Financial Accounting

Eighth Canadian Edition

Chapter 1
The Financial Statements

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Learning Objective One
Explain why accounting is the language of business

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Financial Statements
• Financial statements are the business documents that
companies use to report the results of their activities
to various user groups. The system of accounting
produces the following statements:

Income
Statement
Statement of
Retained Earnings
Balance Sheet
Statement of Cash
Flows

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Flow of Accounting Information

Business
People make Companies
transactions
decisions report results
occur

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Users of Accounting Information

Government
Investors and
Managers and Regulatory
Creditors
Bodies

Not-For-Profit
Individuals
Organizations

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Kinds of Accounting

Financial Accounting Management Accounting

• Provides information for • Provides information for
internal and external users internal users only
– Managers
• Includes:
– Investors
– Budgets
– Creditors
– Forecasts
– Government agencies
– Projections
– The public

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Organizing a Business

Proprietorship Partnership Corporation

Owner(s) Proprietor - one Partners – two or Shareholders – usually
more many
Personal liability Proprietor is Partners are Shareholders are NOT
of owner(s) for personally liable usually personally liable
business debts personally liable

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Proprietorships
• Single owner
• Common business form for small retail stores and
professional service providers
• Proprietor personally liable for business debts

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Partnerships
• Two or more parties as co-owners
• Not a taxpaying entity
– Income passes through to partners
• Partners are usually personally liable
– Limited liability partnerships lessen risk

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Corporations (1 of 2)
• Owned by shareholders
– Shares represents share of ownership
• Ability to raise large sums of capital
• Generally larger than proprietorships and partnerships
(although small companies can be incorporated as
well)
• Formed under federal or provincial law
– Legally distinct from its owners

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Corporations (2 of 2)
• Double taxation
– Corporate income is taxed
– Shareholders taxed on distributions of earnings
(dividends) but Canada’s income tax laws attempt to
minimize double taxation
• Shareholders elect Board of Directors
– Set policy and appoint officers

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Learning Objective Two
Describe the purpose and explain the elements of each
financial statement

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 The Financial Statements
Question Financial Statement Answer
How much income did the Income statement Revenues + gains
company earn during the −Expenses + losses
year? Net income or (net loss)
Why did the company’s Statement of retained Beginning retained earnings
retained earnings change earnings + Net Income
during the year? +Other comprehensive income
−Dividends
Ending retained earnings
What is the company’s Balance sheet Assets =
financial position at the end Liabilities + Owners’ equity
of the year?
How much cash did the Statement of cash Operating cash flows
company generate and flows +/− Investing cash flows
spend during the year? +/− Financing cash flows
Increase (decrease) in cash

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Accounting Standards

Accountants follow professional guidelines.

The rules that govern accounting are called GAAP

(generally accepted accounting principles).

CPA Handbook: Official source of GAAP

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Multiple Sets of GAAP

International Financial Reporting Standards (IFRS):

For publicly accountable enterprises

Accounting Standards for Private Enterprises (ASPE):

For private enterprises

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The Income Statement (1 of 2)
• Also called the statement of profit and loss
• Reports two main categories
– Income (revenues and gains)
– Expenses and losses
• Shows the “bottom line”
– Net income or net loss for the period
• Net income is the most important item in the financial
statements

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The Income Statement (2 of 2)
ABC Corporation
Income Statement
For the Year Ended December 31, 20XX
Net sales $XX,XXX
Other revenue +XX,XXX
Total revenues XX,XXX
Cost of goods sold (XX,XXX)
Gross margin XX,XXX
Selling, general, and administrative expenses (XX,XXX)
Income from operations XX,XXX
Interest expense (XX,XXX)
Income before income taxes XX,XXX
Income tax expense (XX,XXX)
Net Income $XX,XXX

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Statement of Retained Earnings (1 of 3)
• Retained earnings is the portion of net income a
company has kept over a period of years
• Positive balance indicates revenues exceeded
expenses
• Accumulated deficit indicates expenses have
exceeded revenues
• Net income (or net loss) flows from the Income
Statement to the Statement of Retained Earnings

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Statement of Retained Earnings (2 of 3)
• Opens with beginning retained earnings balance
• Adds net income (or subtracts net loss)
– Which flows from the Income Statement
• Subtracts dividends
• Reports ending retained earnings balance

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Statement of Retained Earnings (3 of 3)

ABC Corporation
Statement of Retained Earnings
For the Year Ended December 31, 20X2
Retained earnings, December 31, 20X1 $XX,XXX
Plus: Net income XX,XXX
Less: Dividends XX,XXX
Retained earnings, December 31, 20X2 $XX,XXX

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The Balance Sheet
• Also called the Statement of Financial Position
• Reports
– Assets
– Liabilities
– Owners’ equity
• Shows that assets equal the sum of liabilities and
owners’ equity (A = L + OE)
• Reports retained earnings, which comes from the
statement of retained earnings

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Assets on the Balance Sheet (1 of 2)
Current Assets Non-Current Assets
• Expected to be converted • Will be held longer than one
to cash, sold or consumed year
in the next year or within • Include
the business’s operating – Property and equipment
cycle
 Land
– Whichever is longer
 Buildings
• Include
 Computers
– Cash and cash
equivalents  Equipment
– Short-term investments – Intangibles
– Long-term investments
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Assets on the Balance Sheet (2 of 2)

Current Assets
– Accounts and notes
receivable
– Inventory
– Prepaid expenses

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Liabilities on the Balance Sheet
Current Liabilities Non-Current Liabilities
• Debts payable in the next • Debts payable more than
year or within the one year from the balance
business’s operating cycle sheet date
• Include • Include
– Accounts payable – Long-term notes payable
– Income taxes payable – Bonds payable
– Accrued expenses
payable
– Current maturities of long-
term debt
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Owners’ Equity on the Balance Sheet
• Represents ownership of the net business assets
• In a corporation, consists of:
– Common shares
– Retained earnings

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 Sample Balance Sheet
ABC Corporation
Balance Sheet
As at December 31, 20XX
Assets Liabilities and Shareholders'
Equity
Cash and cash equivalents Accounts payable
Merchandise inventory Taxes payable _________
Prepaid expenses __________ Total current liabilities
Total current assets __________ Long-term debt _________
Total liabilities _________
Property and Equipment
Less: accumulated depreciation __________ Common shares
Net Property and Equipment Retained earnings _________
Other assets __________ Total shareholders' equity _________
Total assets __________ Total liabilities & shareholders' equity _________

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The Statement of Cash Flows
• Measures cash receipts and cash payments
• Shows whether cash increased or decreased during
the year
• Reports ending cash as shown on the balance sheet
• Categorizes into three types of activities:
– Operating activities
– Investing activities
– Financing activities

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Cash Flow Categories
• Operating activities
– Cash receipts and payments from selling goods and
services
• Investing activities
– Purchasing and selling long-term assets
• Financing activities
– Issuing shares, paying dividends, borrowing, and
repayment of borrowed funds

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Notes to the Financial Statements
• An integral part of the financial statements
• Should be read carefully with the financial statements
• Provide information on the accounting policies used
• Example of policies used: Methods used to account
for inventories and depreciation

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Financial Reporting Responsibilities
• Company management are responsible for preparing
the financial statements.
• Auditor’s responsibility is to gather evidence and
decide whether the information reported in the
financial statements complies with the applicable
GAAP.
• Auditor provides a signed report that states its opinion
on the fairness of the company’s financial statements
relative to GAAP.

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Exercise E1-20 (1 of 2)

(a) Common shares Balance Sheet

(b) Income tax payable Balance Sheet
(c) Dividends Statement of Retained Earnings
(d) Income tax expense Income Statement
(e) Ending balance of retained earnings Statement of Retained Earnings
Balance Sheet
(f) Total assets Balance Sheet
(g) Long-term debt Balance Sheet
(h) Revenue Income Statement

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Exercise E1-20 (2 of 2)
(i) Cash spent to acquire equipment Statement of Cash Flows
(j) Selling, general & administrative Income Statement
expenses
(k) Adjustments to reconcile net Statement of Cash Flows
income to net cash from operations
(l) Ending cash balance Balance Sheet
Statement of Cash Flows
(m) Current liabilities Balance Sheet
(n) Net income Income Statement
Statement of Retained Earnings
Statement of Cash Flows
(0) Cost of goods sold Income Statement

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Learning Objective Three
Prepare financial statements and analyze the
relationships among them

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Financial Information Flow
Income Statement

Statement of Retained
Earnings

Balance Sheet

Statement of Cash Flows

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Relationships among Financial
Statements (1 of 3)
Income Statement
For the Year Ended December 31, 20XX

Revenues $XX,XXX
Expenses (XX,XXX)
Net income $XX,XXX

Statement of Retained Earnings

For the Year Ended December 31, 20XX
Beginning retained earnings $XX,XXX
Net income XX,XXX
Cash dividends (XX,XXX)
Ending retained earnings $XX,XXX

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Relationships among Financial
Statements (2 of 3)
Statement of Retained Earnings
For the Year Ended December 31, 20XX
Beginning retained earnings $XX,XXX
Net income XX,XXX
Cash dividends (XX,XXX)
Ending retained earnings $XX,XXX

Balance Sheet
As at December 31, 20XX
Assets $XX,XXX
Liabilities $XX,XXX
Shareholders’ equity:
Common shares $XX,XXX
Retained earnings XX,XXX
Total liabilities and equity $XX,XXX
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Relationships among Financial Statements
(3 of 3)
Balance Sheet, As at December 31, 20XX
Assets $XX,XXX
Liabilities $XX,XXX
Cash from
Shareholders’ equity: the Asset
Common shares $XX,XXX section of
Retained earnings XX,XXX the Balance
Total liabilities and equity $XX,XXX Sheet
equals
Statement of Cash Flows, Year Ended December 31, 20XX ending Cash
on the
Cash flows from operating activities $XX,XXX
Statement of
Cash flows from investing activities XX,XXX Cash Flows
Cash flows from financing activities XX,XXX
Net cash flows XX,XXX
Cash balance, beginning of year XX,XXX
Cash balance, end of year $XX,XXX

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Learning Objective Four
Explain and apply underlying accounting concepts,
assumptions, and principles

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Conceptual Framework

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Assumptions & Principles
• Going-Concern assumption
– Entity will continue operating normally for the
foreseeable future
• Separate-Entity assumption
– A business is a separate economic unit
• Historical-Cost assumption
– Assets are recorded at purchase price
• Stable-Monetary-Unit assumption
– Value of the currency is stable

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Learning Objective Five
Ethically evaluate business decisions

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Influences on Business Decisions

Economic Legal
maximize the free societies are
economic benefits governed by laws

Ethical
higher level of
conduct required

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Ethical Analysis
• Which options are most honest, open, and truthful?
• Which options are most kind and compassionate, and
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?

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Decision Framework for Making Ethical
Judgments

1. What is the issue?

2. Who are the stakeholders and what are the consequences of

the decisions to each?

3. What are the decision alternatives, and how do they affect

each stakeholder?
4. What decision alternative will you choose?

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Chartered Professional Accountants (CPA
Ontario) Code of Professional Conduct
• Many professional organizations, businesses, and
other entities adopt their own ethical guidelines or
codes of conduct so their members have more-
specific guidance.
• CPA Ontario has a code of professional conduct that
applies to all of its members

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Learning Objective Six
Identify tools and technologies used in accounting and
business

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Tools and Technologies
Examples of tools and technologies used in accounting:
• Spreadsheets
• Data analytics
• Artificial intelligence (AI)
• Machine learning
• Robotic process automation (RPA)

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Technology Risks
Technology used improperly can lead to catastrophic
decisions:
• Key data could be input incorrectly
• Key data could be missing

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Introduction to Excel
These are the major items found in a blank worksheet in Excel:

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End of Chapter One

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