financial accounting

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FINANCIAL ACCOUNTING

Robert LibbyPatricia A. LibbyDaniel G. ShortGeorge Kanaan

Maureen Gowing

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Chapter 1

Financial Statements and Business Decisions

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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

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Business Background

Business owners (called investors or shareholders) look for two sources of

possible gain:

Sellownership

interest in thefuture for more

than they paid.

Receive aportion of thecompany’s

earnings in cash(dividends).

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Business Background

Creditors lend money to a company for a specific length of time and gain by

charging interest on the money loaned.

Mel’sDiner

Loan

Interest

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Understanding Business Operations

Manufacturers either make the parts needed to produce its products or buy

the parts from suppliers.

Manufacturer Product Customer

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Understanding Business Operations

All businesses should have an accounting system that . . .

Collects and processesfinancial information

about an organization.

Reportsinformationto decision

makers.

Businessmanagers(internal)

Investors(external)

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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).

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Information Conveyed in Financial Statements

The four basic financial statements . . .

Income StatementBalance Sheet

Cash Flow Statement Statement of Retained Earnings

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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

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Let’s look at MAXIDRIVE

CORP.’s financial

statements.

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MAXIDRIVE CORP.Balance Sheet

At December 31, 20A(In thousands of dollars)

AssetsCash 4,235$ Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets 26,601$

Liabilities and Shareholders' EquityLiabilities

Accounts payable 7,156$ Notes payable 9,000 Total liabilities 16,156$

Shareholders' EquityShare capital 2,000$ Retained earnings 8,445 Total shareholders' equity 10,445 Total liabilities and shareholders' equity 26,601$

1. Name of entity (the separate-entity assumption)2. Title of statement3. Specific date (financial snapshot at a specific point in time)4. Unit measure (thousands of dollars)

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The Balance Sheet

Body of the StatementAssetsAssets

Economic resources controlled by the entity as a result of past transactions from which future economic benefits may be obtained.

LiabilitiesLiabilities Debts or obligations of the entity that result from past

transactions.

Shareholders’ EquityShareholders’ Equity Amount of financing provided by owners of the corporation and

from earnings.

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The Balance Sheet

Basic Accounting Equation

Economic Sources of financing . . .resources Liabilities: from creditors

Equity: from shareholders.=

Assets = Liabilities + Shareholders’ Equity

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MAXIDRIVE CORP.Balance Sheet

At December 31, 20A(In thousands of dollars)

AssetsCash 4,235$ Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets 26,601$

Liabilities and Shareholders' EquityLiabilities

Accounts payable 7,156$ Notes payable 9,000 Total liabilities 16,156$

Shareholders' EquityShare capital 2,000$ Retained earnings 8,445 Total shareholders' equity 10,445 Total liabilities and shareholders' equity 26,601$

Assets are listed by their

ease ofconversion into

cash.

Cash Amount of cash in the company’s bank account.

Accounts receivable

Amounts owed by customers from prior sales.

Inventories Partial and completed but unsold products.

Plant and equipment Factories and production machinery.

Land Property on which factories are located.

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MAXIDRIVE CORP.Balance Sheet

At December 31, 20A(In thousands of dollars)

AssetsCash 4,235$ Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets 26,601$

Liabilities and Shareholders' EquityLiabilities

Accounts payable 7,156$ Notes payable 9,000 Total liabilities 16,156$

Shareholders' EquityShare capital 2,000$ Retained earnings 8,445 Total shareholders' equity 10,445 Total liabilities and shareholders' equity 26,601$

Accounts payable

Amounts owed to suppliers for prior purchases.

Notes payable

Amounts owed on written debt contracts.

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MAXIDRIVE CORP.Balance Sheet

At December 31, 20A(In thousands of dollars)

AssetsCash 4,235$ Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets 26,601$ Liabilities and Shareholders' Equity

LiabilitiesAccounts payable 7,156$ Notes payable 9,000 Total liabilities 16,156$

Shareholders' EquityShare Capital 2,000$ Retained earnings 8,445 Total Shareholders' equity 10,445 Total liabilities and shareholders' equity 26,601$

Share capital

Amounts invested in the business by shareholders.

Retained earnings

Past earnings not distributed to shareholders.

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MAXIDRIVE CORP.Balance Sheet

At December 31, 20A(In thousands of dollars)

AssetsCash 4,235$ Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets 26,601$

Liabilities and Shareholders' EquityLiabilities

Accounts payable 7,156$ Notes payable 9,000 Total liabilities 16,156$

Shareholders' EquityShare capital 2,000$ Retained earnings 8,445 Total shareholders' equity 10,445 Total liabilities and shareholders' equity 26,601$

Use $ on the first item in a

groupand on the group total.

Assets = Liabilities + Shareholders’ Equity

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1. Name of entity2. Title of statement 3. Specific date (Unlike the balance sheet, this statement covers a specified period of time.)4. Unit measure (in thousands of dollars)

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The income statement is divided into three major captions.

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Revenues are earnings from the sale of goods or services.

Revenue is recognized in the period in whichgoods and services are sold, not necessarily

the period in which cash is received.

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The Income Statement

June 2003

Cash from salecollected on June 10.X

May 2003

$1,000 sale madeon May 25.

X

RevenuesRevenues

When will the revenue from thistransaction be recognized?

Earnings from the sale of goods or services.

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The Income Statement

May 2003

$1,000 revenue$1,000 revenuerecognized in Mayrecognized in May

Earnings from the sale of goods or services.

When will the revenue from thistransaction be recognized?

June 2003

RevenuesRevenues

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Expenses are the dollar amount of resources usedup by the entity to earn revenues during a period.

An expense is recognized in the period in whichgoods and services are used, not necessarily

the period in which cash is paid.

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Cost of goods sold

The cost of the products sold during this period.

Selling, general and

administrative

Operating expenses not directly related to production.

Research and development

Expenses incurred to develop new products.

Interest expense The cost of using borrowed funds.

Income tax expense

Income taxes on the current period’s pre-tax income.

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The Income Statement

May 2003 June 2003

Paid $75 cash on May 11 for newspaper ad.

X

Ad appearson June 8.

X

ExpensesExpensesThe dollar amount of resources used

up by the entity to earn revenuesduring a period.

When will the expense for thistransaction be recognized?

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The Income Statement

May 2003 June 2003

Advertising expenseAdvertising expenserecognized in June.recognized in June.

The dollar amount of resources usedup by the entity to earn revenues

during a period.

When will the expense for thistransaction be recognized?

When will the expense for thistransaction be recognized?

ExpensesExpenses

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When revenues exceed expenses,we report net income.

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When expenses exceed revenues,we report net loss.

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Statement of Retained Earnings

Income of the corporation

Shareholders

Dividends Retained by

the corporation

Retained Earnings

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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 Dividends for 20A (1,000) Retained earnings, December 31, 20A 9,105$

1. Name of entity2. Title of statement 3. Specific date (like the income statement, this statement covers a specified period of time.)4. Unit measure (in thousands of dollars)

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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 2,640 Dividends for 20A (1,000) Retained earnings, December 31, 20A 8,445$

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Cash Flow Statement

Because revenues reported do not always equal

cash collected. . .

. . . and expensesreported do not

always equalcash paid . . .

Income isusually not equal

to the changein cash forthe period.

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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) Cash paid for interest (450) Cash paid for taxes (1,190) Net cash flow from operating activities 1,069$ Cash flow from investing activities: Cash paid to purchase equipment (1,625)$ Net cash flow from investing activities (1,625) Cash flow from financing activities: Cash received from bank loan 1,400$ Cash paid for dividends (1,000) Net cash flow from financing activities 400 Net decrease in cash during the year (816)$ Cash at beginning of the year 5,051 Cash at end of the year 4,235$

1. Name of entity2. Title of statement 3. Specific date (like the income statement and statement of retained earnings, this statement covers a specified period of time.)4. Unit measure (in thousands of dollars)

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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) Cash paid for interest (450) Cash paid for taxes (1,190) Net cash flow from operating activities 1,069$ Cash flow from investing activities: Cash paid to purchase equipment (1,625)$ Net cash flow from investing activities (1,625) Cash flow from financing activities: Cash received from bank loan 1,400$ Cash paid for dividends (1,000) Net cash flow from financing activities 400 Net decrease in cash during the year (816)$ Cash at beginning of the year 5,051 Cash at end of the year 4,235$

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Cash Flow StatementFor 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) Cash paid for interest (450) Cash paid for taxes (1,190) Net cash flow from operating activities 1,069$ Cash flow from investing activities: Cash paid to purchase equipment (1,625)$ Net cash flow from investing activities (1,625) Cash flow from financing activities: Cash received from bank loan 1,400$ Cash paid for dividends (1,000) Net cash flow from financing activities 400 Net decrease in cash during the year (816)$ Cash at beginning of the year 5,051 Cash at end of the year 4,235$

Cash flows directly related to earning income are shown in the

operating section.

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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) Cash paid for interest (450) Cash paid for taxes (1,190) Net cash flow from operating activities 1,069$ Cash flow from investing activities: Cash paid to purchase equipment (1,625)$ Net cash flow from investing activities (1,625) Cash flow from financing activities: Cash received from bank loan 1,400$ Cash paid for dividends (1,000) Net cash flow from financing activities 400 Net decrease in cash during the year (816)$ Cash at beginning of the year 5,051 Cash at end of the year 4,235$

Cash flows related to the acquisition or sale of productive

assets are shown in the investing section.

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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) Cash paid for interest (450) Cash paid for taxes (1,190) Net cash flow from operating activities 1,069$ Cash flow from investing activities: Cash paid to purchase equipment (1,625)$ Net cash flow from investing activities (1,625) Cash flow from financing activities: Cash received from bank loan 1,400$ Cash paid for dividends (1,000) Net cash flow from financing activities 400 Net decrease in cash during the year (816)$ Cash at beginning of the year 5,051 Cash at end of the year 4,235$

Cash flows from or to investors or creditors are shown in the

financing section.

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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) Cash paid for interest (450) Cash paid for taxes (1,190) Net cash flow from operating activities 1,069$ Cash flow from investing activities: Cash paid to purchase equipment (1,625)$ Net cash flow from investing activities (1,625) Cash flow from financing activities: Cash received from bank loan 1,400$ Cash paid for dividends (1,000) Net cash flow from financing activities 400 Net decrease in cash during the year (816)$ Cash at beginning of the year 5,051 Cash at end of the year 4,235$

The statement ends with a reconciliation of Cash.

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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.

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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.

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Decision makers need to understandDecision makers need to understandaccounting measurement rules.accounting measurement rules.

Responsibilities for the Accounting Communication Process

Effective communication means that the recipient understands what the

sender intends to convey.

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The Securities and Exchange Commission Securities and Exchange Commission (SEC)has been given broad powers to determine

measurement rules for financial statements in the United States.

Securities Act of 1933Securities and Exchange Act of 1934

Generally Accepted Accounting Principles (GAAP)

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The OntarioOntario Securities Commission Securities Commission (OSC)has been given broad powers to determine

measurement rules for financial statements in Canada.

Generally Accepted Accounting Principles (GAAP)

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Generally Accepted Accounting Principles (GAAP)

Currently, the AccountingAccountingStandards Board (AcSB)Standards Board (AcSB) is recognized

as the body to formulate GAAP in Canada.

The OSC has worked closely with theaccounting profession to

work out the detailed rules that havebecome known as GAAP.

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Generally Accepted Accounting Principles (GAAP)

Companies are interested inGAAP because methods ofreporting can have the followingeconomic consequences . . .

Affect the selling price of shares. Affect the amount of bonuses received by managers and other employees. Cause a loss of competitive advantage.

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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.

Management Responsibility and the Demand for Auditing

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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.

Overall, I believethese financialstatements are

fair.

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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.

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Accounting Designations

Chartered Accountant = CACertified General Accountant = CGA

Certified Management Accountant = CMACertified Public Accountant = CPA*

(* in USA only)

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Ethics, Reputation, and Legal Liability

In Canada all Accounting Institutes require that all members adhere to a

professional code of ethics.

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The reputation for honesty and competence is the most important asset of an accountant.

Like physicians, all accountants haveLike physicians, all accountants haveliability for malpractice.liability for malpractice.

Ethics, Reputation, and Legal Liability

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End of Chapter 1