each transaction Analytical Tools - Journalentry: a summary of a transaction and its effects on various accounts, using the double-entry bookkeeping system • Reference: letter, number, or date • Accounttitles: debited accounts on top, credit accounts on bottom • Amounts:debited amounts on left, credited amounts on right - Compoundentry: journal entry that affects more than 2 accounts - Recording external transactions in the journal is based on legal documents (contractual commitments). The T-account - After recording journal entries, amounts are posted to the general ledger. The ledger is often a 3-ring binder with a separate page for each account. How is the Statement of Financial Position Prepared and Analyzed? Classified Statementof Financial Position - Exhibit 2.8 (p.72) The Debt-to-EquityRatio - Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders' Equity - Indicates how much debt has been used to finance the company's acquisition of assets, relative to equity financing that is supplied by shareholders - High ratio -> company relies heavily on funds provided by creditors Some Misconceptions - Bookkeepinginvolves the routine, clerical part of accounting and requires only minimal knowledge of accounting. A bookkeepermay record the repetitiveand uncomplicated transactions and may maintain the simple records of a small business. The accountant is a highly trained professional, competentin the design of informationsystems,analysis of complex transactions, interpretation of financial data, financial reporting, auditing, taxation, and managementconsulting. - Accounting #s are influenced by estimates. Financial statementsdo not report the entity's market value. Chapter 3: Operating Decisions and the Income Statement September-17-12 11:30 AM How Do Business ActivitiesAffect the Income Statement? Operating Cycle - The long-term objectivefor any business is to turn cash into more cash (higher profits, faster growth). This excess cash must be generated from operations, not from borrowing money or selling non-current assets. - Operating(cash-to-cash)cycle: the time it takes for a companyto pay cash to suppliers, sell goods and services to customers, and collect cash from customers - Companies attempt to shorten the operating cycle by creating incentives to encourage customersto buy sooneror pay faster in order to improvethe company's cash flows. - Until a company ceases activities, the operating cycle is repeated continuously. - Periodicityassumption: the long life of a company can be repeated in shorter periods (e.g. months, quarters, & years) - 2 types of issues in reporting periodic income to users: 1. Recognition issues: When should the effects of operating activities be recognized (recorded)? 2. Measurementissues: What amounts should be recognized? Elements of the Income Statement - Exhibit 3.1 (p.106) - Multiple subtotals (e.g. operating profit, profit before interest and taxes) - Multiple step format is common -> Classification of income statementitems helps financial statementusers assess the company's operating performanceand predict its future profitability. - 3 major sections: 1. Results of continuing operations 2. Results of discontinued operations -> only somecompanies report info from section 2 Profit (the sum of 1 & 2) 3. Earnings per share Continuing Operations - Presents the results of continuing operations Operating Revenues - Revenues: increases in assets or settlementsof liabilities from ongoing operations. Operating revenues result from the sale of goods or services. - Sometimes,a company receivescash in exchange for a promise to provide goods/servicesin the future. Revenue is not earned, but a liability account, deferred revenue, is created. When the company provides the promised goods/servicesto the customer, revenue is recognized and the liability is settled. Operating Expenses - Expenditure:any outflow of cash for any purpose (e.g. buy equipment, pay off a bank loan, etc.) - An expense is more narrowly defined; it results when an asset is used to generate revenue during a period, or when an amount is incurred to generate revenues during a period, even if the amount will be paid in the future. Not all expenditures are expenses, and expenses are necessary to generate revenues. - Expenses: decreases in assets or increases in liabilities to generate revenues during the period - Cost of goods sold is the cost of products sold to customers -> usually the most significant expense - Gross Profit (GrossMargin) = Net Sales - Cost of Goods Sold - Operating expenses are the usual expenses, other than COGS, that are incurred in operating a business during a specific accounting period. International Accounting Standard 1 requires companies to classify their expenses by function (e.g. marketing and promotion,distribution) or by nature of the expense. Classification by nature includes the 3 main costs of production: materials, labour, and property and equipment use. • Distribution expenses: a variety of expenses related to the distribution of the company's products to its customers(e.g. wages earned, depreciation of delivery vehicles) • Marketing and administrative expenses: (e.g. salaries of marketing personnel) • Research & development expenses: relate to R&D of new products - Operating Profit (Profit from Operations) = Gross Profit - Operating Expenses - Operating Profit (Profit from Operations) = Gross Profit - Operating Expenses Non-operating Items - Not all activitiesaffecting an income statementare central to continuing operations. - Investment income (finance income): any interest/dividends earned on an investment - Borrowing money is a financing activity. However,the cost of using that money is interest expense. - Except for financial institutions, incurring interest expense or earning investmentincome are not the central operations of mostbusinesses. These are peripheral (normal but not central) transactions. - Gains: increases in assets or decreases in liabilities from peripheral transactions - Losses: decreases in assets or increases in liabilities from peripheral transactions - If subject to income taxes, added or subtracted from operating profit to obtain profit before income taxes (pretax profit). - Pretax Profit = Revenues - Expenses (except Income Tax Expense) Income Tax Expense - Last expense listed on income statement - For-profit corporations required to computeincome taxes owed to federal, provincial & foreign gvts - Calculated as a % of profit before incometaxes - Effective Tax Rate = Income Tax Expense ÷ Pretax Profit Discontinued Operations - When the decision is made to discontinue a major componentof a business, the profit or loss from that component,as well as any gain or loss on subsequent disposal - Non-recurring nature, financial results are not useful in predicting future recurring profits Non-controlling Interests - the portion of the consolidated profit that belongs to non-controlling shareholders - Controlling shareholder: owning a majorityof the shares of another company - Other shareholders -> non-controlling/minorityshareholders Earnings per Share - Used to evaluate the operating performance& profitability of a company - Earnings per Share = Profit ÷ Weighted Avg # of Shares Outstanding During the Period How are Operating ActivitiesRecognized and Measured? Cash basis accounting: records revenues when cash is received and expenses when cash is paid - • Often adequate for organizations that usually do not have to report to external users Accrual Accounting - Cash basis can be misleading. A company can report higher profit in one period because a customer paid cash in advance of receiving a good/serviceor the companypostponed the payment of utility bills until the next period. - Accrualbasis accounting: records revenues when earned and expenses when incurred, regardless of the timing of cash receipts or payments -> required by IFRS for financial reporting purposes The Revenue Principle - States that revenues are recognized when the significant risks and rewards are transferred to the buyer, it is probable that future economicbenefits will flow to the entity, and the benefits and the costs associated with the transaction can be measured reliably - Conditions to recognize/recordrevenue: a. The entity has transferredto the buyer the significant risks and rewards of ownership of the goods. b. The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold. c. The amount of revenue can be measured reliably. d. It is probable that the economic benefits associated with the transaction will flow to the entity. e. The costs incurred or to be incurred in respect of the transaction can be measured reliably. • If any of the conditions is not met, revenue normally is not recognized and should not be recorded. These conditions are usually met at the point of delivery of goods/services. - Cash can be receivedbefore, at the same time, or after the goods/servicesare delivered (Exhibit 3.3 (p.113)). The Matching Process - Requires that expenses be recorded when incurred in earning revenue (matching costs with - Requires that expenses be recorded when incurred in earning revenue (matching costs with benefits) - Some expenses are matched directly to sales revenue (e.g. COGS). Other expenses (e.g. utilities) may not be identifiable with specific sources of revenue but need to be incurred in order to generate revenue during the period. - Expenses are recorded as incurred, regardless of when cash is paid (Exhibit 3.4 (p.116)). The Expanded Transaction Analysis Model Transaction Analysis Rules - Exhibit 3.5 (p.118) - Revenues increase profit, thus increasing retained earnings and shareholders' equity (CR balances). - Expenses decrease profit, thus decreasing retained earnings and shareholders' equity. Therefore, expenses have DR balances. When increasing an expense, profit & retained earnings decrease. - Revenues > Expenses = Profit -> retained earnings & shareholders' equity increase - Revenues < Expenses = Loss -> retained earnings & shareholders' equity decrease Total Asset Turnover Ratio - Measures the sales generated from the use of assets - High ratio -> company is managing its assets (resources to generate revenues) efficiently - Total Asset Turnover Ratio = Sales (or Operating) Revenues ÷ Average Total Assets - Note: Average Total Assets = (BeginningTotal Assets + Ending Total Assets)÷ 2 Return on Assets Ratio - Measures how much the company earned from the use of assets during the period - High ratio -> company is managing its assets efficiently - Return on Assets = [Profit + Interest Expense (net of tax)] ÷ Average Total Assets Chapter 4: Adjustments, Financial Statements, and the Quality of Earnings September-26-12 11:30 AM Adjusting Revenues and Expenses Accounting Cycle - The process used by entities to analyze & record transactions, adjust the records at the end of the period, prepare financial statements,& prepare the records for the next cycle - Exhibit 4.1 (p.163) Purpose and Types of Adjustments Purpose of Adjustments - Adjusting entries: entries necessary at the end of the accounting period to identify and record all revenues and expenses of that period • Revenues are recorded when earned (the revenue principle). • Expenses are recorded when they are incurred to generate revenue during the same period (the matching process). • Assets are reported at amounts that represent the probable future benefits remaining at the end of the period. • Liabilities are reported at amounts that represent the probable future sacrifices of assets/services owed at the end of the period. - Companies wait until the end of the accounting period to adjust their accounts because adjusting the records daily would be very costly and time-consuming. Adjustments are required every time a company wants to prepare financial statementsfor external users. Types of Adjustments - 4 types of adjustments divided into 2 categories: • Revenues ○ Deferred revenues: previouslyrecorded liabilities that were created when cash was receivedin advance and that must be adjusted for the amount of revenue actually earned during the period  e.g. deferred ticket revenue, deferred subscription revenue  AJE: ↓ Liability and ↑ Revenue ○ Accrued revenues: revenues that were earned but not recorded because cash was received after the services were performed or goods were delivered  e.g. interest receivable, rent receivable  AJE: ↑ Asset and ↑ Revenue • Expenses ○ Deferred expenses: previouslyrecorded assets that were created when cash was paid in advance and that must be adjusted for the amount of expense actually incurred during the period through use of the asset  e.g. supplies, prepayments (rent, insurance), buildings and equipment  ↑ Expense and ↓ Asset ○ Accrued expenses: expenses that were incurred but were not recorded because cash was paid after the goods or services were used  e.g. interest payable, wages payable, property taxes payable  ↑ Expense and ↑ Liability - Each of these types of adjustments involves2 entries: 1. One for the cash receipt of payment 2. One for recording the revenue or expense in the proper period (through the AJE) - The deferred revenue is a liability representing the company's promise to perform or deliver the goods or servicesin the future. Recording the revenue is deferred until the company meets its obligation. - Exhibit 4.2 (p.165) - Adjusting entries affect one account on the statementof financial position and one account on the income statement,but cash is never adjusted. - Exhibit 4.3 (p. 166) Adjustment Process 1. Identify the type of adjustment. 2. Determinethe amount of revenue that has been earned or expense that has been incurred during the period. 3. Record the adjusting journal entry and post it to the appropriate accounts. Unadjusted Trial Balance - Trial balance: a list of all accounts with their balances, to provide a check if DR = CR (usually in financial statementorder), a schedule prepared for internal pruposes and is not a financial statementfor external users (Exhibit 4.4 (p.168)) - If the 2 columns are not equal, errors have occurred in 1 or more of the following: • In preparing journal entries when debits do not equal credits. • In posting the correct monetaryeffects of transactions from the journal entry to the ledger. • In computing ending balances in accounts. • In copying ending balances in the ledger to the trial balance. These errors can be traced and should be correctedbefore adjusting the records. - Property,plant, and equipment increase when assets are acquired and decrease when they are sold. These assets are also used over time to generate revenue. These assets depreciate over time as they are used. Depreciationis an allocation of an asset's cost over its estimateduseful life to the company. - Contra account:an account that is directly related to another account, but has a balance on the opposite side of the T-account (property,plant, and equipment: the contra account is accumulated depreciation) - On the statementof financial position, the amount that is reported for property, plant, and equipment is its carrying amount(bookvalue/netbook value) = acquisition cost - accumulated depreciation. DeferredRevenues - AJE 1: Deferred Service Revenue • DR Deferred revenue (-L) CR Service revenue (+R -> +SE) Accrued Revenues - AJE 2: Trade Receivables • DR Trade receivables (+A) CR Sales revenue (+R -> +SE) DeferredExpenses - AJE 3: Prepayments • DR Marketing and administrative expenses (+E -> -SE) CR Prepayments(-A) - AJE 4: Property, Plant, and Equipment • DR Depreciationexpense (+E -> -SE) CR Accumulated depreciationProperty,plant, and equipment (+XA -> -A) - AJE 5:Accrued Expenses (Utilities) • DR Marketing and administrative expenses (+E -> -SE) CR Accrued liabilities (+L) - AJE 6: Accrued Expenses (Salaries) • DR Distribution expenses (+E -> -SE) DR Marketing and administrative expenses (+E -> -SE) CR Accrued liabilities (+L) - AJE 7: Borrowings (Interest) • DR Interest Expense (+E -> -SE) CR Accrued liabilities (+L) - AJE 8: Income Taxes payable • recorded last b/c all other adjustments should be incorporated in computing profit before income taxes • DR Income tax expense (+E -> -SE) CR Income taxes payable (+L) - Adjustments are required to record revenues and expenses in the proper period because the cash part of the transaction occurs at a different point in time. part of the transaction occurs at a different point in time. Materiality and Adjusting Entries - Materiality:the relative significance of financial statementinformation in influencing economic decisions made by financial statementusers (An item of information,or an aggregate of items, is material if it is probable that its omissionor misstatementwould influence or change a decision.) - The concept of materiality allows accountants to estimateamounts and even to ignore specific accounting principles if the results of their actions do not have a material effect on statements. - AJE to record accrued expenses or revenues may be ignored if the monetaryamounts are immaterial. - Materiality depends on the nature of the item and on its monetaryvalue. (e.g. If an employeehas been stealing small amounts of money systematically,these amounts should not be judged as immaterialbecause they indicate a weakness in the company'sinternal control system that requires correction. - While each item may be immaterial when considered by itself, the combined effect of many items may be material. Preparing and AnalyzingFinancial Statements - The 4 financial statementsare interrelated; a number on 1 statementwill affect other statements. Statement Relationships among Elements of the Statements Income Statement Revenues + Gains - Expenses - Losses = Profit Statementof Changes Beginning Retained Earnings + Profit - Dividends = Ending Retained in Equity Earnings Statementof Financial Assets = Liabilities + Shareholders' Equity (Share Capital + Retained Position Earnings + Other Components [including Cash]) Statementof Cash Change in Cash = +/- Cash provided by or used in operating activities Flows +/- Cash provided by or used in investing activities +/- Cash provided by or used in financing activities Income Statement - Prepared first because profit is a componentof retained earnings - EPS = Profit Available to the Common Shareholders ÷ Weighted-Average # of Common Shares Outstanding during the Period (used to evaluate operating performance& profitability of a company) Statementof Changes in Equity - The profit amount (from income statement)is carried to the retained earnings column. - Dividends declared are deducted to arrive at an ending balance. Statementof Financial Position - The ending balances from the statementof changes in equity are included. - Accumulated depreciation has been subtracted from the appropriate account's carrying amount. Key Ratio Analysis Net Profit Margin Ratio - Measures how much profit each sales $ generated during the period (high/rising ratio: co. is managing its sales & expenses efficiently) - Net Profit Margin = Profit ÷ Net Sales Return on Equity - Measures how much the firm earned for each $ of shareholder's investment - Return on Equity = Profit ÷ Average Shareholders' Equity Closing the Books End of the Accounting Cycle - Permanent(real) accounts:statementof financial position accounts whose ending balances are - Permanent(real) accounts:statementof financial position accounts whose ending balances are carried into the next accounting period (0 balance when the item represented is no longer owned/owed) - Temporary (nominal)accounts: income statement(and sometimesdividends declared) accounts that are closed to retained earnings at the end of the accounting period - Closingentries: transfer balances in temporary accounts to retained earnings and establish 0 balances in temporaryaccounts • 2 purposes: to transfer profit or loss to retained earnings & to establish a 0 balance in each of the temporaryaccounts to start the accumulation in the next accounting period. - Incomesummary: a temporary account used only during the closing process to facilitate closing temporaryaccounts (credit balances closed by debiting, debit balances closed by crediting) -> balance reflects profit or loss and is then closed to retained earnings - Closing entries are dated the last day of the accounting period, entered in the usual format in the journal, and immediatelyposted to the ledger or T-accounts. Temporary accounts with debit balances are credited and accounts with credit balances are debited. Post-closingTrial Balance - After the closing process is complete,all of the income statementaccounts have a 0 balance. These accounts are then ready for recording revenues & expenses in the new accounting period. The ending balance in retained earnings now is up to date (matches the amount on the statement of financial position) and is carried forward as the beginning balance for the next period. As the last step of the accounting cycle, a post-closing trial balance (Exhibit 4.7 (p.185)) should be prepared as a check that DR = CR and that all temporaryaccounts have been closed. Appendix 4A: An Optional Recordkeeping Efficiency - Paymentsor receipts are often recorded, however, as expenses or revenues on the transaction date. This is done to simplify recordkeeping since revenues or expenses are frequently earned or incurred by the end of the accounting period. When the full amount is not completelyincurred or earned, an adjustment is necessary (see p.196-197). Chapter 5: Reporting and Interpreting Cash Flows October-01-12 11:30 AM Classification of Cash Flows - The statementof cash flows explains how the cash balance at the beginning of the period changed to another cash balance at the end of the period. - Cash = cash & cash equivalents:a short-term,highly liquid investmentwith an original maturity of < 3 months • also readily convertibleto known amounts of cash & so near their maturity that there is little risk that their value will change if interest rates change • e.g. T-Bills (a short-term governmentdebt), money market funds, and commercialpaper (short-term notes payable issued by large corporations) - Exhibit 5.1 (p.235) -> 3 categories:operating activities,investing activities, financing activities Cash Flows from Operating Activities - Cash inflows & outflows directly related to earnings from normal operations - cash flows not affected by accruals, deferrals, and allocations that result from the timing of revenue & expense recognition - 2 approaches for presenting the operating activities section: 1. Direct method:reports the componentsof cash flows from operating activities listed as gross receipts & gross payments Inflows Outflows Cash received from Cash paid for Customers Purchase of goods for resale & services (electricity, etc.) Dividends and interest on investments Salaries & wages Income taxes Interest on borrowings • Net cash inflow (outflow) from operating activities= Inflows - Outflows • More expensive to implementthan the indirect method 2. Indirectmethod: starts with profit for the period & then eliminates non-cash items to arrive at net cash inflow (outflow) from operating activities - The total amount of cash flows from operatingactivities is always the same, whether it is computed by using the direct or indirect method. Cash Flows from Investing Activities - Cash inflows & outflows related to the acquisition or sale of productive facilities and investments in the securities of other companies Inflows Outflows Cash received from Cash paid for - Sale or disposal of property, plant, and equipment - Purchase of property, plant, and equipment - Sale or maturity of investments in securities - Purchase of investments in securities - Net cash inflow (outflow) from investingactivities= Inflows - Outflows Cash Flows from Financing Activities - Cash inflows & outflows related to external sources of financing (owners & creditors)for the enterprise Inflows Outflows Cash received from Cash paid for - Borrowing on notes, mortgages, bonds, etc., from - Repayment of principal to creditors creditors - Interest on borrowings if it is classified as a financing - Issuing shares to shareholders activity - Repurchasing shares from owner - Dividends to shareholders - Net cash inflow (outflow) from financing activities= Inflows - Outflows Net Increase (Decrease)in Cash - Net Increase (Decrease) in Cash = Net cash flows from operating, investing,& financing activities - Net Increase (Decrease) in Cash = Net cash flows from operating, investing,& financing activities Relationships to the Statement of Financial Positionand the Income Statement - Must analyze accounts recorded under accrual basis and adjust them to a cash basis - To prepare the statementof cash flows, accountants need: 1. Comparative statements of financial position that are used in computing the cash flows from all activities (operating, investing, and financing) 2. A complete income statement, which is used primarily in identifying cash flows from operating activities 3. Additional details concerning selected accounts that reflect different types of transactions and events. Analysis of individual accounts is necessary because often the net change in an account balance during the year does not reveal the underlying nature of the cash flows. - Δ Cash = Δ Liabilities+ Δ Shareholders' Equity - Δ Non-cash Assets • Any transaction that changes cash must be accompanied by a change in liabilities, shareholders' equity, or non-cash assets. - Cash inflow: Decreasein Non-cash Assets & Increase in Liabilities and Shareholders' Equity Cash outflow: Increase in Non-cash Assets & Decreasein Liabilities and Shareholders' Equity • Exhibit 5.2 (p.239) - Exhibit 5.3 (p.240) • The financial position accounts related to earning income (operating items) include: ○ Most current assets (other than short-term investmentswhich relate to investing activities) ○ Most current liabilities (other than amounts owed to investors and financial institutions (financing)) ○ Retained earnings because it increases by the amount of profit, which is the starting point of the operating section. (Retained earnings also decreases by the amount of dividends declared and paid, which is a financing outflow.) • The financial position accounts related to investing activities include all of the remaining assets on the statementof financial position (e.g. property, plant, and equipment, long-term investments, goodwill). • The financial position accounts related to financing activities include all of the remaining liability and shareholders' equity accounts (e.g. share capital, retained earnings (dividends declared and paid)). Reporting and Interpreting Cash Flows from Operating Activities A Simplified Illustration - Revenues earned by a company do not necessarily result in an equal amount of cash collectionsfrom customersduring the year. The amount of cash received from customers during the year could be equal to, lower, or higher than the amount of revenues. The amount of expenses incurred during the year may not coincide with the amount of cash paymentsfor these expenses. Given that revenues and expenses include both cash and non-cash components,we need to removethe non-cash revenues and non-cash expenses from profit to obtain the cash components(Exhibit 5.5 (p.244)). - The direct method focuses on the cash elements of profit by computing cash receipts and cash payments for operating purposes, and reports to details to arrive at net cash flows from operating activities. The indirect method starts with profit and eliminates the non-cash elements. • Profit = Cash elements +/- Non-cash elements • Cash elements = Profit +/- Non-cash elements - Reminders: • Cash flows from operating activities is always the same regardless of whether it is computed by using the direct or indirect method. • The investing and financing sections are always presented in the same manner, regardless of the format of the operating section. Reporting Cash Flows from Operating ActivitiesIndirectMethod - General structure: Operating Activities Profit Add/Subtract items not affecting cash: + Depreciation expense + Decrease in non-cash current assets - Increases in non-cash current assets - Increases in non-cash current assets - Increases in current liabilities - Decreasesin current liabilities_________ Net Cash Flows from Operating Activities - Involves 2 steps: 1. Adjust profit for the effect of depreciation expense. Since depreciation expense is subtracted in computing profit, but does not affect cash, we always add it back. 2. Adjust profit for changes in current assets and current liabilities marked as operating. Each change in current assets and current liabilities (other than cash & cash equivalents) causes a difference between profit and cash flows from operating activities. • General rules: ○ Add the change when a current assets decreases or a current liability increases. ○ Subtract the change when a current asset increases or current liability decreases. - Exhibit 5.6 (p.246) Change in Trade Receivables - Cash flows from operating activities must reflect cash collections from customers. - When sales revenues are recorded, trade receivablesincrease, and when cash is collected from customers,trade receivables decrease. - Ending balance - Beginning balance = Change - The statementof financial position for APL indicates an increase in trade receivablesof $5,509for the period, which means cash collected from customersis lower than revenue. To convert to cash flows from operating activities, the amount of the increase must be subtracted from profit. Change in Inventory - Cash flows from operating activities must reflect cash purchases. - Both the change in inventory and the change in trade payables (borrowing from suppliers) determine the magnitude of this difference. - Change in inventory = Purchases - Cost of sales - APL's statementof financial position indicates that inventory increased by $1,382,which means that the cost of purchases is larger than the cost of merchandise sold. The increase must be subtracted from profit to convertto cash flows from operating activities. Change in Prepayments - Cash flows from operating activities must reflect the cash payments. Cash paid in advance increases the prepayments balance, and expenses recognized during the period decrease the balance. - APL's statementof financial position indicates that prepayments increased by $1,006during the quarter, which means that the amount of expenses is smaller than new cash prepayments. The increase (the extra payments) must be subtracted from profit. Change in Trade Payables - Cash flow from operations must reflect cash purchases, but not all purchases are for cash. Purchases on account increase trade payables, and cash paid to suppliers decreases trade payables. - APL's trade payables increased by $5,708,indicating that cash payments were smaller than purchases on account, and this increase (the lower payments) must be added to profit. Change in Accrued Liabilities - The statementof cash flows must reflect actual paymentsfor those expenses. Recording accrued expenses increases the accrued liabilities balance, and cash payments for the expenses decrease it. - APL's accrued liabilities decreased by $1,165,which indicates that accrual-basis expenses are smaller than cash paid for the expenses. The decrease must be subtracted from profit. Interpreting Cash Flows from Operating Activities - Focuses attention on firm's ability to generate cash internally through operationsand its managementof working capital (= current assets - current liabilities) - Seen as the most important section of the statement -> operations are the only sustainable source of cash - A commonrule followed by financial and credit analysts is to avoid firms with rising profit but falling cash flow of operations. Rapidly rising inventories require the use of cash until goods are sold. Rapidly rising trade receivables reflect a delay in the collection of cash. Rising inventoriesand trade receivables often predict a future slump in profit as revenues fall. This increases the need for external financing as overall cash inflows from operations decline. Analyzing Changes in Trade Receivables Analyzing Changes in Trade Receivables - Managers sometimesattempt to boost declining sales by extending credit terms or by lowering credit standards (e.g. lending to riskier customers).The resulting increase in trade receivables can cause profit to outpace cash flow from operations. Analyzing Inventory Changes - An unexpected increase in inventorycan cause profit to outpace cash flow from operations. Such inventory growth can be a sign that planned sales growth did not materialize. A decline in inventory can be a sign that the company is anticipating lower sales. Key Ratio Analysis Quality of Earnings Ratio - Indicates what portion of profit was generated in cash - Quality of Earnings Ratio = Cash Flows from Operating Activities÷ Profit - Higher ratio: less likely that the company is using aggressive revenue recognition policies to increase profit - When the ratio does not equal 1.0, analysts must establish the source of the difference to determine the significance of the findings. There are 4 potential causes of any difference: 1. The corporate life cycle (growth/decline in sales). When sales are increasing, receivablesand inventory normallyincrease faster than trade payables. This often reduces operating cash flows below the reported profit, which reduces the ratio. When sales are declining, the opposite occurs and the ratio increases. 2. Seasonality 3. Changes in revenue and expense recognition. Aggressive revenue recognition or failure to accrue appropriate expenses will inflate profit and reduce the ratio. 4. Changes in management of operating assets & liabilities. Inefficient managementwill increase operating assets and decrease liabilities, which will reduce operating cash flows and reduce the ratio. More efficient management will have the opposite effect. Reporting and Interpreting Cash Flows from Investing Activities Reporting Cash Flows from Investing Activities Investing Activity Related Statement of Financial Position Account(s) Cash Flow Effect -Purchase of property, plant, and equipment or -Property, plant, and equipment and intangible assets Outflow intangible assets for cash (e.g. patents) -Sale of property, plant, and equipment or Inflow intangible assets for cash -Purchase of investment securities for cash -Short- or long-term investments in shares and bondsOutflow issued by other companies -Sale (maturity) of investment securities for cash Inflow - Typical investing activities: 1. Cash expenditures that include the acquisition of tangible productive assets such as buildings and equipment or intangible assets such as trademarks and patents. Only purchases paid for with cash or cash equivalents are included. 2. Cash proceeds from the sale of productive assets or intangible assets. This is the amount of cash that was received from the sale of assets, regardless of whether the assets were sold at a gain or a loss. 3. Purchase of short- or long-term investmentsfor cash. These investmentscan include shares or bonds issued by other companies, GICs, or governmentsecurities with maturities of > 3 months. 4. Cash proceeds from the sale or maturity of short- or long-term investments.This is the amount of cash that was receivedfrom the sale, regardless of whether the assets were sold at a gain or a loss. Property,Plant, and Equipment (net) - Typically, the net change in PPE is the result of 3 main changes: (1) purchase of new assets (↑ balance), (2) disposal of old assets (↓ balance by the carrying amount), and (3) periodic depreciation of these assets (↓ balance due to ↑ accumulated depreciation). - APL purchased new PPE for cash for $3,006,which is a cash outflow.This amount less the depreciation expense is added to the profit in the operations section. - Cash purchases and sales of plant and equipment are listed separately on the statementof cash flows. Long-Term Investments - Exhibit 5.7 (p.253) - Exhibit 5.7 (p.253) Interpreting Cash Flows from Investing Activities - 2 commonways to assess a company'sability to finance its expansion needs from internal sources: capital acquisitions ratio & free cash flow Key Ratio Analysis Capital Acquisitions Ratio - Measures the ability to finance purchases of PPE from operations (high ratio = less need for outside financing for current and future expansion) - Capital AcquisitionsRatio = Cash Flow from Operating Activities÷ Cash Paid for PPE Free Cash Flow - A measure of the firm's ability to pursue long-term investmentopportunities - Free Cash Flow = Cash Flows from Operating Activities - Dividends - Capital Expenditures Reporting and Interpreting Cash Flows from Financing Activities Reporting Cash Flows from Financing Activities - Financing activities are associated with generating capital from creditors and owners. - Affects notes payable on financial institutions (short-termborrowings), current portion of long-term borrowings, non-current liabilities and shareholders' equity accounts Related Statement of Financial Position Account(s) Cash Flow Financing Activity Effect -Short-term borrowings -Borrowing cash from bank or other financial institution Inflow -Repayment of loan principal Outflow -Long-term borrowings -Long-term borrowings for cash Inflow -Repayment of principal on long-term borrowings Outflow -Share capital -Issuance of shares for cash Inflow -Repurchase (retirement) of shares with cash Outflow -Retained earnings -Payment of cash dividends Outflow - Typical financing activities: 1. Proceeds from issuance of short- and long-term borrowings 2. Principal payments on short- and long-term borrowings 3. Proceeds from the issuance of shares 4. Purchase of shares for retirement 5. Interest and dividends - Dividends receivedmay be classified as investing cash flows because they represent returns on investments.They may be classified as operating cash flows because they enter into the determinationof profit or loss. - Interest paid and interest received may be classified as financing cash flows because they are costs of obtaining financial resources or returns on investments. They may be classified as operating cash flows because they enter into the determinationof profit or loss. Interpreting Cash Flows from Financing Activities - The long-term growth of a company is normally financed from 3 sources: internally generated funds (cash from operating activities), the issuance of shares, and money borrowed on a long-term basis. The statementof cash flows shows how management has elected to fund its growth (used to evaluate capital structure and growth potential of a business). Additional Cash Flow Disclosures - Companies that use the direct method for computing cash flow from operations usually present a reconciliation of profit to cash flow from operationsas a supplemental schedule. Companies must also provide 2 other disclosures related to the statementof cash flows. Non-cash Investing and Financing Activities - Transactions that do not have direct cash flow effects; they are reported as a supplement to the statementof cash flows in narrative or schedule form - e.g. The purchase of a $100,000building with a $100,000mortgage is given by the former owner. Supplemental Cash Flow Information - Companies that use the indirect method of presenting cash flows from operations must also disclose the amounts of interest and dividends received and paid during the period as well as cash paid for income taxes (normally listed at the bottom of statementor in the notes). Appendix 5A: Adjustment for Gains and LossesIndirectMethod - The transactions that cause gains and losses should be classified on the statementof cash flows as operating, investing, or financing activities, depending on their dominant characteristics. For example, if the sale of a productive asset (e.g. delivery truck) produced a gain, it would be classified as an investing activity. - An adjustment must be made in the operating activities section to avoid double counting of the gain or the loss. • DR Cash 8,000 DR Accumulated depreciation 4,000 CR PPE 10,000 CR Gain on sale of assets 2,000 ○ Because the gain is included in the computationof profit, it is necessary to remove(subtract) the $2,000gain from the operating activities section of the statementto avoid double counting. - When a loss is reported on the income statement,it must also be removedfrom cash flows from operating activities. • DR Cash 41,000 DR Accumulated depreciation 15,000 DR Loss on sale of assets 12,000 CR PPE 68,000 ○ On the statementof cash flows, the loss of $12,000must be removed(added to profit) in the computationof cash flows from operating activities, and the total cash collectedof $41,000must be shown In the investing activities section of the statement. Chapter 6: Communicating and Interpreting Accounting Information October-12-12 11:30 AM Players in the Accounting Communication Process - Exhibit 6.1 (p.294) Regulators (CSA, AcSB, AASB, Stock Exchanges) - Public Canadian corp. must comply with provincial securities regulations (Canadian Securities Administrators (CSA)) - CSA: forum for the 13 securities regulators of Canada's provinces & territories that was established to harmonize regulation of the Canadian capital markets • Mission: to protect investorsfrom unfair, improper, or fraudulent practices & to foster fair, efficient, and vibrant capital markets - Securities regulators work closely with the Accounting Standards Board (AcSB) that is responsible for establishing standards of accounting and reporting by Canadian companies. External auditors ensure that companies prepare their financial reports in accordance with these standards, and their audit work is guided by International Standards on Auditing, which have been adopted by the Canadian Auditing and Assurance Standards Board (AASB) as Canadian Auditing Standards. - Non-compliancewith accounting standards suspicion -> stock exchanges perform independent investigations and share info with securities commissions(CRA) & other law enforcementagencies (RCMP) • May also enforce their rules through penalties (temporarycease trade orders to fines and delisting of co.) Managers (CEO, CFO, and Accounting Staff) - Chief executive officer (CEO): highest officer in the company - Chief financial officer (CFO): highest officer associated with the financial and accounting side of business - Accounting staff -> responsibility for accuracy, legal responsibility is smaller Board of Directors(Audit Committee) - Elected by the shareholders to represent their interests, is responsible for maintaining the integrity of the company's financial reports - Must be composedof non-management (independent) directors with financial knowledge - Responsible for hiring the company's independent auditors - Meet separately with auditors to discuss management's compliancewith financial reporting responsibilities Auditors - Provincial securities commissionsrequire public corporationsto have their statementsaudited (International Standards of Auditing). - Unqualified(clean)auditopinion: auditor's statementthat the financial statementsare fair representationsin material respects in conformitywith Canadian Auditing Standards - Companies often hire financial managers from their audit firms (broad financial experience & specific company knowledge gained during prior years' audits) Information Intermediaries: Analysts and InformationServices - Exhibit 6.2 (p.297) Financial Analysts - Receive accounting reports & other info about the company from electronic informationservices - Gather informationthrough conversationswith company executivesand visits to company facilities and competitors-> results combined into analysts' reports - Analysts reports normally include forecastsof share price and future quarterly and annual EPS; a buy, sell, or hold recommendationfor the companyshares; and explanations for these judgements. - Earningsforecasts: predictions of earnings for future accounting periods - Analysts often work in research depts. of brokerage and investment banking houses, mutual fund companies, and investmentadvisory services. - Market efficiency: quick, unbiased reaction to information Information Services Information Services - SEDAR (System for Electronic Document Analysis and Retrieval): official site for the filing of documentsby public companies as required by securities laws in Canada Users: Institutional and Private Investors,Creditors, and Others - Institutionalinvestors: managers of pension funds, mutual funds, endowmentfunds, & other funds that invest on behalf of others • Usually employ their own analysts who rely on information intermediaries • Control the majority of publicly traded shares of Canadian companies - Private investors: individuals who purchase shares in companies • Retail investorsnormally lack the expertise to understand financial statementsand the resources to gather data efficiently. They often rely on the advice of informationintermediaries or turn their money over to the managementof mutual & pension funds (institutional investors). - Lenders (creditors):suppliers & financial institutions that lend money to companies • Often the primary external user group for financial statementsof private companies • Institutional & private investors also becomecreditors when they buy a company's publicly traded bonds & debentures. The Disclosure Process Press Releases - A written news announcement normally distributed to major news services Annual Reports - Normally include: 1. Basic financial statements 2. Related notes 3. Report of independent accountants (auditors' opinion) - Normally split into 2 sections: • "Non-financial": letter to shareholders from the chairperson & CEO, desc. of company's management philosophy, products, successes (sometimesfailures), exciting prospects & challenges for the future • "Financial": core of report ○ Principal components(order may vary): 1. Summarized financial data for a 5- or 10-year period 2. Management's Discussion and Analysis, covering financial condition and results of operations  Key figures of financial statementsand future risks, non-financial & strategic info to help users interpret the financial statements 3. The basic financial statements 4. Notes (Footnotes) 5. Report of Independent Accountants (Auditors' Opinion) and the Management Certification 6. Recent stock price information 7. Summaries of the unaudited quarterly financial data 8. Lists of directors and officers of the company and relevant addresses Quarterly Reports - Normally begin with letter to shareholders, followed by condensed income statementfor the quarter & a condensed statemento financial position dated at the end of the quarter (both unaudited) - Often, the statementof cash flows, statementof changes in equity, and some notes are omitted. Reports to Securities Commissions - Include an annual report, quarterly reports, an annual informationform, & an information circular - Annual information form:more detailed description of business (e.g. company's corporatestructure, the industry in which it operates, the products and services it offers, product and project development,sales & marketing, manufacturing, and competition),lists properties owned & leased by the company, significant contracts the company has signed - Information circular: legal document that is forwarded to the company's shareholders prior to the annual meeting of shareholders, provides informationabout the items that the shareholders will be asked to consider and voteon during the meeting (election of new directors, appointment of independent auditors, other matters of a legal nature), provides details of the monetarycompensationof key mgmt personnel other matters of a legal nature), provides details of the monetarycompensationof key mgmt personnel - Short-form prospectus:provides details of the equity and/or debt securities that they plan to issue to investors,& press releases concerning new developments Guiding Principles for CommunicatingUseful Information - Exhibit 6.4 (p.303) Relevance - Information disclosed is relevant if it can influence users' decisions by helping them assess the economic effect of past activitiesand/or predict future events - Elements of an income statement have predictive value if they help users predict future levels of profit or its subcomponents(e.g. operating profit). Elementshave confirmatory value if it confirms or changes prior expectationsbased on previous evaluations. - Material amounts:amounts that are large enough to influence a user's decision (entity-specific aspect of relevance) Faithful Representation - Suggests that information provided in financial statementsmust reflect the substance of the underlying transactions (informationmust be complete,neutral, & free from material error) - The usefulness of accounting information is enhanced when it is neutral (free from bias in its measurement and presentation. Bias in measurementoccurs when the item being measured is consistentlyunderstated or overstated. Comparability - Enables users to identify similarities & discrepancies b/w 2 sets of financial reports produced by 2 diff co. - is enhanced if there is consistent informationavailable by using the same accounting methods over time Verifiability - Information is verifiable if independent accountants can agree on the nature & amount of the transaction Timeliness - Timely informationenhances both its predictive & confirmatoryvalues. - Relevance of accounting information for decision making declines as time passes. Understandability - Enables users to comprehend its meaning (e.g. through clear and concise classification and presentation) Constraints of Accounting Measurement Cost - Cost constraint:information should be produced only if the perceived benefits of increased decision usefulness exceed the expected costs of providing that information - Mandatory disclosure: when standard setters requirementcompanies to disclose specific information Prudence - Care should be taken not to overstateassets and revenues or understate liabilities and expenses - Financial statementsthat show assets at historical cost, but reduce these amounts when current values are significantly lower -> lower-of-cost-or-marketguideline A Closer Look at Financial Statements and Notes Classified Statementof Financial Position - Assets may be reported by increasing order of liquidity. The equity section could be presented before liabilities, with non-current liabilities listed before current ones -> method adopted by IFRS Classified Income Statement - Most manufacturing and merchandising companies use this basic structure: • Net Sales - Cost of Sales = Gross Profit • Gross Profit - Operating Expenses = Operating Profit • Operating Profit +/- Non-operating revenues/expen
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