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FINANCIAL ACCOUNTING Robert Libby Patricia A. Libby Daniel G. Short George Kanaan Maureen Gowing McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Chapter 1 Financial Statements and Business Decisions McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 The Objectives of Financial Accounting Financial statements are the primary means of communicating financial information to parties outside the business organization. Balance Sheet Income Statement Stakeholders McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Business Background Business owners (called investors or shareholders) look for two sources of possible gain: Sell ownership interest in the future for more than they paid. McGraw-Hill Ryerson Receive a portion of the company’s earnings in cash (dividends). © McGraw-Hill Ryerson Limited, 2003 Business Background Creditors lend money to a company for a specific length of time and gain by charging interest on the money loaned. Loan Mel’s Diner Interest McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Understanding Business Operations Manufacturers either make the parts needed to produce its products or buy the parts from suppliers. Manufacturer McGraw-Hill Ryerson Product Customer © McGraw-Hill Ryerson Limited, 2003 Understanding Business Operations All businesses should have an accounting system that . . . Collects and processes financial information about an organization. McGraw-Hill Ryerson Business managers (internal) Reports information to decision makers. Investors (external) © McGraw-Hill Ryerson Limited, 2003 Understanding Business Operations Accounting System Financial Accounting System (preparation of four basic financial statements). Managerial Accounting System (preparation of detailed plans, forecasts and reports). External Decision Makers (investors, creditors, suppliers, customers, etc.). Internal Decision Makers (managers throughout the organization). McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Information Conveyed in Financial Statements The four basic financial statements . . . Cash Flow Statement Balance Sheet McGraw-Hill Ryerson Statement of Retained Earnings Income Statement © McGraw-Hill Ryerson Limited, 2003 Information Conveyed in Financial Statements Most companies prepare financial statements at the end of the month, the end of the quarter (called quarterly reports) and the end of the year (called annual reports). 2003 X McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Let’s look at MAXIDRIVE CORP.’s financial statements. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Cash $ 4,235 Accounts receivable 5,714 Inventories 8,517 1. Name of entity Plant and equipment 7,154 (the separate-entity assumption) 981 Land Total assets of statement $ 26,601 2. Title Liabilities and Shareholders' Equity 3. Specific date Liabilities (financial snapshot at a specific Accounts payable point in time) Notes payable 4. Unit measure Total liabilities (thousands of dollars) Shareholders' Equity Share capital Retained earnings Total shareholders' equity Total liabilities and shareholders' equity McGraw-Hill Ryerson $ 7,156 9,000 $ 16,156 $ 2,000 8,445 10,445 $ 26,601 © McGraw-Hill Ryerson Limited, 2003 The Balance Sheet Body of the Statement Assets Economic resources controlled by the entity as a result of past transactions from which future economic benefits may be obtained. Liabilities Debts or obligations of the entity that result from past transactions. Shareholders’ Equity McGraw-Hill Ryerson Amount of financing provided by owners of the corporation and from earnings. © McGraw-Hill Ryerson Limited, 2003 The Balance Sheet Basic Accounting Equation Assets = Liabilities + Shareholders’ Equity Economic resources = McGraw-Hill Ryerson Sources of financing . . . Liabilities: from creditors Equity: from shareholders. © McGraw-Hill Ryerson Limited, 2003 Assets are listed by their ease of conversion into cash. MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Cash $ 4,235 Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets $ 26,601 Liabilities and Shareholders' Amount of cashEquity in the company’s bank Cash Liabilities account. Accounts payable $ 7,156from prior Accounts Amounts owed by customers Notes payable sales. 9,000 receivable Total liabilities Partial and completed but unsold$ 16,156 Inventories Shareholders' Equity products. Share $ 2,000 Plantcapital and Factories and production machinery. Retained earnings 8,445 equipment Total shareholders' equity 10,445 on which factories are located. TotalLand liabilitiesProperty and shareholders' equity $ 26,601 McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Cash Accounts receivable Accounts Amounts Inventories owed to suppliers for prior payable purchases. Plant and equipment Notes Amounts owed Land on written debt payable contracts. Total assets Liabilities and Shareholders' Equity Liabilities Accounts payable $ 4,235 5,714 8,517 7,154 981 $ 26,601 $ 7,156 Notes payable 9,000 Total liabilities $ 16,156 Shareholders' Equity Share capital Retained earnings Total shareholders' equity $ 2,000 8,445 10,445 Total liabilities and shareholders' equity McGraw-Hill Ryerson $ 26,601 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Share capital Retained earnings Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Shareholders' Equity Liabilities Amounts invested in the business by Accounts payable shareholders. Notesnot payable Past earnings distributed to shareholders. Total liabilities Shareholders' Equity Share Capital Retained earnings Total Shareholders' equity $ 4,235 5,714 8,517 7,154 981 $ 26,601 $ 7,156 9,000 $ 16,156 $ 2,000 8,445 10,445 Total liabilities and shareholders' equity McGraw-Hill Ryerson $ 26,601 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Use $ on the first item in a group and on the group total. Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Shareholders' Equity Liabilities Accounts payable $ 4,235 5,714 8,517 7,154 981 $ 26,601 $ 7,156 Notes payable 9,000 liabilities Assets = LiabilitiesTotal + Shareholders’ Equity Shareholders' Equity Share capital Retained earnings Total shareholders' equity $ 2,000 8,445 10,445 Total liabilities and shareholders' equity McGraw-Hill Ryerson $ 16,156 $ 26,601 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues 1. Name of entity Sales revenue $ 37,436 2. Title of statement Expenses 3. Specific sheet, this Cost of goodsdate sold(Unlike the balance $ 26,980 statement covers a specified period of time.) Selling, general and administrative 3,624 4. Unit measure (in thousands of dollars) Research and development 1,982 Interest expense 450 Total expenses 33,036 Income before income taxes Income tax expense Net income McGraw-Hill Ryerson $ 4,400 1,760 $ 2,640 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Income Statement the Year Ended December 31, 20A TheFor income statement is divided into (In thousands of dollars) three major captions. Revenues Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total expenses 33,036 Income before income taxes Income tax expense Net income McGraw-Hill Ryerson $ 4,400 1,760 $ 2,640 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Revenues are earnings from the sale of goods Cost of goods sold $ 26,980 or services. Selling, general and administrative 3,624 Research andisdevelopment 1,982 Revenue recognized in the period in which Interest expense 450 goods and services are sold, not necessarily period in which cash is received. 33,036 Totalthe expenses Income before income taxes Income tax expense Net income McGraw-Hill Ryerson $ 4,400 1,760 $ 2,640 © McGraw-Hill Ryerson Limited, 2003 The Income Statement Revenues Earnings from the sale of goods or services. When will the revenue from this transaction be recognized? $1,000 sale made on May 25. May 2003 McGraw-Hill Ryerson X Cash from sale collected on June 10. X June 2003 © McGraw-Hill Ryerson Limited, 2003 The Income Statement Revenues Earnings from the sale of goods or services. When will the revenue from this transaction be recognized? $1,000 revenue recognized in May May 2003 McGraw-Hill Ryerson June 2003 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Expenses are theIncome dollar amount of resources used Statement up by the to earn revenues during a period. Forentity the Year Ended December 31, 20A (In thousands of dollars) An expense is recognized in the period in which goods and services are used, not necessarily Revenues the period in which cash is paid. Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total pre-tax expenses 33,036 Income before income taxes Income tax expense Net income McGraw-Hill Ryerson $ 4,400 1,760 $ 2,640 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Cost of The cost of the products sold during Revenues goods sold this period. Sales revenue $ 37,436 Selling, Expenses Operating expenses not directly related general and sold Cost of goods $ 26,980 to production. administrative Selling, general and administrative 3,624 Research and 1,982 new Research and development Expenses incurred to develop Interest expense 450 development products. Total expenses 33,036 Interest Pretax income The cost of using borrowed funds. $ 4,400 expense Income tax expense 1,100 Income tax Income taxes on the current period’s Net income $Ryerson 3,300 © McGraw-Hill Limited, 2003 McGraw-Hill Ryerson expense pre-tax income. The Income Statement Expenses The dollar amount of resources used up by the entity to earn revenues during a period. When will the expense for this transaction be recognized? Paid $75 cash on May 11 for newspaper ad. X May 2003 McGraw-Hill Ryerson Ad appears on June 8. X June 2003 © McGraw-Hill Ryerson Limited, 2003 The Income Statement Expenses The dollar amount of resources used up by the entity to earn revenues during a period. When will the expense for this transaction be recognized? Advertising expense recognized in June. May 2003 McGraw-Hill Ryerson June 2003 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total pre-tax expenses 33,036 When revenues exceed expenses, Income before income taxes we report net income. Income tax expense Net income McGraw-Hill Ryerson $ 4,400 1,760 $ 2,640 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total pre-tax expenses 33,036 Income before income taxes $ 4,400 When exceed revenues, 1,760 Income taxexpenses expense we report net loss. Net income $ 2,640 © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Statement of Retained Earnings Income of the corporation Shareholders McGraw-Hill Ryerson Retained Earnings © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 20A (In thousands of dollars) Retained earnings, January 1, 20A $ 6,805 Net income for 20A 3,300 1. Name of entity Dividends for 20A (1,000) 2. Title of statement 3. Specificearnings, date (likeDecember the income31, statement, Retained 20A $ this 9,105 statement covers a specified period of time.) 4. Unit measure (in thousands of dollars) McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 20A (In thousands of dollars) Retained earnings, January 1, 20A Net income for 20A Dividends for 20A $ 6,805 2,640 (1,000) Retained earnings, December 31, 20A $ 8,445 McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Cash Flow Statement Because revenues reported do not always equal cash collected. . . . . . and expenses reported do not always equal cash paid . . . Income is usually not equal to the change in cash for the period. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Cash Flow Statement For the Year Ended December 31, 20A (In thousands of dollars) Cash flows from operating activities: Cash collected from customers $ 33,563 Cash paid to suppliers and employees (30,854) 1. Name of entity Cash paid for interest (450) 2. Title Cash paidof forstatement taxes (1,190) 3. dateoperating (like the income statement$and1,069 NetSpecific cash flow from activities Cash flow from investing activities: earnings, this statement of retained Cash paid to purchase equipment $ (1,625) statement covers a specified period of time.) Net cash flow from investing activities (1,625) 4. Unit measure (in thousands of dollars) Cash flow from financing activities: Cash received from bank loan Cash paid for dividends $ 1,400 (1,000) Net cash flow from financing activities Net decrease in cash during the year Cash at beginning of the year McGraw-Hill Ryersonat Cash end of the year 400 $ (816) 5,051 © McGraw-Hill $ Ryerson 4,235 Limited, 2003 MAXIDRIVE CORP. Cash Flow Statement For the Year Ended December 31, 20A (In thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: Cash received from bank loan Cash paid for dividends $ 33,563 (30,854) (450) (1,190) $ $ (1,625) (1,625) $ 1,400 (1,000) Net cash flow from financing activities Net decrease in cash during the year 400 $ Cash at beginning of the year Cash at end of the year McGraw-Hill Ryerson 1,069 (816) 5,051 $ 4,235 © McGraw-Hill Ryerson Limited, 2003 Cash Flow Statement For the Year Ended December 31, 20A (In thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: $ 33,563 (30,854) (450) (1,190) $ $ 1,069 (1,625) Cash flows directly related to(1,625) Cash received income from bank loan are shown $ 1,400 earning in the Cash paid for dividends (1,000) section. Net cash flowoperating from financing activities 400 Net decrease in cash during the year $ Cash at beginning of the year Cash at end of the year McGraw-Hill Ryerson (816) 5,051 $ 4,235 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Cash Flow Statement For the Year Ended December 31, 20A (In thousands of dollars) Cash flows related to the Cash flows from operatingor activities: acquisition sale of productive Cash collected from customers $ 33,563 Cash paid to suppliers and employees (30,854) assets are shown in the Cash paid for interest (450) Cash paid for taxes (1,190) investing section. Net cash flow from operating activities $ 1,069 Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: Cash received from bank loan Cash paid for dividends $ (1,625) (1,625) $ 1,400 (1,000) Net cash flow from financing activities Net decrease in cash during the year 400 $ Cash at beginning of the year Cash at end of the year McGraw-Hill Ryerson (816) 5,051 $ 4,235 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Cash Flow Statement For the Year Ended December 31, 20A (In thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: $ 33,563 (30,854) (450) (1,190) Cash flows from or to investors $ 1,069 or creditors are shown in the $ (1,625) financing section. (1,625) Cash received from bank loan Cash paid for dividends $ 1,400 (1,000) Net cash flow from financing activities Net decrease in cash during the year 400 $ Cash at beginning of the year Cash at end of the year McGraw-Hill Ryerson (816) 5,051 $ 4,235 © McGraw-Hill Ryerson Limited, 2003 MAXIDRIVE CORP. Cash Flow Statement For the Year Ended December 31, 20A (In thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: $ 33,563 (30,854) (450) (1,190) $ $ (1,625) The statement ends with a Cash received from bank loan $ 1,400 of Cash. Cash paidreconciliation for dividends (1,000) Net cash flow from financing activities Net decrease in cash during the year McGraw-Hill Ryerson (1,625) 400 $ Cash at beginning of the year Cash at end of the year 1,069 (816) 5,051 $ 4,235 © McGraw-Hill Ryerson Limited, 2003 Notes Notes provide supplemental information about the financial condition of a company. Three types . . . Describe accounting rules applied. Present additional detail about an item on the financial statements. Provide additional information about an item not on the financial statements. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Price/Earnings Ratio Price/Earnings Ratio = Market Price (of the Company) Net Income This ratio is one method for estimating the value of a company. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Responsibilities for the Accounting Communication Process Effective communication means that the recipient understands what the sender intends to convey. Decision makers need to understand accounting measurement rules. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Generally Accepted Accounting Principles (GAAP) Securities Act of 1933 Securities and Exchange Act of 1934 The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements in the United States. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Generally Accepted Accounting Principles (GAAP) The Ontario Securities Commission (OSC) has been given broad powers to determine measurement rules for financial statements in Canada. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Generally Accepted Accounting Principles (GAAP) The OSC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP. Currently, the Accounting Standards Board (AcSB) is recognized as the body to formulate GAAP in Canada. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Generally Accepted Accounting Principles (GAAP) Companies are interested in GAAP because methods of reporting can have the following economic consequences . . . Affect the selling price of shares. Affect the amount of bonuses received by managers and other employees. Cause a loss of competitive advantage. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Management Responsibility and the Demand for Auditing To ensure the accuracy of the company’s records: Management maintains a system of controls. Management hires an outside independent auditor. The board of directors reviews these two safeguards. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Independent Auditors Auditors express an opinion as to the fairness of the financial statement presentation. Independent auditors have responsibilities that extend to the general public. McGraw-Hill Ryerson Overall, I believe these financial statements are fair. © McGraw-Hill Ryerson Limited, 2003 Independent Auditors An audit involves . . . Examining the financial reports to ensure compliance with GAAP. Examining the underlying transactions incorporated into the financial statements. Expressing an opinion as to the fairness of presentation of financial information. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Accounting Designations Chartered Accountant = CA Certified General Accountant = CGA Certified Management Accountant = CMA Certified Public Accountant = CPA* (* in USA only) McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Ethics, Reputation, and Legal Liability In Canada all Accounting Institutes require that all members adhere to a professional code of ethics. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 Ethics, Reputation, and Legal Liability The reputation for honesty and competence is the most important asset of an accountant. Like physicians, all accountants have liability for malpractice. McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003 End of Chapter 1 McGraw-Hill Ryerson © McGraw-Hill Ryerson Limited, 2003