Chapter 1: The Financial Statements

Introduction to Accounting, Purpose/Relationships of Differing Financial Statements, Ethics


What are the Core Accounting Financial Statements?

  • Income Statement: Sometimes known as the statement of profit or loss (P/L).
  • Statement of Retained Earnings: Sometimes included in the statement of changes in owners’ equity.
  • Balance Sheet: Also known as the statement of financial position.
  • Cash Flow Statement: Also known as the statement of cash flows.
  • Statement of Other Comprehensive Income

What are Financial Statements?

Reports that companies use to convey financial results of business activities to groups, like managers, investors, creditors, regulatory agencies, etc. These parties use the information to make decisions.

Explain Why Accounting is the Language of Business

What is Accounting?

An information system that measures & records business activities, processes data into reports & reports results to decision makers.

Who Uses Accounting Information?

  • Managers: Accounting information helps managers decide whether to introduce new products, set up regional offices, acquire competitors, extend credit to customers, etc.
  • Investors & Creditors: They provide financing to a business. Investors want to know the rate of return. Creditors want to know if & how a loan is going to be paid back.
  • Government & Regulatory Bodies: Governments require organizations & people to pay income/sales taxes.
  • Individuals: Accounting information allows people to manage bank accounts, decide financial decisions, determine monthly income, how much to spend/save, etc.
  • Not-for-Profit Organizations: Religions institutions, charities, hospitals, base decisions on this information. It also helps in reporting in the organization’s stewardship of funds received & allows it to comply with regulations.

What are the 2 Kinds of Accounting?

  • Financial Accounting: For internal & external users. Provides faithful representation of economic activities.
  • Management Accounting: For internal users (managers). Includes budgets, forecasts & projection.

3 Forms of Business Organizations

Accounting is used in every type of business. A business generally takes one of the following forms.

  • Proprietorships: An unincorporated business with a single owner (proprietor). Tend to be small businesses or individual professional organizations (lawyers & accountants). Legally, the proprietor is personally liable for all business debts. For accounting, the proprietor’s personal finances aren’t included in the proprietorships records.
  • Partnerships: An unincorporated business with 2+ parties as co-owners who are co-partners. All types of entities can be partners. The income or loss flows through to the partners based on the agreed-upon percentage interest. The partnership is not a taxpaying entity. Instead, each partner takes a proportionate share of the entity’s taxable income & pays the according individual or corporate rate. Most are small or medium-sized but can get pretty big. The law views partnerships as the partners. Accounting sees partnerships as a distinct, separate organization.
  • Normally, each partner is personally liable for all the partnership’s debts. Thus, limited liability partnerships (LLPs) are popular.
  • Corporations: An incorporated business owned by shareholders, who own shares representing partial ownership. An advantage of incorporating is the ability to raise large sums of capital by issuing shares to the public. Legally, corporations are separate entities than their owners (this is known as limited liability). They also pay income taxes. Shareholders get 1 vote per share & can elect board of directors, who set policy & appoints the chairperson & other officers.

Purpose & Elements of Financial Statements

What are Elements of Financial Statements?

Broad classes that are used to group transactions & events according to their economic characteristics.

What are Generally Accepted Accounting Principles (GAAP)?

GAAP specify standards for how accountants must record, measure & report financial information. In Canada, GAAP are established by the Chartered Professional Accounts of Canada (CPAC). Canada has multiple sets of GAAP, with each being applied to a specific type of entity/organization.

Publicly accountable enterprises (PAEs) are corporations or organization that have issued or plan to issue shares or debt in public markets such as the Toronto Stock Exchange, and they must apply International Financial Reporting Standards (IFRS). IFRS are set by the International Accounting Standards Board.

Private enterprises, which have not issued or do plan to issue shares or debt on public markets, have the option of applying the IFRS. However, most apply the Accounting Standards for Private Enterprises (ASPE) which has been set by the CPAC.

What is the Income Statement (Statement of Profit or Loss)?

It measures a company’s operating performance for a specified period, typically a month, a quarter or a year. The income statement has 2 elements: income & expenses. A single-step income statement only includes 2 types of accounts: revenues & expenses.

Fiscal year-end date can be chosen by firms. Banks typically end their fiscal year on October 31st.

Income

Includes both revenue & gains.

  • Revenue: Amounts earned during ordinary, day-to-day business activities, primarily from sales of products.
  • Revenue is referred to by a variety of names, including sales, fees, interest, dividends, royalties & rent.
  • Gains: Represents other items that results in increases in economic benefits to a company & may, but usually does not occur during ordinary business activities.
  • For example, it includes re-selling property for a higher value than initially purchased.
  • Other Income: Includes categories of revenues & gains that are sufficiently material to report on separate lines.

Expenses

A company’s expenses consist of losses & expenses that are incurred during ordinary business activities:

  • Expenses: Consists mainly of costs incurred to purchase products a company needs to run its business on a day-to-day basis. Includes costs of goods sold or cost of sales, wage, rent, interest, taxes, etc.
  • Losses: Represents items that result in a decrease in economic benefits to a company. They may, but usually don’t, occur during ordinary business activities. Usually listed separately in the statement or disclosed in the notes to the financial statements.

Net Income

Net Income = Total Revenues & GainsTotal Expenses & Losses

When total expenses exceed total income, the result is called a net loss. Net income is also known as net earnings or net profit, & is considered the most important amount in financial statements.

What is the Statement of Retained Earnings?

A company’s retained earnings represent the accumulated net income (or net earnings) of the company since the day it started business, less any net losses & dividends declared during this time. The beginning balance of retained earnings for a new business is always 0. When it’s negative, the term deficit is used to describe it.

The statement of retained earnings reports the changes in a company’s retained earnings during the same period covered by the income statement.

Under ASPE, this statement is generally added to the bottom of income statements. Under IFRS, changes in retained earnings is included in the statement of changes in owners’ equity.

What is the Balance Sheet (Statement of Financial Position)?

The balance sheet consists of 3 elements: assets, liabilities & the owners’ equity. It reports these 3 elements at a specific date, which always falls on the last day of the monthly, quarterly or annual reporting period. It balances the accounting equation.

What is the Accounting Equation?

Assets = Liabilities + Shareholders’ Equity

What are Assets?

A resource controlled by the company as a result of past events & from which the company expects to receive future economic benefit. There are 2 categories of assets:

  • Current Assets: An asset we expect to convert to cash, sell or consume within 1 year (or a business’ normal operating cycle) of the balance sheet date.
  • Listed in order of liquidity.
  • Non-Current (Long-Term) Assets: All assets that don’t qualify as current assets.

What are Liabilities?

A present obligation of the company arising from past events, the settlement of which is expected to result in an outflow of resources. There are 2 categories of liabilities:

  • Current Liabilities: A liability we expect to pay within 1 year (or a business’ normal operating cycle) of the balance sheet date.
  • Non-Current (Long-Term) Liabilities: All liabilities that don’t qualify as current liabilities.

What is Owners’ Equity?

The owners’ remaining interest in the assets of the company after deducting all its liabilities. Sometimes referred to as the net assets.

What is the Statement of Cash Flows?

Statement of cash flows (or cash flow statement under ASPE) reports a company’s cash receipts & cash payments for the same fiscal period covered by the income statement. It shows specific business activities that generated cash or resulted in cash payments. There are 3 categories of activities.

  • Operating Activities: The main revenue source of a company & generally result from transactions/events that determine net income.
  • Includes cash receipts from sales, & cash payments to suppliers/employees.
  • Investing Activities: Activities include the purchase & sale of long-term assets & other investments that result in cash flows related to resources used for generating future income.
  • Cash payments to acquire property, plant & equipment, and the cash received upon the sale of these assets are common investing activities.
  • Investing activities also include cash flows from the purchase/sale of investments in other companies & those related to loans made to other entities.
  • Financing Activities: These activities result in changes in the size & composition of a company’s contributed equity & borrowings.
  • Common financing activities include the issuance & acquisition of shares, the payment of cash dividends, the cash proceeds from borrowings, and the repayment of amounts borrowed.

What are the Notes to the Financial Statement?

The notes provide information that cannot be reported conveniently on the financial statements. For example, it tells readers information such as what accounting policies were used in preparing the financial statements & what methods were used to account for inventories & depreciation.

Financial Reporting Responsibilities

2 parties have critical financial reporting responsibilities:

  • Company’s management: Has the primary financial reporting duties because they’re responsible for designing, maintaining & monitoring the company’s financial reporting process & for preparing the financial statements based on the information generated.
  • Independent External Auditor: Has the responsible to gather evidence regarding the financial information reported by management, and then decide if it complies with the applicable GAAP. After the audit, the auditor provides a report to the board of directors & shareholders that states its opinion on the fairness of the company’s financial statement relative to GAAP.
  • Public enterprises in Canada must have their financial statements audited, and many private companies must also do so.

Explain Relationships Among Financial Statements

The net income from income statements show up in the statement of retained earnings. The ending retained earnings from the statement of retained earnings shows up in the balance sheet. The amount of cash shows up in the balance sheet & the statement of cash flows.

Decision Guidelines for Evaluating a Company

Explain Accounting’s Conceptual Framework

Accounting’s Conceptual Framework

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2 Fundamental Qualitative Characteristics

  • Relevance: Information must have predictive value, confirmatory value or both.
  • Information must be material, which means it’s significant enough in nature or magnitude that omitting or misstating it could affect the decisions of an informed user. A small error might be immaterial.
  • Faithful Representation: For accounting information to provide a faithful representation to users, it must reflect the economic substance of a transaction or event, which may not be the same as its legal form. It must also be complete, neutral (free of bias) & accurate (free of material error).

4 Enhancing Qualitative Characteristics

  • Comparability: Information must be reported in a way that makes it possible to compare it to similar information being reported by other companies. It must also be comparable to other accounting periods.
  • Verifiability: Information needs to be able to be checked for accuracy, completeness & reliability. This enhances the change that the information reflects a faithful representation of the economic substance of a transaction/event.
  • Timeliness: Information must be reported to users in time for it to influence their decisions. Accounting information can lose relevance over time, so it should be reported as soon after the accounting period.
  • Understandability: Information must be clearly & concisely classified, and presented to knowledgeable users.

The Cost Constraint

Accounting information is costly to produce. The cost of disclosure should not exceed the value of disclosing.

Assumptions Underlying the Conceptual Framework

The conceptual framework has only 1 explicit underlying assumption:

  • Going-Concern Assumption: We assume the entity is expected to operate normally for the foreseeable future.

There are 3 implicit assumptions:

  • Separate-Entity Assumption: We assume that the business activities of the reporting entity are separate from the activities of its owners.
  • Historical-Cost Assumption: We assume that assets should be recorded at their actual cost, measured on the date of purchase as the amount of cash paid plus the dollar value of all non-cash considerations (other assets, privileges, rights, etc.). This means that as assets potentially change value over time, in the company’s books it will also be reported at its historical cost. When this hypothetical asset it sold, the difference is reported as a loss/gain.
  • Fair Value: The amount that business could sell an asset for, or the amount the business could pay to settle a liability. IFRS permits certain types of assets/liabilities to be reported in fair value, but ASPE rarely does.
  • Stable-Monetary-Unit Assumption: We assume that the value of the currency is stable, despite the fact that its value does change due to economic factors (such as inflation).

Ethical Business Decisions

The application of IFRS and ASPE frequently requires the use of professional judgment because accounting standards contain few clear-cut rules on how to account for transactions/events.

3 Factors Influence Business & Accounting Decisions

  • Economic: This factor states that the decision being made should maximize the economic benefit to the decision maker.
  • Legal: This factor states that free societies are governed by laws & involves applying the relevant laws to each decision, and choosing the action that complies with those laws.
  • Ethical: This factor states that certain actions might be profitable & legal, but might still be wrong. Ethical standards are shaped by our cultural, socioeconomic & religious backgrounds.

A Potential Ethical Analysis

  • Which options are most honest, open & truthful?
  • Which options are most kind and compassionate & build a sense of community?
  • Which options create the greatest good for the greatest number of stakeholders?
  • Which options result in treating others as I would want to be treated?

What is Fraud?

The intentional misrepresentation of facts done to persuade another party to act in a way that causes financial damage to that party. This is also known as cooking the books.

2 Most Common Types of Fraud

  • Misappropriation of Assets: Committed by stealing assets from a company and then covering the theft up by adjusting the accounting records or other relevant information. Examples include stealing inventory, falsifying invoices, forging or altering cheques, or overstating of expense reimbursement requests.
  • Fraudulent Financial Reporting: Committed by managers who make false/misleading entries in the records, usually to present a more favourable financial picture than reality.

Why do Managers Engage in Fraud?

  • To meet profit targets set by market analysts to increase share price.
  • To meet loan conditions so a bank won’t demand early repayment.
  • To meet an earnings target to get large bonus payments to senior executives.

Decision Guidelines for Making Ethical Judgements

To simplify, we might ask 3 questions:

  • Is the action legal?
  • Who will be affected by the decision & how? Analyze from all 3 standpoints (economic, legal & ethical).
  • How will this decision make me feel? How would it make me feel if my family finds out?

Summary of IFRS-ASPE Differences


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