Chapter 1: The Purpose and Use of Financial Statements
Accounting (“the language of business”): the information system that
identifies and records the economic events of an organization, and then
communicates them to a wide variety of interested users.
Users of accounting information can be divided into:
o Internal Users
They plan, organize, and run companies (work for the
Human resource personnel
Questions they may need to answer:
Is there enough cash to pay the bills? (finance)
What should we sell iPads for to maximize profit?
How many employees can we afford to hire this year?
Which production line is the most profitable?
Accounting information must be available when its needed.
o External Users
Investors (whether to buy, hold, or sell their ownership
Lenders (evaluate risks of lending money)
Other creditors i.e. suppliers (whether or not to grant
credit; sell on account)
Employees and labour unions (can they provide
employment opportunities and pay salaries and
Customers (will they support its product lines and
honour product warranties)
Taxing authorities (are they respecting tax laws)
Regulatory agencies i.e. provincial securities
commissions (are they operating within prescribed
Questions they may need to answer:
Is the company earning enough to give me a return on
my investment? Will the company be able to pay its debts as they come
Accountants and other professionals have extensive rules of conduct to guide
their behaviour with each other and the public.
o Many companies also have codes of conduct that outline their
commitment to ethical behaviour in their internal/external
When analyzing ethical situations, you should:
o Recognize an ethical situation and the ethical issues involved
Use personal ethics or an organization’s code of ethics to
identify ethical situations and issues.
o Identify and analyze the main elements in the situation
Identify the persons or groups who may be harmed or
Ask: What are the responsibilities and obligations of the
o Identify the alternative, and weigh the impact of each alternative on
Select the most ethical alternative, considering all the
consequences (may not exist just one right answer).
Three common forms of business organization:
A business owned by one person (often called a sole
Unlimited liability: the owner is personally liable for all debts
of the business.
Business profits are reported as self-employment income and
taxed on the owner’s personal income tax return.
Reporting entity concept: economic activity that can be
identified with a particular company be kept separate and
distinct from the activities of the owner(s) and of all other
A business owned by more than one person.
Usually formed because one person does not have enough
economic resources to initiate/expand the business, or
because partners bring unique skills/resources to the table.
Partnership agreement (written): outlines the formation of the
partnership, partners’ contributions, how profits and losses are
shared, provisions for withdrawals of assets and/or partners,
dispute resolution, and partnership liquidation.
Partners usually have unlimited liability.
Assets: resources that provide future economic benefits.
Profits are reported as self-employment income and taxed on
each partner’s personal income tax return. Typically used to organize professional service businesses (i.e.
practices of lawyers, doctors, architects, engineers, and
A business organized as a separate legal entity owned by
Easier to raise capital than proprietorship and partnerships
o It continues on regardless of who owns its shares
(not affected by withdrawal, death, or incapacity
of an owner).
Ease of transferring ownership
o Shares can be easily sold on stock exchanges.
o Shareholders are not responsible for corporate
debts unless they have personally guaranteed
They pay income tax as separate legal entities on any corporate
# of proprietorships + partnerships > # of corporations
Revenue of corporations > revenue of proprietorships +
Public corporations: shares sold to the public on stock
Financial statements are distributed publicly.
Private corporations: shares are issued but are not made
available to the general public nor are they traded on public
Financial statements are almost never distributed
Consolidated: financial results include results from all
companies that are owned or controlled by a corporation.
Individual accounting records and financial statements
are also produced for each company (needed to
accurately assess the performance and financial
position of each company.
Another application of the reporting entity concept.
Generally Accepted Accounting Principles (GAAP): include broad policies and
practices as well as rules and procedures that have substantive authoritative
support and agreement about how to report economic events.
Publicly traded corporations must use International Financial Reporting
o A set o global accounting standards developed by the International
Accounting Standards Board (IASB). Private corporations have a choice between using IFRS or Accounting
Standards for Private Enterprises (ASPE).
o Developed by the Canadian Accounting Standards Board (CASB).
Proprietorships/partnerships do not have to choose between either as their
statements are generally prepared only for internal use of the owners.
There are three types of activity that all businesses are involved in:
Two ways of raising capital in a corporation:
Debt financing (take out a loan)
Equity financing (sell shares)
Can also include repaying debt.
Creditors (lenders): those who you owe money to.
Liabilities: the debts and obligations of a business. Liabilities
are claims of lenders and other creditors on the assets of a
Operating line of credit: a pre-arranged bank loan for a
maximum amount that allows a company to draw more money
than there is on hand in its bank account.
Results in a liability called bank indebtedness.
Long-term debt can be:
Finance lease obligations
Other types of debt securities borrow for longer periods
Common shares: the amount paid by investors for shares of
ownership in a company.
Lenders generally have a payment schedule for when the
money is to be paid (interest included).
Creditors have a legal right to be paid at the agreed time (you
may force the company to sell assets to pay its debts).
Companies are not obligated to buy back shares.
Creditors and lenders receive their payment and only after will
shareholders be paid in the event of bankruptcy.
Dividends: the distribution of retained earnings from a
corporation to its shareholders, often-in cash form.
Involve the purchase (or sale) of long-lived assets that a
company needs in order to operate.
Assets: resources that a company owns or controls.
Long-lived assets are referred to as property, plant, and
Investments: when a company has excess cash that they don’t
need for a while and decide to purchase bonds/secu