Chapter 1: Financial Statements and Business Decisions
September-10-12 11:30 AM
Understanding the Business
- 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
- 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
- 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
- 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
- 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
- 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
- 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
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
The Statement of ComprehensiveIncome
- 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
- 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
- Revenues - Expenses = Profit
- Revenues: earned from the sale of goods and services to customers whether or not they have been
- 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
- 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
- Profit normally does not equal the net cash generated by operations.
The Statement of Changes in Equity
- 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
- Shows how the incomestatement and the statementof financial position are linked through the
retained earnings section of shareholders' equity
The Statement of Cash Flows
- 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
- 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
- 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
- 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
- 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
- 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
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
- Are independent professional servicesthat improvethe quality of information, or its context, for
- 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
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
- 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
- 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
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
- 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
• 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,
- 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
- 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
- Signing a contract -> only the exchange of promises (not included in statements)
- A standardized format that organizations use to accumulate the monetaryeffects of transactions on each
- 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: 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
- Journalentry: a summary of a transaction and its effects on various accounts, using the double-entry
• 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).
- 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)
- 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
- 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?
- 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
- 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
- Presents the results of continuing operations
- 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.
- 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
- 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
- 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
- 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
- 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
- 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
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
- 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
September-26-12 11:30 AM
Adjusting Revenues and Expenses
- 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
• Assets are reported at amounts that represent the probable future benefits remaining at the end of
• 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:
○ 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
○ 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
- 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
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
- 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
- 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
- AJE 1: Deferred Service Revenue
• DR Deferred revenue (-L)
CR Service revenue (+R -> +SE)
- AJE 2: Trade Receivables
• DR Trade receivables (+A)
CR Sales revenue (+R -> +SE)
- AJE 3: Prepayments
• DR Marketing and administrative expenses (+E -> -SE)
- AJE 4: Property, Plant, and Equipment
• DR Depreciationexpense (+E -> -SE)
CR Accumulated depreciationProperty,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
• 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
- 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
- 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
- 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
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
- 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.
- 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
Cash received from Cash paid for
Customers Purchase of goods for resale & services (electricity, etc.)
Dividends and interest on investments Salaries & wages
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
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
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
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,
• 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
• 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 ActivitiesIndirectMethod
- General structure:
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
- 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
- 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.
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
-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
- 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 LossesIndirectMethod
- 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
• 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
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
- 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
- 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)
- 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 &
The Disclosure Process
- A written news announcement normally distributed to major news services
- 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
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
- 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)
- 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
- 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
- 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
- Information is verifiable if independent accountants can agree on the nature & amount of the transaction
- Timely informationenhances both its predictive & confirmatoryvalues.
- Relevance of accounting information for decision making declines as time passes.
- Enables users to comprehend its meaning (e.g. through clear and concise classification and presentation)
Constraints of Accounting Measurement
- 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
- 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