Financial Statements

The Purpose and Use of Financial Statements

(Chapter 1)

Ø LO1.2: Primary Forms of Business Organizations

LO1.1: What is Accounting?

Accounting versus Bookkeeping

Bookkeeping is the recording of a company's transactions into the accounts contained in the general ledger. A bookkeeper takes the information provided by an accountant and records the journal entry. Bookkeepers are very technical in nature. Objective in nature.

Accounting is a much higher level. Accountants provide the information needed for management, investors, creditors, and others to make decisions. Accountants identify when entries need to be made, determine what entry needs to be made, analyze the information in financial reports, and interpret that information. Accountants are very strategic in nature.

The Purpose of Accounting

The purpose of accounting is to identify, record, and communicate economic events! Midterm applicable.

Each of these is getting more difficult, as businesses are becoming more complex, business transactions are becoming more inventive and complicated, and interested parties are becoming more numerous and diverse. Becoming more complex as a result of subsidiaries and globalization.

- Midterm: “which one of these isn’t…”

Users of Financial Information

Stakeholders (not to be confused with shareholders) are parties who prepare, rely on, review, audit, or monitor the company’s financial information. Interests in the deployment of financial information. There are two broad categories of users:

· Internal Users (inside the company)

o Company management

o Employees

o Uses financial information to make decisions regarding resource allocation.

· External Users (outside the company)

o Auditors: verifies accuracy and authenticity

o Creditors (banks, vendors): lenders

o Securities commissions and stock exchanges:

o Credit-rating agencies (e.g. Dunn and Bradstreet): rates ability to pay back debts.

o Shareholders or other investors (owners):

o Tax authorities

o Customers (existing and potential)

o Standard setters (CICA, FASB, IASB)

o Competitors

o Etc.

o Uses financial information to make decisions re. interacting with a business.

Financial Accounting versus Managerial Accounting

Financial accounting:

· Prepares financial reports for the business as a whole

· Reports are used by both internal and external parties. Primary user is external parties.

· Rigidly controlled (IFRS, ASPE, etc.)

· Understands broad financial condition: recording process.

Managerial accounting:

· Prepares financial analysis and reports for business segments, product lines, etc.

· Reports are used exclusively internally

· Less rigidly controlled

· Decision-making; e.g. reporting vs. budget drafting.

Mirror vs. headlights analogy: rear-view vs. forward looking

LO1.2: Primary Forms of Business Organizations

Businesses can be organized in different ways and the accounting standards they use can vary depending on the type of organization. There are three common forms of business organization: proprietorships, partnerships, and corporations.

Proprietorships: one person runs a business.

· Owned by one person (proprietor)

· Simple to set up

· Owner has control over business.

· Limited life

o No legal distinction between the business as an economic unit and the owner, so the life of the proprietorship is limited to the life of the owner

· Unlimited liability

o The owner is personally liable (responsible) for all debts of the business. Can be sued beyond the value of the business.

· Income tax paid by owner

o All business income is reported and taxed on the owner’s personal income taxreturn.

Partnerships

· Similar to proprietorship except it has multiple owners

· Formalized in a written agreement

o Outlines the formation of the partnership, partners’ contributions, how net income and losses are shared, provisions for withdrawals of assets and/or partners, dispute resolution, and partnership liquidation.

· Limited life

· Each partner has unlimited liability

o Each partner generally has unlimited liability for all debts of the partnership, even if one of the other partners created the debt. There are certain situations where partnerships can be formed with limited liability for selected partners.

o Other partners can be sued for the actions of individual partners, even if not directly linked to the business’ actions.

o Limited-liability partnerships can reduce liability to the amount contributed.

· Income tax paid by individual partners

o portion of income that each partner is entitled to of the total partnership income is reported and taxed on each partner’s personal income tax return.

Corporations

· Separate legal entity owned by shareholders (owners of shares)

· Indefinite life

· Ease of raising capital

· Shareholders enjoy limited liability

· Corporation pays income tax

· May be public or private:

o Public if shares are publicly traded

o Private if shares are not available to the general public

· Possesses all rights of a person, barring biological rights.

LO1.3: Types of Business Activities

All businesses are involved in three types of activity: financing, investing, and operating. Each of these activities can result in inflows of cash (cash flowing into the company) or outflows of cash (cash flowing out of the company).

Operating

· Operating activities are the main day-to-day activities of the business (e.g. revenues, expenses, accounts payable, etc.)

· Includes:

o Most income statement items

o Current assets

o Current liabilities

Investing

· Purchase or sale of long-lived assets needed to operate the company (e.g. purchase or sale of property, plant, & equipment)

· Includes:

o Long-term assets

· Any asset you’re going to derive benefit from over the course of a year.

Financing

· Obtaining (and repaying) funds to finance the operations of the business (e.g. obtaining loans, issuing shares, paying dividends). Bring in cash from an outside source, e.g. startups.

· Includes:

o Long-term liabilities: debt financing (borrowing/loans)

o Shareholder’s Equity: selling a portion of the company

LO1.4: Financial Statements

Financial statements are the way that accountants quantitatively communicate financial information. These statements each have a prescribed format and content.

The statements are prepared in the following order to ensure they balance correctly:

Statement of Income (Income Statement)

Reports revenues and expenses, showing how a company’s operations performed during a period of time.

· Revenues are from the sale of products or services and result in an inflow of assets

· Expenses are the costs of assets consumed or services used to generate revenues

· Net Income/(Loss) = Revenue – Expenses

How much money did we bring in? How much did we pay out? Net income?

Statement of Changes in Equity (Statement of Retained Earnings)

Shows the changes in each component of shareholders’ equity (including common shares and retained earnings), as well as total equity, during a period of time. How much is the company worth? How much money did you hold onto?

· Share capital – think of this as what was given

o Amounts contributed by shareholders

o May include common and preferred share classes

· Retained earnings /deficit – think of this as what was earned

o Cumulative net income retained in the corporation LESS any dividends paid to shareholders

o Other shareholders’ accounts

Statement of Financial Position (Balance Sheet)

Reports what a company owns (its assets), what it owes (its liabilities), and the resulting difference (its shareholders’ equity) at a specific point in time.

Assets - Resources owned or controlled by a business

Liabilities - Claims of lenders and other creditors

Shareholders’ Equity - Claims of shareholders

What you have – what you owe = what you’re worth. Equity.

Accounting Equation

Statement of Cash Flows

Shows the net increase or decrease in cash for the period, where a company obtained cash during a period of time, and how that cash was used. Where did the cash come from? Where did it go?

Organized by the three types of business activities (operating, investing, and financing).

The Relationship Between Statements

The statements are interrelated, so results from some statements are used as data in other statements. For example:

· Net income from the Statement of Income is reported in the Statement of Changes in Equity

· Ending balances of each shareholders’ equity account is reported in both the Statements of Financial Position and Statement of Changes in Equity

· The Statement of Cash Flows uses accounts from the Statement of Income and Statement of Financial position