Chapter 1: The Purpose and Use of Financial Statements
Accounting is the information system that identifies and records the economic
events of an organization, and then communicates them to a wide variety of interest
Marketing offers a good example of how having an understanding of the basics of
accounting; marketing managers must also be able to decide on pricing strategies
based on costs.
Users and Uses of Accounting
Internal users of accounting information plan, organize, and run companies. They
work for the company.
Users need detailed accounting information on a timely basis; be available when it is
Investors and creditors are the main external users of accounting information;
others include: customers, taxing authorizes, regulatory agencies, economic
Ethics in accounting is of the utmost importance to accountants and decision-
makers who rely on the financial information they produce.
Forms of Business Organization
o Simple to set up; gives you control over the business; only relatively small
amount of money is needed to start; owner receives all profit, loses, and is
personally liable for all debt.
o Formed because one person does not have enough resources to initiate or
expand a business; partners bring unique skills to the partnership; unlimited
liability for all debts of the partnership; some can be formed with limited
liability with partners.
o You receive shares to indicate your ownership claim; investing relatively
small amounts of money.
o Factors that need to be considered when deciding which organizational form
to choose; legal liability and income taxes.
o Proprietors and partners pay personal income tax on their respective share
of the profits, while corporations pay income taxes as separate legal entities
on any corporate profits.
o Private corporations do not issue publicly traded shares; these companies
almost never distribute their financial statements publicly.
o Two ways to make money; (1) borrow money, (2) issuing/selling shares.
o Amounts owed to creditors are called liabilities.
o Funds taken from a line of credit owed to a bank is called bank indebtedness. o Short-term or long-term notes payable can apply to debt (i.e. mortgage,
lease, car etc.)
o Common shares in the term used to describe the amount paid by investors
for shares of ownership in a company.
o If you loan money to a company, you are their creditors; the law requires
that creditor claims be paid before shareholder claims.
o Companies pay shareholders a return on their investment on a regular basis,
as long as there is enough cash to cover required payments to creditors.
o Borrowing cash from lenders by issuing debt, or conversely, using cash to
repay debt; cash can be raised from issuing shares, or paid to shareholders
by distributing dividends.
o Assets are resources that a company owns; assets are capable of short-term
of long-term lives; investments are short-term and long-term.
o Purchasing and disposing of long-lived assets such as property, plant, and
equipment and short-term or long-term investments.
o Most of a company’s long-lived assets are purchased through investment
activities, assets with shorter lives result from operating activities.
o Amounts earned from sales of goods and services are called revenues;
revenues increase economic resources; an increase in an asset or a decrease
in a liability.
o Sources of revenue that are common to many businesses are sales revenue,
service revenue, and interest revenue.
o The right to receive money in the future is called accounts receivable; result
in future benefit.
o Other examples include: income tax receivable.
o Items that are held for future sale to customers result in an asset called
inventory; the cost of inventory sold is an expense called cost of goods sold.
o Expenses are the cost of assets that are consumed or services that are used
in the process of generating revenues; operating expenses, depreciation, and
o Obligations that businesses must pay are accounts payable; interest payable,
dividends payable, salaries payable, and goods and services taxes payable.
o When revenues are more than expenses, net earnings result; when expenses
exceed revenues, a net loss results.
o From day-to-day operations and include revenues and expenses related
accounts such as receivables, inventory, and payables.
Communicating With Users
Statement of Earnings reports revenues and expenses to show how successfully a
company performed during a period of time; issue of share and distribution of
dividends do not affect net earnings.
Statement of Retained Earnings indicates the portion of company’s earnings that
was distributed to you and the other shareholders of a company in the form of
dividends, and how much was retained in the business to allow for future growth;
cumulative earnings that have been retained in the corporation; pay high dividends
(Manitoba Telecom and Rothmans); pay low dividends (Indigo Books, RIM).
Balance Sheet presents a picture of what a company owns, what is owes, and it’s net
worth at a specific point in time; assets and claims to those assets at a specific point in time; claims of creditors before owners; shareholder’s equity is in two parts (1)
share capital, (2) retained earnings; creditors analyze the balance sheet for the
likelihood to repay debt.
Managers use the balance sheet to determine whether inventory is adequate to
support the future sales and whether cash on hand is sufficient for immediate cash
needs. Managers also look at the relationship between total liabilities and
shareholder’s equity to determine whether they have the best proportion of debt
and equity financing.
Cash Flow Statement shows where a company obtained cash during a period of time
and how that cash was used; provide financial information about the cash receipts
and cash payments of a business for a specific period; answers these questions: (1)
where did cash come from during this period? (2) how was cash used during the
period (3) what was the change in the cash balance during the period?.
The Statement of Shareholders Equity explains the changes in all of the equity
The Statement of Comprehensive Income must be prepared by a business when
other types of income are gained or lost.
External reporting condenses and simplifies information so that it is easier for the
reader to understand.
Relationship Between Statements
(1) The Statement of Retained Earnings depends on the Statement of Earnings.
(2) The Balance Sheet and Statement of Retained Earnings are interrelated because
the ending amount on the Statement of Retained Earnings is reported as the
retained earnings amount in the Shareholder’s Equity section of the balance sheet.
(3) The Cash Flow and the Balance Sheet are also interrelated. The Cash Flow
statement shows how the cash account changed during the period by stating the
amount of cash at the beginning of the period, the sources and uses of cash during
the period, and the amount of cash at the end of the period. The ending amount of
cash shown must agree with the amount of cash on the assets section of the balance
Elements of An Annual Report
Publicly traded companies must give their shareholders an annual report each year.
Included are nonfinancial (missions, goals, prospects etc.) and financial information
(management discussion and analysis, an auditor’s report, comparative statements,
notes, and summaries of key financial ratios.
Chapter 2: Financial Statements – Framework, Presentation, and Usage
Conceptual Framework of Accounting
The conceptual framework of accounting is “a coherent system of interrelated
objectives and fundamentals that can lead to consistent standards and that
prescribes the nature, the function, and limits of financial accounting statements.
o Guides decisions about what to present in financial statements, alternative
ways of reporting economic events, and appropriate ways of communicating
1. It ensures that existing standards and practices are clear and consistent.
2. It makes it possible to respond quickly to new issues. 3. It increases the relevance, faithful representation, comparability, and
understandability of financial reporting results.
More than 100 countries throughout the world have already adopted IFRS. (Canada,
India, Japan, Korea moved in 2011, US 2014-2016)
The conceptual framework of accounting has four main sections:
o 1. THE OBJECTIVE OF FINANCIAL REPORTING
The main objective of financial reporting is to provide information
that is useful to individuals who are making investment and credit
Amounts, timing, and uncertainty of future cash flows,
economic resources (assets), and claims to those resources
(liabilities an equity).
Should include management’s explanations about the company’s
o 2. THE QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION
Information should have these qualitative characteristic:
It will make a difference in users’ decisions.
Help users make predictions about potential effects of past,
present, or future transactions; predictive value.
Help users confirm or correct their previous expectations;
Must be timely; available to decision makers before it loses
it’s ability to influence their decisions.
2. Faithful Representation:
Financial reporting must present the economic substance of
a transaction, not just its legal form.
Must be verifiable, neutral, and complete.
o Verifiable means that two or more people reviewing
the same information and using the same method,
would reach the same results.
o Neutrality means the absence of bias, accounting
information cannot be selected, prepared, or
presented to favour one set of interested users over
o Completeness means that all the information needed
to present economic reality is included.
When companies with similar circumstances was the same
Enables users to identify similarities and differences
Enables users to compare company’s financial results over
Consistency refers to the use of the same accounting
treatment for similar events from year to year. 4. Understandability
Necessary to agree on a base level that will help both the
preparer of financial information and its user; that base level
is: the average user is assumed to have a reasonable
understanding of accounting concepts and policies, as well as
a general business and economic conditions; willing to pay
Is greater when the information is classified, characterized,
and presented clearly and concisely.
Relevance should be applied first as it will help identify specific information that
would affect the decisions of investors, creditors, and other users of accounting
o 3. ELEMENTS OF FINANCIAL STATEMENTS
These are assets, liabilities, equity, revenues and expenses, and gains
o 4. RECOGNITION AND MEASUREMENT CRITERIA
o Create a foundation for the accounting process.
o Monetary Unit: requires that only things can be expressed in
money be included in the accounting records.
o Economic Entity: economic activity can be identified with a
particular accounting unit, which is separate and distinct from
the activities of the shareholders and of all economic entities.
o Time Period: the life of a business can be divided into artificial
time periods; less than one year are interim reports; the shorter
the period, harder to faithfully represent results.
o Going Concern: businesses will remain in operation for the
foreseeable future; assets would be stated at liquidation value
(fair market value) if going concern is not assumed.
o Indicate how economic events should be reported.
o Generally Accepted Accounting Principles (GAAP) widely
recognized and have authoritative support from corporations
Cost Principle: assets should be recorded at their cost at
the time of acquisition; counters faithful representation.
Full Disclosure: requires that all circumstances and
events, which would make a difference to financial
statement users be disclosed.
Revenue Recognition: when the “risks and rewards”
have passed on, easy to measure, collectability is
Matching: expenses are matched with revenue, all costs
associated with generating revenue should be recorded.
“Cause and Effect” relationship.
o Make it possible to relax the principles under certain
circumstances. Materiality: relates to financial statement item’s impact
on a company’s overall financial condition and
operations; professional judgment.
Material: likely to influence decision of investor
Immaterial: will not influence decision maker.
Cost-Benefit: ensures that the value of the information is
greater than the cost of providing it.
All this information is enable users to measure how a company is
o Intracompany basis (within the company itself)
o Intercompany basis (between companies)
o Industry Averages (against that particular industry’s averages)
Ratio analysis is looking at least two data and creating relationships.
Relationship between Sales and COGS
Sales – COGS = Gross Profit
o Gross Profit % = Gross Profit/Net Sales
Revenue – Expenses = Net Profit
o Net Profit % = Net Profit/Net Sales *100
Return on Assets = Net Profit/Total Assets *100
Return on Equity = Net Profit/Total Equity *100
Earnings/Share = Net Profit+Tax/Issued
Price Earnings Ratio = Market Price/Earnings per
Short-term ability to pay needs for cash.
Comparing CA’s and CL’s.
Working Capital = CA – CL
Current Ratio = CA/CL
Quick Ratio = CA – Inv. – Prepaids/CL
The ability to repay debt upon maturity, as well as
Solvent, but not profitable (still able to pay operations
Debt/Total Assets Ratio = TL/TA * 100
Times Interest Earned = Earnings BIT/Interest
Free Cash Flow = Net Cash Operating – Dividends
– Net Capital Expenditures o Activity
The ability to generate revenues from the overall
operations of the business.
Inventory Turnover = COGS/EI
Average Collection Periods = AR/Daily Net Credit
Chapter 3 and 4: Information For Decision-Making And Cost Flows and Terminology
A decision is simply the choosing of one option from a set of options to achieve a
o Step 1: Specify the decision problem, including the decision maker’s goals.
Decisions help us accomplish goals.
Personal goals might influence decisions.
Understanding the factors that influence the decision maker’s goals
and their relative importance is the first step in making effective
o Step 2: Identify options.
Business decisions frequently have numerous options.
Identifying the set of options is one of the most important tasks of
o Step 3: Measure benefits (advantages) and costs (disadvantages) to
determine the value (benefits reaped less costs incurred) of each option.
Every option presents a unique trade-off between benefits and costs.
The value of an option equals its benefits less its costs.
We measure value relative to the status quo, which is doing nothing
Whenever we make a decision and choose an option, we give
Opportunity cost is the value of what you give up by making
The opportunity cost of any decision is the value to the
decision maker of the next best option.
Businesses typically measure value and opportunity cost in
terms of money, or profit.
Effective decision makers ensure that the value of the chosen
decision option exceeds its opportunity cost.
Putting resources to the best possible use and maximizing
Value and opportunity cost emphasize that every decision
involves trading off what we get with what we give up.
o Step 4: Make the decision, choosing the option with the highest value.
The best choice is the option with the highest value to the decision
The four-step decision making framework applies equally well to both individual
and organizational decisions, however there are two important differences: o Unlike individuals, whose goals have several factors, organizational needs
tend to have focused goals.
o Organizations are a collection of individuals, individual goals relate to
organizational goals; individual goals differ from organizational goals, often
leading to actions that are not in the firm’s best interest.
Organizational goals for a for-profit business, specifies according the ownership,
usually to maximize profits.
Organizational goals for a publicly traded company maximize shareholder value
(maximize returns to shareholders).
Companies hire managers to act in the best interests of shareholders, these
individuals wish to maximize their own compensation and happiness.
Owner’s align individual and organizational goals:
o Policies and procedures, to define acceptable behavior.
o Monitoring, to enforce policies and procedures.
o Incentive schemes and performance evaluation, to motivate employees to
consider organizational goals.
Planning decisions relate to choices about acquiring and using resources to deliver
products and services to customers: which products or services to sell, their prices,
and the resources needed, such as materials, labour and equipment.
Keep a watchful eye on how well our plans meet our goals, which is the purpose of
control decisions (examining past performance, with the purpose of improving
The planning and control cycle involves: PIER (Plan, Implement, Evaluate, Revise)
Products and services
Customers and prices
Use resources to make products and deliver services
Set performance targets
Achievement or performance targets
Reasons for deviations
Best mix of products and services
Implement has elements of both planning and control.
The primary role of accounting is to help measure the costs and benefits of decision
options (decision makers outside the firm rely on financial accounting, decision
makers inside the firm rely on managerial accounting).
Financial accounting information is useful for assessing an organization’s overall
current state and future prospects. Managerial accounting information aims to satisfy the information needs of decision
makers inside the firm; determines what products or services to offer, what to
purchase, whom to hire, and how to pay them; useful for both planning and control
Managerial accounting information supports decisions related to the acquisition and
use of organizational resources as well as decisions related to motivating,
monitoring, and evaluating performance.
Ethics relates to every aspect of the decision framework.
Unethical acts sometimes put a strain on managers as it provides monetary benefits
in excess of costs, on occasion.
Ethics shapes decision-making goals and influences the set of options to consider.
Laws, rules, and regulations, organizations, and government specify behaviours that
cross ethical boundaries and the resulting penalties.
o Sarbanes-Oxley Act of 2002 (SOX) mandates that senior executives of
publicly traded companies take individual responsibility for the accuracy
and completeness of financial reports.
Individual company policies provide additional guidance regarding standards.
o Employee handbooks.
The code of ethics created by the Management Accounts of Canada stipulates that
accountants should not engage in any business that is incompatible with the
professional ethics of a management accountant. Competence, confidentiality,
integrity, and objectivity are expected.
An organization chart:
o A Board of Directors: responsible for overseeing the firm’s operations.
Chief Executive Officer (CEO)
Delegates most decisions, highest-ranking executive.
Chief Financial Officer (CFO): responsible for all accounting
and financial functions, reports to CEO.
o Controller: manages day-to-day accounting and
oversees accounting policies.
o Treasurer: manages the firm’s cash flow and serves
as a contact point for banks, bondholders, and
creditors; ensures firm raise the required capital at
the lowest cost and uses the capital wisely to
maximize shareholder returns.
o Chief Internal Auditor (CIA): manages internal audit
Functional Manager: oversee operations in key business
Division Managers: oversee day-to-day operations of product
lines and managers.
o Functional Managers
o Division Controllers
The costs associated with getting products and services ready for sale are product
costs. Period costs do not directly relate to readying products or services for sale, these
include rent, advertising, customer service, and sales force compensation and relate
more to the passage of time.
Period costs are all costs that are not product costs.
o Costs Incurred:
Salaries, Facilities Rent, Equipment Depreciation, Utilities,
(Product Costs, above Gross Margin)
Accounting, Office Rent, Advertising, Sales Staff
(Period Costs, below Gross Margin)
o Offer not tangible or storable objects.
o It can be vital to modify accounting reports and use nonfinancial data to
estimate the controllable costs and benefits of a decision option.
o Period costs combine controllable and noncontrollable costs, as well as fixed
costs and variable costs.
o Dividing total product or period costs by the number of customers would
yield a poor estimate of the cost per member.
o Buy goods from suppliers and resell the same products to customers.
o Inventories are necessary.
o Distinguish between cost of goods purchased and cost of good sold.
o Firms expense costs of items when they sell the items, not when they
COGS = BI + Purchases – EI
o Prepare the goods for sale (product costs) and costs associated with sales
and administration (period costs).
o Costs Incurred:
Goods Purchased Inventory Account; Product Costs; Above GP
Sales and Administration Period Costs; Below GP
Product Costs (costs of manufacturing the products)
Direct material (purchases for manufacturing)
Direct labour (payment for manufacturing)
Manufacturing Overhead (the total of these indirect costs)
Variable overhead (energy cost to operate machinery)
Fixed overhead (salaries of shift supervisor)
Selling and Administration (costs with managing organization itself)
Variable S&A (cost of transport and commission)
Fixed S&A (rent and salaries) Direct Materials + Direct Labour
Prime Costs (primary inputs of manufacturing process)
Variable Overhead + Fixed Overhead
Capacity Costs (indirect costs provide firm with the ability to make its products)
Capacity Costs + Direct Labour
Conversion Costs (expenditures to convert raw materials to finished goods)
When firms purchase raw materials, this is added to the cost of materials inventory
Firms incur labour and overhead costs during a given accounting period.
Firms assign the cost of materials, labour, and overhead from the respective inventory
and control accounts to a work-in-process (WIP) account.
The sum of materials, labour, and overhead costs added to the WIP account during
the period are the total manufacturing costs charged to production.
When firms sell finished goods, they physically transfer goods to buyers.
Firms remove the costs from the FG inventory to the COGS account.
Purchase raw materials Materials Inv.
Pay Wages WIP Inv
Overhead Control COGS
Finished Goods Inv.
Chapter 12: Performance Evaluations in Decentralized Organizations
Benefits of Decentralization
o Permits timely decisions with the best available information
Employees at lower levels have access to more detailed and
o Tailors managerial skills and specializations to job requirements.
Expertise and experience required to manage business and
increase the firm’s size and complexity.
Decision making to individuals with appropriate functional
experience enhances decision quality.
o Empowers employees and increases job satisfaction. Powerful motivational tool gives employees a sense of
ownership and results in increased job satisfaction.
o Trains future managers
Prepares employees at the lower level for high-level positions.
Costs of Decentralization
o Leads to decisions that emphasize local goals over global goals.
Lower-level managers may not understand the big picture.
Make decisions without considering the impact on other
o Requires costly coordination of decisions.
Proper internal information systems, formal coordination
mechanisms; ensure that all managers work toward the same
o Triggers improper decisions because of the divergence between
individual and organizational goals.
Worsens this problem by giving control over organizational
resources to lower-level managers who are far removed from
o May lead to an increase in total costs.
Effort and tasks are often duplicated.
o Control over costs, NOT revenues and investments.
Minimize the cost of producing a specified level of output or
the cost of delivering a specified level of service.
Improve efficiency of operations by finding ways to cut cost of
Ex. Plant maintenance, data processing, human
resources, production, and general administration.
o Control over revenue.
Expenses but not those required manufacturing the product or
delivering the service.
Expenses associated with selling, such as sales, commissions,
advertising, and travel.
Ex. Sales divisions, fundraising departments.
o Minimize costs and maximize revenues.
Ex. Proctor and Gamble, Sears.
o Influence costs, revenues, and investments.
o Maximize the returns from invested capital, or to put the capital
invested by owners and shareholders of their organizations to the
most profitable use.
Ex. Large independent divisions: Sony, Seimens, Microsoft Controllable performance measure holds decision makers accountable only
for the costs and benefits that they can control.
o Ex. Production manager accountable for production delays; marketing
managers have the authority to changes prices.
Informative Principle holds a measure is informative if it provides
information about a manager’s effort.
Evaluating a firm relative to another firm in industry is a relative
An ideal performance measure:
o Aligns employee and organizational goals
o Yields maximum information about the decisions or actions of the
individual or organizational unit
o Is easy to measure
o Is easy to understand and communicate
Rewarding employees help align organizational and employee goals; ensures
they pay attention to customers.
Cost centre managers serve two roles: achieving cost targets in the short
term, and continuous efficiency improvements in the long run.
In the short term, organizations typically use budget variances to measure
cost centre performance.
Operating budgets specify resources needed to achieve a targeted level of
output for a planned period.
o Makes assumptions about material usage and prices to determine
expected quantities of raw materials and their costs.
o Benchmarking: comparing the effectiveness and efficiency of various
activities and business processes against the best practices in the
Holds a manager accountable for achieving greater reductions
in a cycle time.
o Kaizen (improvement) encourages continuous improvement and
rewards employees who constantly seek and suggest improvements
to activities and business processes.
Holds managers accountable for achieving permanent cost
Engineered cost centres have a clear relation between inputs and outputs.
Discretionary cost centres, measuring output can be difficult.
o Ex. Output is intangible for legal staff making corporate decisions.
o Evaluation is primarily subjective.
o Required to operate within a fixed budget set at top management’s
discretion; meet qualitative targets. Evaluating a profit centre focuses on managers maximizing profit: increases
revenues and decreases costs.
Firms use profit before taxes to evaluate a profit centre.
o PBT = Revenue – Variable Costs – Traceable Fixed Costs
= Contribution Margin – Traceable Fixed Costs
Firms use the master budget as the benchmark because a profit centre
manager has decision right over outputs and inputs.
Use profit variances analysis to disentangle the effects of these various
factors on profit shortfall and to isolate controllable deviations.
Firms measure profit centre managers’ ability to meet long-term goals in
addition to delivering the operating profit budget for the current period.
o Revenue-oriented measures include customer satisfaction and market
o Cost-oriented measures might focus on employee turnover or the
number of process improvements.
Investment centres are considerable decentralized organizations.
o Ex. Cadillac, Buick, Chevrolet
Sets business priorities, provides strategic direction, allocates investment
funds and monitors performance of its divisions.
Evaluation of an investment centre focuses on how well it uses the funds
o Return on Investment (ROI), Residual Income (RI), Economic Value
Manager is meeting or exceeding performance expectations, allocate
available funds to divisions in the most profitable manner.
ROI = Profit/Investment
Investment centres profit is a result from operations; all revenues and
Assets like marketable securities and land are not included in calculation,
usually measured by corporate.
ROI is an effective summary measure of business profitability; evaluate
investments by comparing their ROIs with similar investments in the past
and the experiences of other firms.
ROI fosters underinvestment; focusing on current income and investment,
ignore future-period considerations, less suitable for the long-term.
Net Book Value (NBV) is the original acquisition less accumulated
Gross Book Value (GBV) is the original acquisition cost; fails to measure the
change in value with passage of time.
Replacement or Current Value (RV/CV) is more likely to represent the true
value of the asset. Identifying the replacement costs, or current value, can be
difficult and tedious. ROI can be decomposed in smaller pieces (DuPont model):
o = Profit/Investment = Profit/Sales x Sales/Investment
o = Profit Margin x Asset Turnover
o Profit Margin = Profit/Sales = Sales – Operating Expenses/Sales
= 1 – Operating Expenses/Sales
Residual Income (RI) is the amount that an investment generates above and
beyond the required rate of return on operating assets.
o RI = Profit – Required Return x Investment
Represents the additional profit or value generated by an investment after
meeting the required rate of return, does NOT lead to underinvestment
Two key limitations: the magnitude of RI depends on the size of the
investment; rankings depend crucially on the chosen rate of return.
Economic Value Added (EVA) reflects the belief that managers are
responsible for covering both the operating and the capital costs of a
business, including taxes.
o EVA = NOPAT – WACC x (Invested Capital – Current Liabilities)
NOPAT is the net operating profit after taxes.
WACC is the weighted average cost of capital.
NOPAT requires a number if adjustments to the income
reported in the financial statements.
EVA calculations also specify how to measure the weighted
average cost of capital and the investment base.
o Expensing research and development costs reduce NOPAT, which will
o Managers are reluctant to undertake valuable R&D activities.
o Capitalizing research and development costs and expensing them
gradually over time, better reflects the fact that R&D provides benefits
These focus on the short-term; current profit and investment.
Longer-term focus, such as market share, customer satisfaction, and growth
in new product sales. Chapter 1: Introduction to Finance
o The study of how and under what terms saving (money) are allocated
between lenders and borrowers.
o How resources are allocated and under what terms, and through what
Funds transferred under a financial contract are called a financial security.
Real assets represent the tangible things that compose personal and business
Finance is essentially the management of an entity’s balance sheet.
Buying another firm, or asset acquisition (capital expenditure)
Financing those expenditures, or corporate financing.
Financial assets are simply what others have lent to another.
o Canadian households owned net financial assets issued by the
government, corporations, and non-residents with a market value of
Four major areas of finance:
o Personal finance
o Government finance
o Corporate finance
o International finance
A shock in the government or international sectors can quickly
work through the system to affect personal and corporate
Younger, less wealthy people have a net negative financial asset position.
Older, higher-income people have a net positive financial asset position.
The household sector is the primary provider of funds to business and
Financial flow is “intermediated”:
o Financial Intermediaries: transform the nature of the securities they
issue and invest in.
o Market Intermediaries: simply make the markets work better.
Intermediation is the transfer of funds from lenders to borrowers.
o Borrowers obtain funds directly OR indirectly from individuals who
have first loaned in their savings to a financial institution.
o First channel, the lender provides money directly to the ultimate
A non-market transaction, exchange is negotiated between
borrower and lender. o Second channel, lender provides money directly to the ultimate
borrower with help, as no one individual can lend the full amount.
A market intermediary is an entity that facilitates the working
of markets and helps provide direct intermediation.
Market intermediaries are called brokers.
Ex. real estate, stock market, insurance brokers.
They assist with the transaction and bring borrowers and
lenders together, do not change the nature of the transaction.
Financial institutions lend the money to borrowers but raises the money
itself by borrowing directly from the individuals.
The ultimate lenders have only an indirect claim on the ultimate borrowers;
their direct claim in on the financial institution (a chartered bank)
o Largest bank in Canada is RBC (revenue-wise)
o They are deposit takers and lenders.
Insurance companies are called contractual savers.
o You buy life insurance and then pay premiums; you die, the policy
Largest insurance company in Canada is Manulife Financial.
“Pure” companies insure homes and cars.
Pension plans are also contractual savers.
o Largest pension fund manager in Canada is the Caisse de depot et
placement du Quebec!
Chartered banks take in deposits and make loans, insurance companies take in
premiums and pay off when an incident occurs, such as a death or a fire, while
pension funds take in contributions and provide pension payments after plan
Mutual funds perform:
o A pool of small sums of money so that they can make investments that
would not be possible for smaller investors.
o An offer of professional expertise in management of those funds.
Major issuer of financial securities: the borrowers!
March 31 is the fiscal year end for Canada.
o The biggest spenders after the federal government in Ontario and
Quebec; then Crown corporations like Hydro Quebec and Ontario
Power Generation Inc.
Governments raise money:
o Monopolizing and charging higher fees on things that we want.
o The only debt people can invest in and know for sure they will get the
The business sector has three times larger net debt position than the
GM Canada is the biggest Canadian company in terms of sales. Financial assets are formal legal documents that set out the rights and
obligations of all parties involved.
o Two major financial security categories:
Legal obligations to repay borrowed funds
Interim interest payments
Ex. Bank loans, commercial papers, bankers’
acceptances, treasury bills, mortgage loans
An ownership stake in a company
Common form is a common share
Preferred shares entitle owners to fixed dividend
payments before common shareholders.
o Non-marketable financial assets:
Savings accounts or demand deposits
Available on demand
Ex. Canada Savings Bond (CSB)
These are non-marketable; they are not tradable.
Can be cashed in at any bank at any time, plus any
o Marketable financial assets:
Traded amount market participants.
Debt or equity securities and by their maturity date.
Money market securities: short-term debt instruments,
T-bills, commercial paper, and Bas.
Capital market securities: long-term debt in securities,
bonds, and debentures.
Equity securities: ownership in a company and
generally have no maturity date.
Governments raise new financing via the debt markets.
o Issue T-bills as a source of short-term financing, issue bonds and
CSB’s for long-term financing.
o Short-term financing through loans, or issuing commercial paper, BAs.
o Raise long-term financing by issuing bonds or in the form of equity.
o Issue of new securities by the borrower in return for cash from
Ex. government sells new issues of T-bills or bonds, company
sells new common shares to the public.
o Key to the wealth transfer process. o Provide trading environments that permit investors to buy and sell
Exchanges or auction markets
Involve a place in a specific location
Investors are represented at these markets by brokers
Dealer or over-the-counter (OTC) markets
Do not involve a physical place with a location
A network of dealers who trade directly with one
o Major exchanges are now computerized since 1997.
In 1999, there were five exchanges:
o TSX, ME, VSE, WSE, ASE
In 2000, that five then turned into two:
o TSX and the TSX Venture Exchange
Had 3,758 issuers in 2005.
Seventh largest exchange in the world.
Only other exchange in Canada is the Winnipeg Commodity
Exchange (handles future trading in commodities)
Traditionally, exchanges were for not-for-profit organizations.
o TSX is for-profit institutions owned by its shareholders.
o Marketing intermediaries:
“Participating organizations” or “Approved Participants”
(brokers) do not have to own seats to trade.
o The average daily trading volume in January 2006 was 321,287
transactions for a value of $5.6 billion, so, on average, shares worth
more than $5 billion changed hands every day.
Trades in unlisted securities in Ontario, the Ontario Securities Commission
(OSC) requires them to be reported on the Canadian Unlisted Board Inc.
o The first Canadian quotation and reporting system is the Canadian
Trading and Quotation System Inc. (CNQ).
o Provides an alternative market for very small emerging companies.
A third market:
o Trading securities that are listed on organized exchanges in the OTC
market, important for “block trades”.
o Extremely large transactions involving at least 10,000 shares or
A fourth market:
o Trades that are made directly between investors.
o Operates through use of privately owned automated systems
(Instinet, Institutional Network), owned by Reuters.
Chapter 2: Venture Capital and Initial Public Offering
To raise money, one can: o Can borrow;
o Sell equity;
Managements goals is to raise the amount of money necessary
to finance business at the lowest cost.
Governments generally do little to provide the capital and support for
businesses in the start-up state.
New businesses are seldom started in large corporations.
Entrepreneurs regularly leave large corporations to start businesses, usually
with ideas developed by previous firm
Bootstrapping is the process by which businesses raise “seed money”.
o The initial seed comes from entrepreneur or other founders
o Venture capitalists do not invest at this stage.
o Seed money is used to develop a prototype of the product and a
o Usually last no more than one or two years.
o Critical time that determines if business is a viable option.
o Help new businesses get started and provide much of their early-stage
o Individual VC’s (angels), wealthy individuals who invest own money
into emerging businesses.
o VC’s firms pool money from various sources and invest it in new
o 42% of VC’s funding comes from private and public pension funds,
21% financial and insurance firms.
o Industry emerged in 1960’s, first VC limited partnership.
o Today, biggest concentration in California and Massachusetts; as well
as Research Triangle in NC, Austin, TX, NYC etc.
o Many focus on capital firms focus on high-technology investments.
Reasons why traditional sources of funding do not work:
o A high degree of risk involved
Most businesses fail; banks, pension funds, insurance
companies are risk averse.
o Types of productive assets
New firms who have primary assets that are intangible are
often difficult to secure financially.
o Informational asymmetry problems
Arises when one party has knowledge of transaction and the
other does not.
Most investors do not have the expertise to distinguish
between competent and incompetent entrepreneurs.
o 1. Bootstrapping, entrepreneur responsible.
o 2. Seed-stage, VC’s provide funds to finish development o 3. Early-stage financing, venture capitalists provide funding to get
o 4. Latter-stage financing, one to five additional stages of financing.
o 5. Exit strategy, VC’s sell to a strategic buyer, financial buyer, or sell on
the public market.
How Venture Capitalists Reduce Risk
o Staged Funding
Opportunity to reassess the management team; can bail out or
cut their losses, help management make some midcourse
Typically go through 3 to 7 stages (mezzanine financing)
o Preferred stock is convertible into common stock; ensures VC’s have
most senior claim if the firm fails or converts shares into gains.
o Personal Investment
Confirms you are confident in the business, highly motivated to
Originating venture capitalists sell percentage of deal to other
o 1. Increases diversification
o 2. Willingness of other VC’s to share in
investment provides independent corroboration
that the investment is a reasonable decision.
o In-depth knowledge of industry and technology
The Exit Strategy
o VC’s are not long-term investors; usually 3 to 7 years.
o Exit by selling equity portion
o There are usually rules (provisions) regarding exit strategy:
2. Method of exit
3. What price is acceptable
Can be controversial.
o a) Strategic Buyer
Looks to create value through synergies between the
acquisition and the firm’s existing productive assets.
o b) Financial Buyer
Often a private equity firm – intends to hold for a period of
time, usually 3 to 5 years, and then sells for a higher price.
o c) Initial Public Offering
After an IPO, able to sell shares he or she holds over time.
Majority of VC’s exit through strategic or financial buyers.
Venture Capitalists: o Provide advice to entrepreneurs.
o Provide counsel when a business is started and during the early
period of the businesses operations.
o Require an agreement that:
Gives them unrestricted access to information about the firms
operations and financial performance.
Right to attend all board meetings.
Insist on a mechanism giving them the authority to assume
control of the firm if the firm’s performance is poor.
Cost of Venture Capital Funding
o Cost is very high, but there are high rates of returns of VC’s are not
o VC’s bear a lot of risk; for every 10 businesses, only 1 or 2 will prove
success; winners cover the losses.
o VC’s may generate annual returns of 15 to 25% on the money that it
o A company’s first sale of common stock in the public market; first-
time stock is given a special name.
SPO (Seasoned Public Offering)
o Sale of securities (stocks or bonds) by a firm that already has similar
publicly traded securities outstanding.
o Public Offering means that the securities being sold are registered
with the Securities and Exchange Commission, and legally sold to the
public at large.
Advantages of Going Public
o Amount of equity capital that can be raised in public equity markets
exceeds capital funded through private sources.
o Additional equity capital can usually be raised through follow-on
seasoned public offerings at a low cost.
o Public markets are highly liquid; investors more likely to pay higher
prices for more liquid shares of public firms.
o Enable entrepreneurs to grow by giving up ownership.
o Active secondary market to buy and sell shares.
o Easier for a firm to attract top management talent; aligns management
behavior with maximizing stockholder value.
Disadvantages of Going Public
o High cost of IPO
o Stock is not seasoned (an established record in a public secondary
market); the likely liquidity of a stock that is sold in an IPO is less well
known and its value is more uncertain.
o Cost of complying to SEC regarding disclosure requirements;
transparency can be costly.
o Failing to meet quarterly earnings projections often see their firm’s
stock price drop. Investment Banking Services
o Three basic services:
Origination – gives firm financial advice and getting the issue
ready to sell.
Determining whether it is ready for IPO.
Management must obtain a number of approvals from
the board of directors.
Must be registered with the SEC; the preliminary
prospectus: detailed information, various analysis, and
expectations; no sales can be made from this document.
SEC approval is not an endorsement of the wisdom or
desirability of making a particular investment.
Underwriting – risk-bearing part of investment banking (price
o Purchase Price – Offer Price
o Covers the IB’s expenses, compensation, and
1. Firm Commitment Basis – investment banker
guarantees the issuer a fixed amount of money from the
o More than 95% of contracts
2. Best Effort Basis – investment banker does not
guarantee to see stock at a certain price.
o Does not bear price risk, and compensation is
based on number of shares sold.
Reducing underwriting risk by creating a underwriting
syndicate – reducing risk by portioning out ownership
within investment (i.e. may enlist another investment
banking firm – a selling group)
Price per share is determined with the following:
o Able to sell shares quickly to market.
o Create a stable secondary market.
A due diligence meeting is formed to list, gather, and
authenticate matters such as articles of incorporation,
by-laws, patents, and ask questions.
Distribution – involves reselling securities.
After due diligence period, the underwriter and issuer
determine the final price in a pricing call.
o Takes place after market has closed for the
Management ultimately makes the pricing decision.
Files amendment with SEX, register on SEC, and then
put up for sale. Most securities are presold to investors prior to
Closing – issues certificates of ownership to the
underwriter and underwriter delivers payments for the
securities, net the underwriter fee, to the issuer.
o Usually takes place on the third day.
Proceeds from Stocks
o TOTAL PROCEEDS = $40,000,000 = ($20/share x 2 million shares)
1. The firm (37.2 million – $18.60/share x 2 million
2. The underwriter (2.8 million - $1.40 per share x 2
Chapter 3: Dividends and Dividend Policy
Dividend policy to firm’s overall policy regarding distribution of value to
Use dividends to distribute value; dividend is something of value that is
distributed to a firm’s stockholders on a pro-rata basis – in proportion to the
percentage of the firm’s shares that they own.
o This can be anything from cash, assets, or something else available
only to stockholders.
o Value of the firm is the value per share multiplied by the number of
shares; subtract the stockbroker’s commission and fees.
Most common form is a regular cash dividend; cash paid on a regular basis.
o Management can position the dividend too low; firms may be able to
pay an extra dividend during a time of higher expected earnings.
A special dividend is a one time payment to stockholders to distribute
unusually large amounts of cash from excess