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Chapter 1

Chapter 1 notes

Financial Accounting
Course Code
G.Quan Fun

of 3
Chapter 1 The Purpose and Use of Financial Statements Notes
Accounting Matters
x accounting : information system that identifies and records economic events of organization, and communicates them to wide
variety of interested users
x accounting—“language of business”; consistently ranked as one of top career opportunities
Users and Uses of Accounting
Internal Users
x plan, organize, and run company or work for company
x include finance directors, marketing managers, HR personnel, production supervisors, company officers
External Users
x investors use information to make decisions to buy, hold, or sell their ownership interest
x creditors use information to evaluate the risks of granting credit or lending money
x investors and creditors are main external users, but others use it including labour unions, customers, taxing authorities, regulatory
agencies, and economic planners
Ethical Behaviour
x ethics is of utmost importance to accountants and decision-makers who rely on financial info
x fortunately, most individuals in business are ethical, whose actions are legal and responsible
Forms of Business Organization
x proprietorship : a business owned by one person
x partnership : a business owned by more than one person
x corporation : business organized as separate legal entity having ownership divided into transferable shares held by shareholders
x only relatively small capital is needed to start business
x proprietor receives any profits, suffers any losses, and is personally liable for any debts
x no legal distinction between business as economic unit and owner
x similar to proprietorships except that there is more than one owner
x each partner generally has unlimited liability for all debts, even if other partner has created it
x buying shares in corporation is often more attractive than investing in proprietorship or partnership because it is easier to sell
x many businesses start out as proprietorship or partnership and eventually incorporate
x public corporations—commonly distribute their financial statements to shareholders, creditors other interested parties, and the
general public upon request
x private corporations—do not issue publicly traded shares and almost never distribute their financial statements publicly
Business Activities
Financing Activities
x two primary ways for corporations to raise outside money are (1) borrowing money and (2) selling shares in exchange for cash
x liabilities : debts and obligations of a business; claims of creditors on the assets of a business
x taking money from an operating line of credit results in bank indebtedness
x a company can take a short-term note payable to a bank for the money borrowed
x a company may also have long-term debt, which can include notes payable, mortgages payable, lease obligations, and other types
of debt securities borrowed for longer periods of time
x share capital : shares representing ownership interest in a corporation; if only one class exists, it is known as common shares
x common shares—term used to describe the amount paid by investors for shares of ownership in company; just one class of share
capital that company can issue
x shareholders have no claim to corporate resources until the claims of creditors are satisfied
x dividends : the distribution of retained earnings from a corporation to its shareholders, normally in the form of cash
Investing Activities
x assets : resources owned by a business
x every asset is capable of providing future services or benefits that can be short- or long-lived
x investing activities generally involve long-lived assets, such as computers, vehicles, buildings, and land, which are generally
referred to as property, plant, and equipment, an asset category
x cash is one of the most important assets owned by any business
x while cash can be used for, or result from, an investing activity, it is not itself an investing activity
x investments are another example of an asset and an investing activity, which can be either short- or long-term
Operating Activities
x operating activities—transactions which create revenues and expenses
x revenues : economic resources that result from operating activities of business, such as sale of product or provision of service
x sources of revenue that are common to many businesses are sales revenue, service revenue, and interest revenue
x accounts receivable—assets because they will result in a future benefit—cash—when amounts owed are eventually collected
x companies also have other types of receivables, such as income tax receivable, that is due from the government
x items that are held for future sale to customers result in an asset called inventory or merchandise inventory and once they are
sold, they are called expenses, specifically cost of goods sold
x expenses : the cost of assets consumed or services used in ongoing operations to generate revenue
x expenses include cost of goods sold, operating expenses, depreciation expense, interest expense, income taxes
x there are also many types of short-term liabilities that may arise from these expenses
x the obligations a company has to pay for goods are called accounts payable
x there is bank indebtedness on amounts owed to bank on operating LOC or demand loan, interest payable on outstanding amounts
owed to various lenders, dividends payable to shareholders, salaries payable to employees, PST and property taxes payable to
provincial government, GST to federal government, and income tax payable
x net earnings : the amount by which revenues are more than expenses; also known as net income
x net loss : the amount by which expenses are more than revenues
Summary of Business Activities
1. Financing activities include borrowing cash from lenders by issuing debt, or conversely, using cash to repay debt. Cash can also
be raised from shareholders by issuing shares or paid to shareholders by distributing dividends.
2. Investing activities include purchasing and disposing of long-lived assets such as property, plant, and equipment and short- or
long-term investments.
3. Operating activities result from day-to-day operations and include revenues and expenses and related accounts such as
receivables, inventory, and payables.
Communicating with Users
x users, especially external users, are interested in a companys assets, liabilities, shareholders’ equity, revenues, and expenses
x for external reporting purposes, it is customary to arrange this information in four different financial statements that are the
backbone of financial reporting:
1) Statement of earnings: A SE reports Rs & Es to show how successfully a company performed during a period of time.
2) Statement of retained earnings: A SRE indicates the portion of a company’s earnings that was distributed to shareholders
of a company in the form of dividends, and how much was retained in the business to allow for future growth.
3) Balance sheet: A BS presents a picture of what a company owns, what it owes, and its net worth at a specific point of time.
4) Cash flow statement: A CFS shows where a company obtained cash during a period of time and how that cash was used.
x additional information is reported in notes to the financial statements that are cross-referenced to the four statements
Statement of Earnings
x statement of earnings : a financial statement that presents the revenues and expenses and resulting net earnings or net loss of a
company for a specific period of time; also known as income statement
x issue of shares and distribution of dividends do not affect net earnings
Statement of Retained Earnings
x retained earnings : the amount of accumulated net earnings (less losses, if any), from the prior and current periods, that has
been kept in the corporation for future use and not distributed to shareholders as dividends
x statement of retained earnings : financial statement that summarizes the changes in retained earnings for specific period of time
x by monitoring the SRE, financial statement users can evaluate dividend payment practices
x some investors look for companies that pay high dividends, while other investors seek companies that pay no dividends and
instead reinvest earnings to increase the company’s growth
Balance Sheet
x balance sheet : a financial statement that reports the assets, liabilities, and shareholders’ equity at a specific date
x shareholders’ equity : the shareholders’ claim on total assets, represented by the investments of the shareholders (share capital)
and undistributed earnings (retained earnings) generated by the company
x accounting equation : assets = liabilities + shareholders’ equity
x shareholders’ equity consists of two parts: (1) share capital and (2) retained earnings
x share capital represents the shareholders’ investments and includes all the classes of shares that a company has issued
x creditors analyze BS to determine likelihood that they will be repaid and carefully evaluate company’s assets and liabilities
x managers use the BS to determine whether inventory is adequate to support future sales and whether cash on hand is sufficient
for immediate cash needs; they also look at the relationship between total liabilities and shareholders’ equity to determine
whether they have the best proportion of debt and equity financing
Cash Flow Statement
x cash flow statement : a financial statement that provides information about the cash inflows (receipts) and cash outflows
(payments) for a specific period of time
x to help investors, creditors, and others in the analysis of a company’s cash position, the CFS reports the effects on cash of a
companys (1) operating activities, (2) investing activities, and (3) financing activities during the period of time
x operating activities are normally presented first in the CFS, followed by either investing or financing activities
x fiscal year : an accounting period that is one year long
x comparative statements : a presentation of the financial statements of a company for two or more years
Elements of an Annual Report
x annual report : a report prepared by management that presents financial and nonfinancial information about the company
x nonfinancial information may include the missions statement, goals and objectives, products, and people
x financial information normally includes a management discussion and analysis, a statement of management responsibility for the
financial statements, an auditorsreport, the comparative financial statements, notes to the financial statements, and a historical
summary of key financial ratios and indicators
Summary of Study Objectives
1. Identify the users and uses of accounting. The purpose of accounting is to provide useful information for decision-making.
There are 2 types of user groups who use accounting information: internal and external users. Internal users work for business
and need accounting information to plan, organize, and run operations. The primary external users are investors and creditors.
Investors use accounting information to help decide whether to buy, hold, or sell shares. Creditors use accounting information to
evaluate the risk of granting credit or loaning money to a business.
There are three types of organizations that use accounting information: proprietorships, partnerships, and corporations. A
proprietorship is a business owned by one person. A partnership is a business owned by two or more people. A corporation is a
separate legal entity whose shares provide evidence of ownership.
2. Explain the three main types of business activity. Financing activities involve collecting the necessary funds (through debt or
equity) to support the business. Investing activities involve acquiring the resources (such as property, plant, and equipment) that
are needed to run the business. Operating activities involve putting the resources of the business into action to generate net
3. Describe the content and purpose of each of the financial statements. The statement of earnings presents the revenues and
expenses of a company for a specific period of time. The statement of retained earnings summarizes the changes in retained
earnings that have occurred for a specific period of time. Retained earnings are the cumulative earnings (less losses) over the
companys life, less any dividends paid to shareholders. The balance sheet reports the assets, liabilities, and shareholders’ equity
of a business at a specific date. The cash flow statement summarizes information on the cash inflows (receipts) and outflows
(payments) for a specific period of time. These statements are included in an annual report, along with nonfinancial and other
financial information.