1. Understanding Accounting and Financial Statements15
Chapter
Understanding Accounting and Financial Statements

2. Learning Objectives
LO 15.1 Explain the functions of accounting, and identify the three basic activities involving accounting.
LO 15.2 Describe the roles played by public, management, government, and not-for-profit accountants.
LO 15.3 Identify the foundations of the accounting system, including GAAP, IFRS, and the role of the Accounting Standards Board (AcSB).
LO 15.4 Outline the steps in the accounting cycle, and define double- entry bookkeeping and the accounting equation.
LO 15.5 Explain the functions and major components of the four principal financial statements: the balance sheet, the income statement, the statement of owner’s equity, and the statement of cash flows.
LO 15.6 Discuss how financial ratios are used to analyze a company’s financial strengths and weaknesses.
LO 15.7 Describe the role of budgets in a business.
LO 15.8 Outline accounting issues facing global business.

3. Users of Accounting Information
Accounting: The process of measuring, interpreting, and communicating financial information to support internal and external business decision-making
People both inside and outside of the organization rely on accounting information to help them make business decisions.
Lecture Enhancer: How can managers use accounting information to help control daily operations?

4. Open Book Management
Open-book management is sharing sensitive financial information with employees and teaching them how to understand and use financial statements.
Viewing financial information may help them better understand how their work contributes to the company’s success.
Outsiders use financial data to evaluate investment opportunities.
To help employees understand the bottom line, many companies share sensitive financial information and teach them how to understand and use financial statements.
Lecture Enhancer: What are some possible downsides to practising open book management?

5. Business Activities Involving Accounting
Financing activities provide necessary funds to start a business and expand it after it begins operating.
Investing activities provide valuable assets required to run a business.
Operating activities focus on selling goods and services, but they also consider expenses as important elements of sound financial management.
The natural progression of business begins with financing. Investing leads to operating. All organizations perform these three basic activities.
Class Activity: Ask students how accounting supports a company's investing activities.

6. Accounting Professionals
Public accountant: An accountant who provides accounting services to other organizations
Auditing, tax preparation, consulting
Provided to individuals or business firms for a fee
Chartered Accountants (CA)
Management accountants provide timely, relevant, accurate, and concise information that executives can use to operate their firms profitably and effectively
Certified Management Accountant (CMA)
Government and not-for-profit accountants
Because public accountants are not employees of a client firm, they can provide unbiased advice about a firm ’s financial condition. A management accountant collects and records financial transactions and prepares financial statements used by the firm’s managers in decision-making. Government and not-for-profit accountants provide similar services to management accountants. They are focused on the efficiency of the organization.
Lecture Enhancer: Compare and contrast the role of a management accountant with the role of a public accountant.
Lecture Enhancer: Why might complying with the new federal regulations be especially important to a not-for-profit as opposed to a for-profit firm?

7. The Foundation of the Accounting System
Generally accepted accounting principles (GAAP): Principles that outline the conventions, rules, and procedures for deciding on the acceptable accounting practices at a particular time
Accounting Standards Board (AcSB): The organization that interprets and modifies GAAP in Canada for private and not-for-profit businesses
Canadian public companies are required to use International Financial Reporting Standards (IFRS). These standards allow for financial statements to be more easily compared from country to country.
Senior executives must personally certify that the financial information reported by the company is correct.
Corruption of Foreign Public Officials Act: A federal law that prohibits Canadian citizens and companies from bribing foreign officials to win or continue business.
Click on the GAAP and AcSB links to access these organizations’ sites. To provide reliable, consistent, and unbiased information to decision makers, accountants follow guidelines. The AcSB evaluates and monitors GAAP in Canada. GAAP includes International Financial Reporting Standards (IFRS) and Accounting Standards for Private Enterprises (ASPE). IFRS are the standards and interpretations adopted by the International Accounting Standards Board (IASB).
In response to accounting fraud and questions about the independence of auditors, the U.S. government enacted the Sarbanes-Oxley Act, commonly known as SOX. All Canadian companies that have publicly traded stock or debt on a U.S. stock exchange must comply with SOX. In Canada, Bill 198 requires similar provisions as SOX for Canadian companies.

8. Test Your Knowledge
Because of the increasing amount of worldwide trade, many Canadian public firms are moving from _______ to ________ when constructing financial statements.
a. GAAP; IRS
b. IFRS; GAAP
c. GATT; IFRS
d. GAAP; IFRS

9. Test Your Knowledge
Because of the increasing amount of worldwide trade, many Canadian public firms are moving from _______ to ________ when constructing financial statements.
a. GAAP; IRS
b. IFRS; GAAP
c. GATT; IFRS
d. GAAP; IFRS
Answer: D

10. The Accounting Cycle
Accounting cycle: The set of activities involved in converting information and individual transactions into financial statements
The accounting process deals with financial transactions between a firm and its employees, customers, suppliers, and owners, and with bankers and various government agencies. The procedure by which accountants convert data about individual transactions to financial statements is called the accounting cycle.

11. The Accounting Equation
Asset: anything with future benefit owned or controlled by a firm
Liability: A claim against a firm’s assets by creditors
Owner’s equity: The funds that owners invest in the business plus any profits not paid to owners in the form of cash dividends
Accounting equation: The relationship that should reflect a firm ’s financial position at any time: assets should always equal the sum of liabilities and owners’ equity
Double-entry bookkeeping: The process used to record accounting transactions; each individual transaction is always balanced by another transaction
Assets include land, buildings, supplies, cash, accounts receivable (amounts owed to the business as payment for credit sales), and marketable securities. A liability of a business is anything owed to creditors—that is, the claims of a firm ’s creditors. A strong owners’ equity position is often used as evidence of a firm ’s financial strength and stability. The accounting equation involves assets, liabilities, and owner’s equity. It illustrates double-entry bookkeeping. Because assets must always equal liabilities plus equity, each transaction must have two or more effects on the accounts.
Lecture Enhancer: What are some other examples of intangible assets?

12. The Impact of Computers and the Internet on the Accounting Process
Simplifies the accounting process by automating data entry and calculations.
Available products are customized for businesses of different sizes.
Entrepreneurs and small businesses use QuickBooks and Sage 50 (formerly Simply Accounting).
Larger firms use more sophisticated software packages like Oracle and SAP.
Software that handles accounting information (other languages/currencies for international businesses is another option.
Some systems offer Web-based packages for small and medium-sized businesses.
Click the company names to view the websites of the software companies. Computers have streamlined the accounting process from manual bookkeeping and ledger entries. Computers have made accounting easier and faster. Web software packages allow users to access their complete accounting systems from anywhere using a standard browser.
Class Activity: Discuss the characteristics of payroll accounting that made this area able to be outsourced earlier than other accounting applications.

13. Financial Statements
Balance sheet: A statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time
Photograph of firm’s assets together with its liabilities and owner’s equity
Follows the accounting equation
Financial statements provide managers with information for evaluating the organization’s ability to meet current obligations and needs through its profitability, its overall financial health, and its liquidity position. The balance sheet is the first, and only permanent, statement. The balance sheet is known as statement of financial position under IFRS.
Lecture Enhancer: What does the balance sheet tell about the status of a firm? What does a balance sheet not tell us about a firm?

14. Test Your Knowledge
The Macro Corporation has purchased land for $100,000, and has financed 50% of the cost using long-term debt. The effect on its balance sheet is
a. an increase in assets of $50,000; an increase in liabilities of $50,000.
b. an increase in assets of $100,000; a decrease in owners’ equity of $100,000.
c. an increase in assets of $100,000; an increase in liabilities of $50,000.
d. a decrease in assets of $50,000; a decrease in owners’ equity of $50,000.

15. Test Your Knowledge
The Macro Corporation has purchased land for $100,000, and has financed 50% of the cost using long-term debt. The effect on its balance sheet is
a. an increase in assets of $50,000; an increase in liabilities of $50,000.
b. an increase in assets of $100,000; a decrease in owners’ equity of $100,000.
c. an increase in assets of $100,000; an increase in liabilities of $50,000.
d. a decrease in assets of $50,000; a decrease in owners’ equity of $50,000.
 Answer: A

16. The Balance Sheet
A balance sheet shows a firm ’s financial position on a particular date. It is similar to a photograph of the firm’s assets, liabilities, and owners’ equity.
Lecture Enhancer: What is the likely reason for expenses of a company increase from year to year?

17. The Income Statement
Income statement: A financial record of a company’s revenues, expenses, and profits over a specific period of time
Reports profit or loss
Focus on revenues and costs associated with revenues
Whereas the balance sheet is a snapshot, the income statement is more like a video. Income statements maintain the information to calculate financial ratios.
Class Activity: Which industries generally have the highest net income and the lowest net income?

18. The Income Statement
Income statements are sometimes called profit-and-loss statements or (a statement of comprehensive income under IFRS). A key number to focus on is the bottom line. Keeping costs under control is an important part of running a business, and many managers push for revenues without managing costs.
The income statement also helps decision-makers to focus on overall revenues and the costs needed to generate these revenues. Finally, the income statement provides many basic data used to calculate the financial ratios that managers use in planning and controlling activities.
Lecture Enhancer: What is the likely reason for expenses of a company increase from year to year?

19. Statement of Changes in Equity
Statement of changes in equity: A record of the change in equity from the end of one fiscal period to the end of the next fiscal period
Begins with the amount of equity shown on the balance sheet
Net income is added, and cash dividends paid to owners are subtracted
All of the additions and subtractions on the statement equal the change in owners’ equity. The new owner’s equity is reported on the balance sheet for the current year.

20. Statement of Changes in Equity
The statement of changes in equity uses information from both the balance sheet and income statement.

21. Statement of Cash Flows
Statement of cash flows: A record of the sources and uses of cash during a period of time
Accrual accounting: An accounting method that records revenue and expenses when they occur, not when cash actually changes hands
The statement of cash flows shows the sources and uses of cash during a period of time. This report is important; inadequate cash flow is a reason for many business failures.
Class Activity: Is a depreciation expense a cash expense (a reduction of cash)?

22. Statement of Cash Flows
The statement of cash flows shows the relevant information about a firm’s cash receipts and cash payments from operations, investments, and financing during a specific accounting period.

23. Test Your Knowledge
Many former owners of failed firms blame ______ for their company’s failure.
a. GAAP rules
b. inaccurate budgeting
c. inadequate cash flows
d. excessive government regulation

24. Test Your Knowledge
Many former owners of failed firms blame ______ for their company’s failure.
a. GAAP rules
b. inaccurate budgeting
c. inadequate cash flows
d. excessive government regulation
Answer: C

25. Financial Ratio Analysis
Ratio analysis is a tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, and how effectively management uses the firm’s resources
Financial ratios help managers interpret statements by comparing data about the firm’s current activities. Financial ratios are one of the most common tools used to measure the firm’s liquidity, profitability, and reliance on debt financing. Ratios help managers by interpreting actual performance and making comparisons to what should have happened. Managers compare their firm ’s ratios with ratios of similar companies to understand their firm’s performance compared with competitors’ results.
Class Activity: Why would a decline in the inventory turnover ratio several years in a row raise concern?

26. Liquidity Ratios
Liquidity ratios measure a firm’s ability to meet its short-term obligations.
Current ratio compares current assets to current liabilities.
Acid-test (or quick) ratio measures the ability of a firm to meet its debt payments on short notice.
Liquidity ratios measure a firm’s ability to meet its short-term obligations. The current ratio shows that Diane’s Java has $2.58 of current assets for every $1.00 of current liabilities. A current ratio of 2 to 1 is satisfactory. Diane’s Java acid ratio is 1.5 to 1. Diane’s Java appears to have a strong level of liquidity. Ratios should be compared across periods and with other firms in the industry.

27. Activity Ratios
Activity ratios measure how effectively management uses the firm’s resources.
Inventory turnover ratio indicates the number of times merchandise moves through a business.
Total asset turnover ratio indicates how much in sales each dollar invested in assets generates.
Inventory turnover ratios can vary widely from industry to industry. Higher total asset turnover ratios indicate greater efficiency. Diane’s inventory ratio of 5.12 shows efficiency compared to the industry standard. Inventory turnover can vary depending on the type of products. Diane’s asset turnover ratio of 2.15 is average.
Lecture Enhancer: Provide examples of industries with low inventory turnover and high inventory turnover.

28. Profitability Ratios
Profitability ratios measure the organization’s overall financial performance by evaluating its ability to generate revenues in excess of operating costs and other expenses.
Three important profitability ratios are gross profit margin, net profit margin, and return on equity. All of these ratios indicate positive evaluations of the current operations. Net profit indicates the firm’s profit. Net profit margins average around 5 percent.

29. Leverage Ratios
Leverage ratios measure how much a firm relies on debt financing.
If management has assumed too much debt in financing the firm’s operations, problems may arise in meeting future interest payments and repaying outstanding loans.
Lecture Enhancer: Is a company with no debt leverage better than a company with some debt leverage? Why or why not?
A total liabilities to total assets ratio (debt ratio) greater than 50 percent indicates that a firm is relying more on borrowed money than owners’ equity.

30. Budgeting
Budget: An organization’s plans for how it will raise and spend money during a specific period of time
Shows the firm’s expected sales revenues, operating expenses, cash receipts, and cash expenses.
Budgets are a financial blueprint that serves as a financial plan.
The cash budget tracks the firm’s cash inflows and outflows.
The budget can be thought of as a short-term financial plan. It becomes the standard that actual performance is compared against. The overall master budget, or operating budget, is composed of many individual budgets for each of the firm’s separate units. These individual budgets typically include the production budget, cash budget, capital expenditures budget, advertising budget, and sales budget. Technology has improved the efficiency of the budgeting process. The cash budget is one of the most important budgets prepared by a firm.
Class Activity: Ask students why sales might be difficult to estimate.
Lecture Enhancer: What items would you include in your personal budget?

31. Budgeting
Because the accounting department is an organization’s financial nerve centre, it provides much of the data for budget development.

32. International Accounting
Accounting procedures and practices must be adapted to accommodate an international business environment.
Exchange rates are the value of one country ’s currency in terms of the currencies of other countries.
Consolidated financial statements must reflect gains and losses due to changes in exchange rates
Can have significant impact on financial statement
Global firms must reliably translate the financial statements of the firm’s international affiliated firms, branches, and subsidiaries and convert data about foreign currency transactions to dollars. Also, foreign currencies and exchange rates influence the accounting and financial reporting processes of firms operating internationally. As market economies in countries have developed, the demand for accountants has increased.
In Canada, GAAP requires firms to adjust their earnings to reflect changes in exchange rates. A weakening dollar generally increases the earnings of a Canadian firm that has international operations: the same units of a foreign currency will translate into more Canadian dollars. A strengthening dollar will have the opposite effect on earnings—the same number of units of a foreign currency will translate into fewer dollars.
Lecture Enhancer: What problems arise for Canadian accounting firms doing business abroad?
Class Activity: How can a decrease in the exchange rate of the Canadian dollar relative to the euro be positive for the export business of a Canadian company?