Chapter 1 Conceptual Framework and Financial Statements.

Chapter 1 Conceptual Framework and Financial Statements

Learning Objective: 1. Understand the role of accounting in communicating financial information. 2.Learn underling concepts,assumptions and principles of accounting. 3.Apply the accounting equation to business organizations. 4.Evaluate business operations. 5.Use information in financial Statements to make business decisions. Copyright ©2014 Pearson Education 2

Accounting is an information system. It measures business activities, processes data into reports, and communicates results to people who make decisions about the company. Accounting is “the language of business.” The better you understand the language, the better you can manage your finances as well as those of your business. Copyright ©2014 Pearson Education 4

Financial accounting provides information for decision makers outside the entity, such as investors, creditors, government agencies, and the public. This information must be relevant for the needs of decision makers and must faithfully give an accurate picture of the entity’s economic activities. Management accounting provides information for managers of a business. Examples of management accounting information include budgets, forecasts, and projections that are used in making strategic decisions of the entity. Internal information must still be accurate and relevant for the decision needs of managers. Copyright ©2014 Pearson Education 6

Types of Accounting FinancialManagerial Provides information for external users ▫Investors ▫Creditors ▫Government ▫The public Provides information for internal users – managers Includes: ▫Budgets ▫Forecasts Copyright ©2014 Pearson Education 7

Accounting is used in every type of business. A business generally takes one of the following forms: 1) proprietorship 2) partnership 3) corporation 8

A proprietorship has a single owner, called the proprietor. Proprietorships tend to be small retail stores or solo providers of professional services— physicians, attorneys, or accountants. Legally, the business is the proprietor, and the proprietor is personally liable for all the business’s debts. But for accounting purposes, a proprietorship is a distinct entity, separate from its proprietor. Thus, the business records should not include the proprietor’s personal finances. Copyright ©2014 Pearson Education 9

A partnership has two or more parties as co-owners, and each owner is a partner. Individuals, corporations, partnerships, or other types of entities can be partners. Income and loss of the partnership “flows through” to the partners and they recognize it based on their agreed-upon percentage interest in the business. The partnership is not a taxpaying entity. Instead, each partner takes a proportionate share of the entity’s taxable income and pays tax according to that partner’s individual or corporate rate. Many retail establishments, professional service firms (law, accounting, etc.), real estate, and oil and gas exploration companies operate as partnerships. Many partnerships are small or medium-sized, but some are gigantic, with thousands of partners. Partnerships are governed by agreement, usually spelled out in writing in the form of a contract between the partners. Copyright ©2014 Pearson Education 10

General partnerships have mutual agency and unlimited liability, meaning that each partner may conduct business in the name of the entity, and can make agreements that legally bind all partners without limit for the partnership’s debts. Partnerships are therefore quite risky, because an irresponsible partner can create large debts for the other general partners without their knowledge or authorization. This feature of general partnerships has spawned the creation of limited-liability partnerships (LLPs). A limited-liability partnership is one in which a wayward partner cannot create a large liability for the other partners. In LLPs, each partner is liable for partnership debts only up to the extent of his or her investment in the partnership, plus his or her proportionate share of the liabilities. Each LLP, however, must have one general partner with unlimited liability for all partnership debts. Copyright ©2014 Pearson Education 11

A corporation is a business owned by the shareholders who own stock representing shares of ownership in the corporation. One of the major advantages of doing business in the corporate form is the ability to raise large sums of capital from issuance of stock to the public. All types of entities (individuals, partnerships, corporations, or other types) may be shareholders in a corporation. Even though proprietorships and partnerships are more numerous, corporations transact much more business and are larger in terms of assets, income, and number of employees. Copyright ©2014 Pearson Education 12

A corporation is formed under the relevant legislation in the country. Unlike proprietorships and partnerships, a corporation is legally distinct from its owners. The corporation is like an artificial person and possesses many of the same rights that a person has. The shareholders have no personal obligation for the corporation’s debts and have limited liability. Ultimate control of a corporation rests with the shareholders, who generally get one vote for each share they own. In general, shareholders elect the board of directors, which sets policy and appoints management officers such as the chief executive officer (CEO), chief operating officer (COO) and chief financial officer (CFO), and other key functions as necessary. Copyright ©2014 Pearson Education 13

Forms of Business Organization ProprietorshipPartnershipCorporation Owner(s)Proprietor – One owner Partners – two or more owners Shareholders – generally many owners Personal liability of owner(s) for business debts Proprietor is personally liable General partners are personally liable; limited partners are not Shareholders are NOT personally liable Copyright ©2014 Pearson Education 14

Partnerships Not a taxpaying entity ▫Income passes through to partners Governed by an agreement Mutual agency ▫Each partner can act on behalf of the entity Unlimited liability Involve risk ▫Limited liability partnerships lessen risk Copyright ©2014 Pearson Education 16

Corporations Formed under state law ▫Legally distinct from its owners Double taxation ▫Corporate income is taxed ▫Shareholders taxed on distributions of earnings (dividends) Shareholders elect Board of Directors ▫Set policy and appoint officers Copyright ©2014 Pearson Education 17

International Financial Standards Historically, different countries use their own accounting standards. ▫Difficult for investors to compare companies that operate in different countries The IASB has developed international standards (IFRS) ▫In the past, U.S. considered its GAAP to be the strongest set of standards In November 2008, the SEC announced it will require all U.S. public companies to adopt IFRS Copyright ©2014 Pearson Education 18

Until recently, one of the major challenges of conducting global business has been the fact that different countries have adopted different accounting standards for business transactions. Historically, the major developed countries in the world have all had their own versions of accounting standards (usually referred to in general as GAAP, Generally Accepted Accounting Principles). As investors seek to compare financial results across entities from different countries, they have had to restate and convert accounting data from one country to the next in order to make them comparable. This takes time and can be expensive, especially in a globalised world with multinationals operating across many countries. Copyright ©2014 Pearson Education 19

The solution to this problem lies with the International Accounting Standards Board (IASB) and International Financial Reporting Standards (IFRSs). The IASB (www.iasb.org) was formed in 2001 to replace the International Accounting Standards Committee (IASC) with the objective of developing a single set of high quality, understandable and enforceable accounting standards to help participants in the world’s capital markets and other users make economic decisions. Whilst IASB now pronounces IFRSs, previously issued International Accounting Standards (IASs) by the IASC continue to remain effective. This is why in your study of accounting, you will see some standards labeled IAS or IFRS. Collectively, they are simply referred to as IFRSs. In addition, these standards may be relabeled somewhat differently in different countries. Copyright ©2014 Pearson Education 20

These standards are now being used by most countries around the world. Since its inception, over 100 countries around the world has either required or permitted the use of IFRSs for financial reporting. The IASB and United States’ Financial Accounting Standards Board (FASB) have also signed a Memorandum of Understanding outlining their commitment to the convergence of US Generally Accepted Accounting Principles (US GAAP) and IFRSs. As this gains momentum, you can expect to hear more about the adoption and use of IFRSs, as well as global harmonization of accounting standards, in the future. When you do, the most important things to remember will be that these changes will be beneficial for financial statement users in the long run, and that most of what you learned in this accounting course will still apply. Copyright ©2014 Pearson Education 21

The advantages to adopting one common set of standards are clear. Companies in jurisdictions that have mandated or allowed the use of IFRS compliant standards, such as Australia, Hong Kong, United Arab Emirates, Europe, and eventually United States, will have financial statements that are more comparable with each other. It will be far easier for investors and other financial statement users to evaluate information of various companies in the same industries from across the globe, and companies will only have to prepare one set of financial statements, instead of multiple versions. Thus, in the long run, global use of IFRS should significantly reduce costs of doing global business. Copyright ©2014 Pearson Education 22

This Exhibit 1-3 gives an overview of the IFRS conceptual framework: The IFRS Framework’s focus is on general purpose financial statements, which are prepared and presented (at least) annually and are directed toward the common information needs of a wide range of financial statement users. Many of these users rely on the financial statements as their major source of financial information and such financial statements should, therefore, be prepared and presented with their needs in view. Special purpose financial reports, such as computations for taxation purposes, are outside the scope of the IFRS Framework. The IFRS Framework states that the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. Users evaluate financial statements to make decisions such as whether or not to make additional investment into the entity, provide credit and financing, or assess management’s performance. Copyright ©2014 Pearson Education 24

The IFRS Framework uses the term qualitative characteristics to describe the attributes that make the information provided in financial statements useful to users. The 6 qualitative characteristics are split into fundamental and enhancing characteristics. The 2 fundamental characteristics are relevance and faithful representation. The remaining 4 are enhancing characteristics, which include comparability, verifiability, timeliness and understandability. In providing information that can be useful to our users, we face a number of constraints: timeliness, balance between qualitative characteristics, and benefits versus cost. Copyright ©2014 Pearson Education 25

The IFRS Framework states that in order meet the objectives financial reporting, there are assumptions we need to make : Firstly, that we prepare our financial statements on an accrual basis. In short, this means that transactions and other events are recognized when they occur and not when cash is received or paid. In measuring and reporting accounting information, we also assume that the entity will continue to operate long enough to use existing assets – land, buildings, equipment and supplies – for its intended purposes. In other words, the business has neither the intention nor the need to liquidate or curtail materially the scale of its operations. This is called the going concern assumption which would normally apply to most entities. This is how a business can buy assets with expectations to derive benefits from the use of the assets beyond the current financial period. An entity that is not continuing would be accounted for very differently from one that is a going concern. Copyright ©2014 Pearson Education 26

Different users make different types of economic decisions, based on their relationship with the entity. 1. Investors would want to know if they are getting adequate returns for the risks they are taking when they invest in the company. They may decide to increase, hold or decrease their ownership of the company by buying or selling The company’s shares in the stock exchange. 2. Employees may be interested in its financial information for many reasons. Job security, salary increments, and compensation bonuses are usually worse off when a company has declining profits, or worse, experiences losses. 3. Creditors, such as bankers or other financial institutions, may need to decide if they will grant the company additional loans for its expansion plans. They would want to know if the company has the ability to service the interest payments and eventually repay the loan principal. Copyright ©2014 Pearson Education 29

4. Suppliers and trade creditors often grant credit terms to its customers. They would want to know that the company will be able to pay their invoices as and when they become due. 5. It is unlikely that retail customers would demand financial information before buying merchandise. However, for other situations where customers have long-term involvement with the entity, customers want to be assured of the continuance of the entity it deals with. 6. Government and its agencies are interested in various aspects of a business, for example, tax collection and allocation of grants or subsidies. Listed companies would also need to comply with the stock exchange’s disclosure requirements or “listing rules”. 7. And with increasing expectations of corporate social responsibility, members of the public may be interested in the company’s executive remuneration, health and safety issues, or even environmental impact of its business operations. Copyright ©2014 Pearson Education 30

Relevance To be relevant, information must be capable of making a difference to the decision maker, having predictive or feedback value. Thus, the manner by which information on past transactions and events is presented may directly influence the predictive value and feedback value of the information. Faithful representation Financial statements represent economic phenomena in words and numbers. Information that faithfully represents the underlying economic phenomenon should be complete, neutral and free from error. Copyright ©2014 Pearson Education 32

Comparability Users usually compare financial statements of an entity over a period of time in order to identify trends in its financial position and performance. Thus, it is important that the basis of preparation and presentation remains comparable over time. Comparability does not mean uniformity, nor continuing to use the same accounting principles and policies when more relevant and reliable alternative exists. Verifiability Verifiability helps assure users that information faithfully represents the economic phenomenon it purports to represent. Timeliness This means that the information must be made available to users early enough to help them make decisions, thus making the information more relevant to their needs. Understandability Understandability means that accounting information must be sufficiently transparent so that it makes sense to users of the information. The framework assumes that users have a reasonable knowledge of business, economic activities and accounting, and a willingness to study the information with reasonable diligence. Copyright ©2014 Pearson Education 34

Constraints Copyright ©2014 Pearson Education 35 Benefits vs Costs Cost: Cost of data collection, processing, verifying and disseminating information Will benefits>cost? In providing information that can be useful to our users, we face the constraint of cost vs benefits. Cost of preparing financial information include cost of data collection, data processing, verifying and disseminating information. These higher costs will lower shareholder returns. Hence there is a need to access whether the benefits of reporting particular information are likely to outweigh costs incurred in providing or using the information.

The IFRS Framework states that in order meet the objectives financial reporting, there are assumptions we need to make. Firstly, that we prepare our financial statements on an accrual basis. In short, this means that transactions and other events are recognized when they occur and not when cash is received or paid. We will explore more about accrual accounting in Chapter 3. In measuring and reporting accounting information, we also assume that the entity will continue to operate long enough to use existing assets – land, buildings, equipment and supplies – for its intended purposes. In other words, the business has neither the intention nor the need to liquidate or curtail materially the scale of its operations. This is called the going concern assumption which would normally apply to most entities. This is how a business can buy assets with expectations to derive benefits from the use of the assets beyond the current financial period. An entity that is not continuing would be accounted for very differently from one that is a going concern. Copyright ©2014 Pearson Education 37

Accounting Equation Elements Economic resources Produce future benefits Assets Present obligations Result in an outflow of economic benefits Liabilities Represents shareholders’ residual claim to the entity’s assets Equity Increases in economic benefits during an accounting period Income Decreases in economic benefits during an accounting period Expenses Copyright ©2014 Pearson Education 38

Assets are economic resources controlled by the entity which are expected to produce future economic benefits to the entity. Examples of assets include cash, inventory, account receivables (money owed to the entity by its debtors), machinery, equipment and properties. Liabilities are present obligations of the entity which are expected to result in an outflow of economic benefits from the entity. Examples of liabilities include bank loans, account payables (money owed by the entity to its creditors) and other obligations. Equity is the residual interest in the entity’s assets after deducting the entity’s liabilities and represents shareholder’s residual claim to the entity’s assets. Copyright ©2014 Pearson Education 39

You will find two major sub-parts in the equity section: share capital and retained earnings. Share Capital is the amount shareholders have invested in the entity (usually in the form of shares) and Retained Earnings is the amount earned by income-producing activities and kept for use in the business. Income is increases in economic benefits during an accounting period (i.e. increases in assets or decreases in liabilities) that result in an increase in equity, other than those related to transactions with shareholders. The IFRS Framework further separates Income into revenue and gains. Revenue arises from the ordinary course of business (such as sales revenue), whereas gains may or may not be in the ordinary course of business (such as gain on disposal of a subsidiary). Copyright ©2014 Pearson Education 40

Expenses are decreases in economic benefits during an accounting period (i.e. decreases in assets or increases in liabilities) that result in a decrease in equity, other than those related to transaction with shareholders. Similarly, expenses can be incurred in the ordinary course of business (such as salaries and wages, rent expense), whereas losses may or may not be in ordinary course of business (losses suffered because of natural disasters). The IFRS Framework also provides guidance on when to recognize these elements of financial statements. It states that when an item that meets the definition of an of element of financial statement, it is recognized if (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. Information about financial position (assets, liabilities and equity) is primarily provided in a Balance Sheet, whereas information about financial performance (income and expenses) is primarily provided in an Income Statement. Copyright ©2014 Pearson Education 41

A company’s financial statements tell us how the business is performing and where it stands. But how do we arrive at the financial statements? Let’s examine the elements of financial statements, which are the building blocks on which these statements rest. The financial statements are based on the accounting equation. This equation presents the resources of a company and the claims to those resources. The third learning objective is to apply the accounting equation to business organizations. Copyright ©2014 Pearson Education 43

Copyright ©2014 Pearson Education 45 The basic accounting equation shows the relationship among assets, liabilities, and equity. Assets appear on the left side and liabilities and owners’ equity on the right. The accounting equation can be written as Assets = Liabilities + Equity, or alternatively, Assets – Liabilities = Equity. As Exhibit 1-4 shows, the two sides must be equal. In this example, the entity’s assets of $1,000 are financed by liabilities of $600 and equity of $400.

A second accounting equation relates to the calculation of profits earned by an entity during a financial period. Profit is simply Income (Revenue and Gains) less Expenses (Expenses and Losses). Exhibit 1-5 shows that a profit of $200 resulted from total revenue of $500 and expenses of $300. When total revenues exceed total expenses, the result is called net income, or net profit. When expenses exceed revenues, the result is a net loss. In accounting, the word “net” refers to an amount after a subtraction. Net income is thus the profit left over after subtracting expenses and losses from revenues and gains. Copyright ©2014 Pearson Education 47

The Components of Retained Earnings Copyright ©2014 Pearson Education 48 Revenues for the period Expenses for the period Ending Balance of Retained Earnings Dividends for the period Net Income (or Net Loss) for the period Beginning Balance of Retained Earnings minus equals Plus or minus minus equals

A second accounting equation relates to the calculation of profits earned by an entity during a financial period. Profit is simply Income (Revenue and Gains) less Expenses (Expenses and Losses). Exhibit 1-5 shows that a profit of $200 resulted from total revenue of $500 and expenses of $300. When total revenues exceed total expenses, the result is called net income, or net profit. When expenses exceed revenues, the result is a net loss. In accounting, the word “net” refers to an amount after a subtraction. Net income is thus the profit left over after subtracting expenses and losses from revenues and gains. Copyright ©2014 Pearson Education 49

Evaluate business operations Copyright ©2014 Pearson Education 50 The financial statements present a company to the public in financial terms. Each financial statement relates to a specific date or time period. The financial statements allow users to evaluate business operations, which is the fourth learning objective.

The Income Statement part of Statement of Comprehensive Income Reports two main categories ▫Revenues and gains ▫Expenses and losses Shows the “bottom line” ▫Net income or net loss for the period Copyright ©2014 Pearson Education 52

ABC Corporation Income Statement Financial Year Ended December 31 Net sales 200,000 + Other income 50,000 = Total income 250,000 - Cost of sales 100,000 = Gross margin 150,000 - Selling, general and administrative expenses 5,000 - Depreciation, amortization and provisions 10,000 - Non-recurring income and expenses 15,000 = Earnings before interest and tax 120,000 - Finance costs 7,000 - Income tax 3,000 + Other income items 5,000 = Net Income 115,000 Copyright ©2014 Pearson Education 53

An example of an income statement is shown above. This company has two kinds of revenue: Net sales and Other revenue. Revenues do not always carry the term revenue in their titles. For example, net sales revenue is often abbreviated as net sales. Net sales means sales revenue after subtracting all the goods customers have returned to the company. Not all expenses have the word expense in their title. For example, for many retailers the largest expense is for cost of sales. Another title of this expense is cost of goods sold (or COGS). This expense represents the direct cost of making sales. This includes the cost of the merchandise it sold to customers. The difference between total income and cost of sales is called gross margin. Copyright ©2014 Pearson Education 54

Other expenses are: Selling, general, and administrative expenses are the costs of everyday operations that are not directly related to merchandise purchases. Many expenses may be included in this category, including labor costs, property rentals, maintenance and repairs, fees, advertising, consumables and other general expenses. Depreciation, amortization and provisions largely relate to the systematic allocation of costs or benefits consumed from long-lived assets such as property, plant and equipment (PPE). Non-recurring income and expenses (line 8) was a slightly unusual item. Some companies would label this type of non-recurring items as “exceptional items”. Finance costs, or interest expense is the cost of borrowing money. Interest revenue, which is the amount earned from investing money, can be netted against interest expense. Companies sometimes offset items like interest income and interest expense against each other and show only the difference. Income tax expense is the expense levied on corporate income by the government as a percentage of income earned. Taxation rules can be complicated, and taxable income is not always equal to net income. The bottom line shoes the net income (or loss). Copyright ©2014 Pearson Education 55

Statement of Changes in Equity The Statement of Changes in Equity shows a company’s transactions with its owners. Net income (or net loss) flows from the Income Statement to the Statement of Changes in Equity. After a company earns net income, its board of directors decides if the company should to pay a dividend to the shareholders. Corporations are not obligated to pay dividends unless their boards decide to pay (i.e. declare) them. Usually, companies who are in development stages or growth mode elect not to pay dividends, opting instead to plough the money back into the company to expand operations or purchase property, plant and equipment. Established companies usually have regular earnings (and cash) to pay dividends. Dividends decrease retained earnings because they represent a distribution of a company’s assets (usually cash) to its shareholders. Copyright ©2014 Pearson Education 56

ABC Corporation Statement of Changes in Equity For the year ending December 31, 20X6 Shareholder equity as of December 31, 20X5 $$,$$$ Plus: Net income $$,$$$ Less: Dividends $$,$$$ Reclassifications and other reserves $$,$$$ Shareholder equity as of December 31, 20X6 $$,$$$ Copyright ©2014 Pearson Education 57 A typical Statement of Changes in Equity shows the activity in the account. Net income increase Shareholder equity and dividends decrease it.

Assets on the Balance Sheet CurrentNon-current Expected to be converted to cash, sold or consumed in the next 12 months or within the business’ operating cycle Include ▫Cash ▫Short-term investments ▫Receivables (or debtors) ▫Inventory ▫Prepaid expenses Will be held longer than one year Include ▫Property, plant and equipment  Land  Buildings  Computers  Equipment ▫Intangibles ▫Long-term investments Copyright ©2014 Pearson Education 59

THERE ARE TWO MAIN CATEGORIES OF ASSETS: CURRENT AND LONG-TERM. CURRENT ASSETS ARE ASSETS THAT ARE EXPECTED TO BE CONVERTED TO CASH, SOLD, OR CONSUMED DURING THE NEXT 12 MONTHS OR WITHIN THE BUSINESS’S OPERATING CYCLE. CURRENT ASSETS INCLUDE CASH, SHORT- TERM INVESTMENTS, RECEIVABLES (ALSO CALLED DEBTORS), MERCHANDISE INVENTORY, AND PREPAID EXPENSES. ALL COMPANIES HAVE CASH. CASH IS THE LIQUID ASSET THAT’S THE MEDIUM OF EXCHANGE, AND CASH EQUIVALENTS INCLUDE MONEY-MARKET ACCOUNTS OR OTHER FINANCIAL INSTRUMENTS THAT ARE EASILY CONVERTIBLE TO CASH. ACCOUNTS RECEIVABLE ARE AMOUNTS THE COMPANY EXPECTS TO COLLECT FROM ITS DEBTORS. SOMETIMES YOU MAY SEE SOME COMPANIES USE THE TERM “DEBTORS” TO DESCRIBE ACCOUNT RECEIVABLES. OFTEN, COMPANIES WILL ALSO DISTINGUISH BETWEEN TRADE AND OTHER RECEIVABLES. TRADE RECEIVABLES ARE USUALLY AMOUNT DUE FROM CUSTOMERS, IN THE CONTEXT OF TRADING ACTIVITIES. NOTES RECEIVABLE ARE AMOUNTS A COMPANY EXPECTS TO COLLECT FROM A PARTY WHO HAS SIGNED A PROMISSORY NOTE TO THAT COMPANY AND THEREFORE OWES IT MONEY. Copyright ©2014 Pearson Education 60

Merchandise inventory, is a retailer’s largest current asset. Prepaid expenses represent amounts paid in advance for advertisements, rent, insurance, and supplies. Prepaid expenses are current assets because the company will benefit from these expenditures in the next fiscal year. The main categories of long-term or non-current assets are Property, Plant, and Equipment (PPE), and intangible assets. Non-current assets may indicate long-term investments and other long-term assets. Property, plant, and equipment (PPE, sometimes also called fixed assets) conveys economic benefits over its useful lives, and their acquisition costs are allocated systematically throughout their useful lives. This process is called depreciation. The cumulative amounts that have been previously allocated are called accumulated depreciation. Intangibles are assets with no physical form, such as patents, trademarks, and goodwill. Copyright ©2014 Pearson Education 61

Liabilities on the Balance Sheet CurrentNon-current Obligations or debts payable in the one year or within the business’s operating cycle Include ▫Accounts payable ▫Taxes payable ▫Short-term notes payable ▫Salaries/wages payable Debts payable more than one year from balance sheet date Include ▫Long-term notes payable ▫Bonds payable Copyright ©2014 Pearson Education 62

Current liabilities typically include accounts such as accounts payable, taxes payable, and other liabilities like short-term notes payable, and salaries/wages payable. Non-current liabilities are obligations that are likely to require an outflow of economic benefits after one year. Account payables are the amount due to a company’s creditors. For a retailer, it is most likely suppliers of its merchandise inventory. Similar to receivables, sometimes you will see companies further classifying Payables into trade payables (or Creditors), note payable, and other payables. Tax payable is the amount due to various tax authorities. Other liabilities comprise provisions, pre-collected revenue (or unearned revenue), and deferred tax liabilities. Copyright ©2014 Pearson Education 63

Shareholders’ Equity on the Balance Sheet Represents shareholders ownership of the business assets Consists of: ▫Paid-in capital (sometimes labeled Share Capital or simply, Capital) ▫Additional paid-in capital (depends on jurisdictions) ▫Retained earnings Copyright ©2014 Pearson Education 64

A corporation’s equity consists of: 1) Paid-in capital (sometimes labeled share capital or simply, capital) 2) Depending on where the company’s is legally registered, some jurisdictions practice a “par value” system, whereas others do not use par values. In situations where a company has par values for its shares, you are likely to see par values of share capital separated from the additional capital paid above par value (usually labeled share premium, additional paid-in capital, or capital in excess of par). 3) Retained earnings, reserves and others. Retained earnings records the earnings of the entity less the dividends it pays out. Copyright ©2014 Pearson Education 65

Copyright ©2014 Pearson Education 66 Share capital This is an example of a template for a corporate balance sheet. Each classification in the assets and liabilities is subtotaled and then the subtotals are combined to result in the total for the section. The total assets will always equal the total liabilities & shareholders’ equity.

The Statement of Cash Flows Measures cash receipts and cash payments Fourth required financial statement Categorizes into three types of activities: ▫Operating ▫Investing ▫Financing Companies engage in three basic types of activities: operating activities, investing activities and financing activities. The Statement of Cash Flows reports cash flows under each of these activities. Copyright ©2014 Pearson Education 67

Cash Flow Categories Operating Cash receipts and payments from selling goods and services Investing Purchasing & selling long-term assets Financing Issuing stock and borrowing Copyright ©2014 Pearson Education 68 Issuing shares and borrowing

Companies operate by selling goods and services to customers. Operating activities result in net income or net loss, and they either increase or decrease cash. The income statement tells whether the company is profitable but this does not necessarily mean the company has been able to generate cash from operations. Sooner or later, to be successful, a company will need to bring in cash from its operations. Companies also invest in non-current assets such as Property, Plant and Equipment. Both purchases and sales of long-term assets are investing cash flows. Cash flows from investing activities show a company’s investments into its production capacity. Companies need money for financing. Financing includes any issuance of shares, repurchase of shares, as well as proceeds and repayments of borrowings. Copyright ©2014 Pearson Education 69

Relationships between Financial Statements Income Statement For the year ended December 31, 20X6 Revenues $$$,$$$ Expenses ($$,$$$) Net income $$,$$$ Statement of Changes in Equity For the year ended December 31, 20X6 Beginning equity $$$,$$$ Net income $$,$$$ Cash dividends ($$,$$$) Ending equity $$,$$$ Copyright ©2014 Pearson Education 70

Statement of Changes in Equity For the year ended December 31, 20X6 Beginning equity $$$,$$$ Net income $$,$$$ Cash dividends ($$,$$$) Ending equity $$,$$$ Balance Sheet December 31, 20X6 Assets $$$,$$$ Liabilities $$$,$$$ Shareholders’ equity: Share capital $$$,$$$ Retained earnings $$$,$$$ Total liabilities and equity $$$,$$$ Copyright ©2014 Pearson Education 71

Statement of Cash Flows For the year ended December 31, 20X6 Cash flows from operating activities $$$,$$$ Cash flows from investing activities $$,$$$ Cash flows from financing activities $$,$$$ Net cash flows $$,$$$ Cash balance, December 31, 2009 $$,$$$ Cash balance, December 31, 2010 $$,$$$ Balance Sheet December 31, 20X6 Assets $$$,$$$ Liabilities $$$,$$$ Shareholders’ equity: Share capital $$$,$$$ Retained earnings $$$,$$$ Total liabilities and equity $$$,$$$ Cash from the Asset section of the Balance Sheet equals ending Cash on the Statement of Cash Flows 72 Copyright ©2014 Pearson Education

Evaluating a Company Question/DecisionWhat to look for Can the company sell its products or services? Sale revenue Increasing or Decreasing? What are the main income measures to watch for trends? Gross profit Operating income and Net income What percentage of sales revenue ends up as profit? Divide net income by sales revenue Can the company collects its receivables? Compare change in receivables to change in sales Can the company pay its liabilities?Compare assets to liabilities Where is the company’s cash coming from? Observe the line items on the cash flow statement Copyright ©2014 Pearson Education 73 This table provides questions financial statement users often ask about companies and indicates where in the financial statements the answers may be found.

Ethics in Business and Accounting Decisions Which options are most honest, open, and truthful? Which options are most kind, 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? Copyright ©2014 Pearson Education 74

Good business requires decision making, which in turn requires the exercise of good judgment, both at the individual and corporate levels. The ethical factor recognizes that while certain actions might be both economically profitable and legal, they may still not be right. Therefore, most companies, and many individuals, have established standards for themselves to enforce a higher level of conduct than that imposed by law. These standards govern how we treat others and the way we restrain our selfish desires. This behavior and its underlying beliefs are the essence of ethics. Ethics are shaped by our cultural, socioeconomic, and religious backgrounds. An ethical analysis is needed to guide judgment for making decisions. The decision rule in an ethical analysis is to choose the action that fulfills ethical duties – responsibilities of the members of society to each other. The challenge in an ethical analysis is to identify specific ethical duties and stakeholders to whom you owe these duties. As with legal issues, a complicating factor in making global ethical decisions may be that what is considered ethical in one country is not considered ethical in another. Copyright ©2014 Pearson Education 75

Chapter 1 Conceptual Framework and Financial Statements.

Similar presentations

Presentation on theme: "Chapter 1 Conceptual Framework and Financial Statements."— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Chapter 1 Conceptual Framework and Financial Statements.

Similar presentations

Presentation on theme: "Chapter 1 Conceptual Framework and Financial Statements."— Presentation transcript:

Similar presentations

About project

Feedback