Finance for Non-Financial Managers, 6th edition
PowerPoint Slides
to accompany
Prepared by
Pierre Bergeron, University of Ottawa
Copyright © 2011 Nelson Education Limited
Finance for Non-Financial Managers, 6th edition
CHAPTER 2
ACCOUNTING AND
FINANCIAL STATEMENTS
Copyright © 2011 Nelson Education Limited
Accounting and Financial Statements
Chapter Objectives
1. Explain the activities related to bookkeeping.
2. Describe the accounting function and give an outline of the four
financial statements.
3. Explain the contents and the structure of the statement of income, the
statement of changes in equity and the statement of financial position.
4. Explain the meaning of analysis in financial management.
5. Discuss the importance of decision-making in financial management.
6. Draw a comparison between the GAAP and IFRS financial statements’
presentation format.
7. Explain the contents and structure of financial statements prepared for
not-for-profit organizations.
Chapter Reference
Chapter 2: Accounting and Financial Statements
Copyright © 2011 Nelson Education Limited
Financial Management Includes
Bookkeeping
Accounting
Financial Statements
Analysis
Decision-Making
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1. Bookkeeping
As a rule, when all accounts are closed at the end of an
accounting period, the asset and expense accounts have
debit balances and the equity, liability and revenue
accounts have credit balances.
Debit
Statement of Financial Position Accounts
Assets
Credit
Equity
Liabilities
Debit
Statement of Income Accounts
Expenses
Revenue
Transfer (profit for the year) is made at
the end of the accounting period
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Copyright © 2011 Nelson Education Limited
Credit
The Accounting Equation
Statement of Financial Position
A
=
E
+
L
Statement of Income
R
-
E
Debit
Increases
Decreases Decreases
Decreases
Increases
Credit
Decreases
Increases
Increases
Decreases
Increases
Profit for the year
Ends with the Trial Balance
Statement of changes
in equity
Debits = Credits
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Profit
The Accounting Cycle
Business
Business
Activity is
recorded in
Activity is
transferred to
Transaction
Document
Journals
Ledgers
takes place
is prepared
Statement of Financial Position
1. Cash account
3. House
2. VISA
4. Car
Statement of Income
1. Salary
3. Rent
2. Food
4. Clothing
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Copyright © 2011 Nelson Education Limited
The Trial Balance (Wiley Inc. Dec. 31, 2010)
Debit
Credit
SFP
$25,000 ______
Cash and cash equivalents
SI
$500,000 ______
Revenue
Finance costs
SFP
20,000 ______
SI
10,000 ______
Cost of sales
SI
300,000 ______
Prepaid expenses
SFP
50,000 ______
Short-term borrowings
SCE
135,000 ______
Retained earnings (beginning of year)
SFP
100,000 ______
Trade receivables
SFP
15,000 ______
Accrued expenses
Distribution costs
SI
50,000 ______
Income tax expense
SI
25,000 ______
Current income taxes payable
2,000 ______
SFP
Future income taxes payable (deferred taxes)
SFP
3,000 ______
SFP
200,000 ______
Long-term borrowings
Inventories
SFP
200,000 ______
SFP
100,000 ______
Trade and other payables
SFP
20,000 ______
Current portion of long-term debt
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Administrative expenses
Non-current assets (at cost)
Depreciation
SI
50,000 ______
SFP
500,000 ______
SI
25,000 ______
SFP
100,000 ______
Accumulated depreciation
Dividends
SCE
20,000 ______
SFP
200,000 ______
Share capital
Total
$ 1,325,000
$ 1,325,000
Copyright © 2011 Nelson Education Limited
Accrued Expenses
Represent a bill which the company stills owes during
the current operating year (i.e., wages, rent, bonus,
federal, provincial, or municipal taxes).
Dec. 24
Dec. 31
An employee works for a
week without being paid
for $800
So, the company owes $800
(liability) to the employee when the
books are closed
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Jan.7
Prepaid Expenses
Payments made on accounts for which services have
not yet been provided (i.e., rent, insurance, office
supplies, property taxes).
June 30
December 31
Pay $4,000 for insurance this
year and show $2,000 as an
expense…
…but, will also show in the closing
statement of financial position an
amount of $2,000 (asset) as a prepaid
expense.
Copyright © 2011 Nelson Education Limited
June 30
2. Financial Statements
To determine the value or wealth of a business, look at
the STATEMENT OF FINANCIAL POSITION (also known
as the balance sheet) since it gives a reading of its
financial position at a given point in time; it’s like a
snapshot or an X-Ray.
To determine the flow or wealth of a business, look at the
STATEMENT OF INCOME (also known as the earnings
statement, the statement of operations and the profit and
loss statement) since it shows the infusion of revenue and
expenses between two accounting periods.
To determine the accumulated wealth of a business,
look at the STATEMENT OF CHANGES IN EQUITY
(statement of retained earnings section) since it shows
the amount paid to the shareholders and the amount
retained in the business.
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3. Financial Statements - Structure and Contents
Statement of Income
Statement of Retained Earnings
Revenue
Retained earnings (beginning) $900,000
Cost of sales
Earnings for the year
Gross profit
Less: dividends
Other income/expenses
Retained earnings (ending)
Profit for the year
$100,000
Statement of Financial Position
Assets
Equity
$80,000
• NonLiabilities
current $230,000
• Long-term $150,000
• Current $25,000
• Current
$25,000
$100,000
$ (20,000)
$ 80,000
$980,000
Statement of Cash Flows
• Sources of funds
(Where they come from)
$100,000 $25,000 $150,000
Profit
CL
LT
• Uses of funds
(Where they went)
$20,000 $230,000 $25,000
Div.
NCA
CA
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Statement of Income (Operating Performance)
Revenue
Cost of sales
1 Gross profit
Other income
Distribution costs
Administrative expenses
Finance costs
Total other income and costs
2 Profit before taxes
Income tax expense
3 Profit for the year
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Statement of Comprehensive Income
Profit for the year
Other comprehensive income/(loss)
Exchange differences on translating
foreign operations
Gain or loss on property revaluation
Actual gains (losses) on defined benefit
pension plans
Total other comprehensive
income/(loss) for the year
4 Total comprehensive income
Copyright © 2011 Nelson Education Limited
Wiley’s Financial Statements
Wiley Inc.
Statement of Income for the Period Ending December 31, 2010
1
Revenue
$500,000
Cost of sales
Gross profit
(300,000)
200,000
($50,000)
Distribution costs
2
3
Income tax expense
Profit for the year
$ 25,000
$ 40,000
$ 65,000
(25,000)
Total operating expenses
Operating income (E B I T)
Finance costs
Profit before taxes
Cash flow
(50,000)
Administrative expenses
Depreciation
(125,000)
75,000
(10,000)
$75,000
25,000
65,000
(25,000)
$40,000
EBITDA $100,000
Wiley Inc.
Statement of Retained Earnings as at December 31, 2010
Retained earnings (beginning of year)
Earnings for the current year
Dividends
$ 135,000
$ 40,000
(20,000)
Retained earnings (end of year)
20,000
$ 155,000
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Wiley’s Financial Statements
$40,000
Profit for the year
Other comprehensive income/(loss)
---
Exchange differences on translating
foreign operations
Gain or loss on property revaluation
-----
Actual gains (losses) on defined benefit
pension plans
---
Total other comprehensive
income/(loss) for the year
---
4 Total comprehensive income
$40,000
Copyright © 2011 Nelson Education Limited
Wiley’s Financial Statements
Wiley Inc.
Statement of Changes in Equity for the Period Ending December 31
2010
2009
$185,000
$180,000
15,000
5,000
• Dividend reinvestment and share purchase plan
---
---
• Share issued on exercise of stock options
---
---
$200,000
$185,000
Balance at beginning of year
---
---
• Stock based compensation
---
---
• Options exercised
---
---
Balance at end of year
---
---
$135,000
$125,000
40,000
20,000
(20,000)
(10,000)
$155,000
$135,000
---
---
• Change in currency translation
---
---
• Change in property revaluation
---
---
Balance at end of year
---
---
Share capital
Balance at beginning of year
• Common shares issued
Balance at end of year
Contributed surplus
Retained earnings
Balance at beginning of year
• Earnings for the year
• Dividends paid to shareholders
Balance at end of year
Total other
comprehensive/(loss) for the
year
Balance at beginning of year
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Statement of Financial Position (Financial Structure)
Non-Current Assets
Equity
Long-term borrowings
• Capital budgeting
• Financial leverage
• Cost of financing
• Cost of capital
Current Assets
Current Liabilities
Working capital
Copyright © 2011 Nelson Education Limited
Wiley’s Financial Statements
Wiley’s Inc.
Statement of Financial Position as at December 31, 2010
1
Non-current assets
$500,000
• Accumulated depreciation
(100,000)
$400,000
Current assets
2
• Inventories
200,000
• Trade receivables
100,000
• Prepaid expenses
20,000
• Cash and cash equivalents
25,000
345,000
Total current assets
$745,000
Total assets
3
• Share capital
200,000
• Retained earnings
155,000
355,000
Total equity
• Long-term borrowings
4
200,000
• Future income taxes payable
3,000
Total non-current liabilities
203,000
Current liabilities
• Trade and other payables
5
100,000
• Short-term borrowings
50,000
• Accrued expenses
15,000
• Current portion of long-term debt
20,000
• Current income taxes payable
2,000
187,000
Total current liabilities
$745,000
Total equity and liabilities
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Taxation, Depreciation and Capital Cost Allowance
1. Corporate tax rate (varies from province to
province)
2. Taxation for small businesses (if taxable profit is
less than $400,000 they benefit from a 25%
small business deduction)
3. Business expenses and deductions
• Operating expenses (i.e., cost of sales, operating
expenses)
• Financing costs (interest on debt)
• Business losses (carried over in future years)
• Capital cost allowance (Canada
Revenue Agency)
Depreciation
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Depreciation
Depreciation (non-current assets)
A $100,000 asset with a 5-year life span.
Revenue
$ 200,000
Expenses
Depreciation
20,000
Other expenses
160,000
• It is an accounting entry.
Total expenses
180,000
• It represents the loss in value of an asset
Profit before taxes
20,000
Income tax expense
10,000
Profit for the year
Add back depreciation
10,000
20,000
Cash flow
$ 30,000
• Goodwill
Amortization
• Patents
• Franchise
• Trademarks
• Legal and architectural fees
• Research and development
due to wear and tear.
• The cost of the asset is spread against
revenue; it is more realistic.
• It is sometimes referred to as “reserve
for depreciation” (accumulated).
(intangible assets)
These costs can also be capitalized and
amortized over a period of time (years) just
like amortization for capital assets.
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CCA and Depreciation
CCA @ 50%
Declining
Depreciation
Straight line
1 $100,000 @ 50% $25,000*
$ 20,000
2
75,000 @ 50% $37,500
20,000
3
37,500 @ 50% $18,750
20,000
4
18,750 @ 50% $ 9,375
20,000
5
9,375 @ 50% $ 4,687
20,000
* Income tax regulations allow only half of
the CCA rate during the first year.
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Income Statement and P&L Statement
Accountant’s
worksheet
Statement of
income
$300,000
$300,000
$300,000
Cost of sales
150,000
150,000
150,000
Gross profit
150,000
150,000
150,000
Operating expenses
50,000
50,000
50,000
CCA/Depreciation
25,000
20,000
20,000
Total expenses
75,000
70,000
70,000
Profit before taxes
75,000
80,000
80,000
Taxes - Current (50%)
37,500
37,500
40,000
2,500
2,500
40,000
40,000
40,000
$35,000
$40,000
$40,000
Year 1
Revenue
Future
Profit for the year
P&L
statement
*The company paid $2,500 less in taxes due to higher CCA rate. Therefore, the company owes this amount to the
government in the form of future income taxes payable (it’s like an interest free loan).
Copyright © 2011 Nelson Education Limited
Future Income Taxes Payable (Deferred Taxes)
Depreciation
Difference
@ 20%
between CCA
CCA @
& depreciation
50%
Years
Difference in Difference in
annual future cumulative
income taxes @
future
50%
income taxes
1
$25,000
$ 20,000
$ 5,000 $ 2,500
$ 2,500
2
$37,500
$ 20,000
$17,500
3
$18,750
$ 20,000
- $ 1,250
-$
625
$ 10,625
4
$ 9,375
$ 20,000
- $ 10,625
- $ 5,312
$ 5,313
5
$ 4,687
$ 20,000
- $ 15,313
- $ 7,656
$ 8,750
Copyright © 2011 Nelson Education Limited
$ 11,250
-----
The Auditor’s Report
Canadian corporate law requires that every limited company appoint
an auditor to represent shareholders and report to them annually on
the company’s financial statements, expressing an opinion in writing
as to their:
• fairness, and
• consistency.
In Canada, the auditor’s report conventionally has two paragraphs:
1. Scope of the examination (accounting procedures in use and tests
of the accounting records);
2. Auditor’s opinion on the statements indicating that the financial
statements present fairly the financial position of the company in
accordance with Generally Accepted Accounting Principles (GAAP)
applied on a basis consistent with that of the preceding year.
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Accounting for Inflation and Changing Values
A.
Need
Question the validity of traditional accounting practices.
Do financial statements prepared according to traditional accounting
principles present fairly the financial position of a company in periods of
inflation?
B.
Suggested Solutions
1.
Price level accounting
Restating all figures in financial statements in terms of current purchasing
power.
2.
Current value accounting
What it would currently cost to acquire an asset with the same capability or
capacity as the one presently owned.
C.
Current Canadian Practice
In 1982, the recommendations call for Canadian enterprises whose
securities are traded in a public market to disclose in their annual reports
supplementary information on the effect of changing prices.
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4. Financial Analysis
• Horizontal analysis
• Vertical analysis
• Statement of cash flows
• Ratio analysis
• Break-even analysis
• Leverage analysis
• Risk analysis
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5. Decision-Making
•
Financing decisions
•
Working capital decisions
•
Capital budgeting decisions
•
Growth decisions
•
Capital structure decisions
•
Lease or buy decisions
•
Pricing decisions
•
Operating budgeting decisions
•
Valuation decisions
Copyright © 2011 Nelson Education Limited
6. Financial Statements – GAAP versus IFRS
GAAP
IFRS
Income Statement
Statement of Income and Statement
of Comprehensive Income
Revenue
Sales revenue
Cost of sales
Cost of sales
1 Gross profit
1 Gross profit
Other income
Operating expenses
Selling expenses
Distribution costs
Administrative expenses
Administrative expenses
Total operating expenses
2 Operating income (EBIT)
Finance costs
Total
2 Profit before taxes
Other income
Income tax expense
Other expenses
Extraordinary expenses
3 Profit for the year
3 Income before taxes
Income taxes
4 Net income
Total other comprehensive
income/(loss) for the year
4 Total comprehensive income
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Financial Statements – GAAP versus IFRS
GAAP
IFRS
Balance Sheet
Statement of Financial Position
Assets
Assets
Current assets
Non-current assets
Capital assets
Intangible assets
Intangible assets
Current assets
Total assets
Total assets
Liabilities
Equity
Current liabilities
Long-term debts
Liabilities
Total liabilities
Non-current liabilities
Current liabilities
Shareholders’ equity
Total liabilities
Total liabilities and equity
Total equity and liabilities
Copyright © 2011 Nelson Education Limited
Financial Statements – GAAP versus IFRS
GAAP
IFRS
Statement of Changes in Equity
Share capital
Statement of Changes in Equity
Share capital
• Preferred shares
• Preferred shares
• Common shares
• Common shares
• Contributed surplus
• Contributed surplus
• Retained earnings
• Retained earnings
• Total other comprehensive
Total shareholders’ equity
income/(loss) for the year
Total shareholders’ equity
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7. Not-For-Profit Organizations
Statement of Operations
Revenue
Less expenses
Equals excess of revenues over expenses
Statement of Changes in Net Assets
Excess (deficiency) or revenue over expenses and
net change in investment in capital assets
Statement of Financial Position
Assets minus liabilities equals net assets
Statement of Cash Flows
Operating activities
Financing and investing activities
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