© 2003 McGraw-Hill Ryerson Limited 2 2 Chapter Review of Accounting McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca College Revised by: PChua

© 2003 McGraw-Hill Ryerson Limited Chapter 2 - Outline  What is Accounting?  The Income Statement (I/S)  The Balance Sheet (B/S)  The Statement of Retained Earnings  The Statement of Cash Flows (CFs)  Limitations of Financial Statements  Comparison of Accounting and Cash Flows  Income Tax Considerations  Summary and Conclusions PPT 2-2

© 2003 McGraw-Hill Ryerson Limited What is Accounting?  Accounting is important to adequately understand the concepts of finance.  Accounting provides financial information about a business.  Accounting provides information as to where a firm has and where it is at the present time. These information provide an estimate of the future direction of the firm.  Financial statements help us understand these.  4 principal financial statements:  Income Statement  Balance Sheet  Statement of Retained Earnings  Statement of Cash Flows  FS are of interest to stakeholders in business:  shareholders  managers  creditors  suppliers and customers  government PPT 2-3

© 2003 McGraw-Hill Ryerson Limited The Income Statement  An Income Statement provides a measure of the profitability of a firm over a time period.  Revenues from customers for services or merchandise  Expenses from vendors for merchandise, services or supplies Revenues Less: Expenses Equals: Net Income/Net Loss PPT 2-4

© 2003 McGraw-Hill Ryerson Limited Preparing Income Statement is Done in Stair-step Fashion - Allows us to examine the profit or loss after each type of expense is deducted. Sales – Cost of Goods Sold Step 1= Gross Profit – Operating Expenses Step 2= Operating Profit – Interest Expense Step 3 = Earnings Before Taxes – Income Taxes Step 4= Earnings Aftertaxes PPT 2-5

© 2003 McGraw-Hill Ryerson Limited About Amortization Expense  The purpose of Amortization is to allocate the cost of an equipment over its life, so that at the end of its life, the cost becomes zero or close to zero.  In essence, we are matching the annual cost of using/owning an equipment over its useful life.  Systematic expensing of a portion of the cost of a fixed asset against sales.  This charging of Amortization is purely an accounting entry procedure and does not directly involve the movement of funds.

© 2003 McGraw-Hill Ryerson Limited KRAMER CORPORATION Income Statement For the Year Ended December 31, Sales $2,000,000 2.Cost of goods sold ,500,000 3.Gross profits ,000 4.Selling and administrative expense ,000 5.Amortization expense ,000 6.Operating profit (EBIT)* ,000 7.Interest expense ,000 8.Earnings before taxes (EBT) ,000 9.Taxes , Earnings aftertaxes (EAT) , Preferred stock dividends , Earnings available to common shareholders.$ 100, Shares outstanding , Earnings per share $ Common stock dividends ,000 *Earnings before interest and taxes. PPT 2-6 Table 2-1

© 2003 McGraw-Hill Ryerson Limited The Income Statement  The Income Statement uses accrual basis of recording transactions, i.e., revenues and expenses are recorded at the time of transaction.  Finance uses cash flow basis, i.e., it records revenues and expenses only when there is cash inflow and outflow involved.  This attention to cash flow will enable the manager to determine the real cash situation of the firm and therefore its short-term survival.

© 2003 McGraw-Hill Ryerson Limited PPT 2-25 Table 2-11a Comparison of accounting and cash flows Accounting Flows Cash Flows Earnings before amortization and taxes (EBAT)..$1,000$1,000 Amortization Earnings before taxes (EBT) Taxes Earnings aftertaxes (EAT) $ Amortization charged without cash outlay Cash flow $ 600

© 2003 McGraw-Hill Ryerson Limited Statement of Retained Earnings  Details changes in Retained Earnings from the beginning to the end of the fiscal year. Retained Earning Balance (start of year) Plus: Net Income After Taxes Less: Cash Dividends Paid Retained Earning Balance (end of year)

© 2003 McGraw-Hill Ryerson Limited Statement of Retained Earnings Retained Earnings, balance, January 1, 2002……… $250,000 Add: Net income After Taxes, 2002 ………………………………...110,500 Deduct: Preferred Stock Dividends declared in 2002……………….10,500 Common Stock Dividends declared in 2002 ……………… 50,000 Retained Earnings, balance, December 31, 2002 ……………………..300,000 KRAMER CORPORATION Statement of Retained Earnings For the Year Ended December 31, 2002

© 2003 McGraw-Hill Ryerson Limited The Balance Sheet A Balance Sheet (B/S) shows what a firm owns and how it is financed at a point in time (ex.; December 31) Remember the ALOE! Assets = Liabilities + Owners’ Equity PPT 2-9

© 2003 McGraw-Hill Ryerson Limited Classifications on the Balance Sheet Assets*:what a business owns Current Assets  Ex: Accounts receivable, Inventory  Will be sold or used up within 1 year Capital Assets  Ex: Building * Asset accounts are listed in order of liquidity Liabilities: what a business owes Current Liabilities  Ex: Accounts payable  Due within 1 year Long-term Liabilities  Due some time after 1 year Equity: what the owner(s) have invested in the business Shareholders’ Equity  Capital stock  Retained earnings PPT 2-10

© 2003 McGraw-Hill Ryerson Limited KRAMER CORPORATION Balance Sheet (Statement of Financial Position) December 31, 2002 Assets Current assets: Cash $40,000 Marketable securities ,000 Accounts receivable $ 220,000 Less: Allowance for bad debts. 20, ,000 Inventory ,000 Prepaid expenses ,000 Total current assets ,000 Other assets: Investments ,000 Capital assets: Plant and equipment, original cost.. $1,100,000 Less: Accumulated amortization 600,000 Net plant and equipment ,000 Total assets $1,000,000 PPT 2-11 Table 2-4a

© 2003 McGraw-Hill Ryerson Limited Liabilities and Shareholders’ Equity Current liabilities: Accounts payable $ 80,000 Notes payable (bank indebtedness) ,000 Accrued expenses ,000 Total current liabilities ,000 Long-term liabilities: Bonds payable, ,000 Total liabilities ,000 Shareholders’ equity: Preferred stock, 500 shares ,000 Common stock, 100,000 shares ,000 Retained earnings ,000 Total shareholders’ equity ,000 Total liabilities and shareholders’ equity.... $1,000,000 PPT 2-12 Table 2-4b

© 2003 McGraw-Hill Ryerson Limited Limitations of Financial Statements  Based on past transactions rather than future forecasts  May not recognize important economic changes as they occur, such as increase in property values  Inflation-adjusted values  Variety of accounting policies and methods are used  inventory valuation PPT 2-14

© 2003 McGraw-Hill Ryerson Limited The Statement of Cash Flows  Provides summary of all inflows and outflows of cash over the same period as the Balance Sheet.  Translates income statement and balance sheet data into cash flow information.  Provides insights into the firm’s operating, investment, and financing cash flows. CF from operating activities PLUS CF from investing activities PLUS CF from financing activities PLUS EQUALS = Net increase (decrease) in cash and marketable securities  Reconciles changes in cash and marketable securities.

© 2003 McGraw-Hill Ryerson Limited Figure 2-1 Illustration of concepts behind the statement of cash flows Cash inflows Cash outflows NIAT Net Loss AmortizationIncrease in CA Decrease in CA Decrease in CL Increase in CL Sale of plantPurchase of plant and equipment Liquidation ofLong-term investment long-term investment Sale of bonds,Retirement or common stock, repurchase of preferred stock, bonds, common stock, and other preferred stock, and securities other securities Payment of cash dividends Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Add items 1, 2, and 3 together to arrive at net increase (decrease) in cash & marketable securities PPT 2-17

© 2003 McGraw-Hill Ryerson Limited KRAMER CORPORATION Comparative Balance Sheets Assets Current assets: Cash $ 40,000 30,000 Marketable securities ,00010,000 Accounts receivable (net)...200,000170,000 Inventory ,000160,000 Prepaid expenses ,00030,000 Total current assets ,000400,000 Investments (long term) ,00020,000 Plant and equipment ,100,000 1,000,000 Less: Accumulated amortization.600, ,000 Net plant and equipment , ,000 Total assets $ 1,000,000 $ 870,000 Dec. 31 Dec PPT 2-19 Table 2-6a

© 2003 McGraw-Hill Ryerson Limited Comparative Balance Sheets Liabilities and Shareholders’ Equity Current liabilities: Accounts payable $ 80,000 $ 45,000 Notes payable , ,000 Accrued expenses ,00035,000 Total current liabilities...210,000180,000 Long-term liabilities: Bonds payable, ,00040,000 Total liabilities ,000220,000 Shareholders’ equity: Preferred stock, ,00050,000 Common stock, ,000350,000 Retained earnings ,000250,000 Total shareholders’ equity. 700,000650,000 Total liabilities and shareholders’ equity $ 1,000,000 $ 870,000 Dec. 31 Dec PPT 2-20 Table 2-6b

© 2003 McGraw-Hill Ryerson Limited KRAMER CORPORATION Statement of Cash Flows For the Year Ended December 31, 2002 Operating Activities Net income (earnings after taxes) $ 110,500 Add items not requiring an outlay of cash: Amortization $50,000 Cash flow from operations160,500 Changes in non-cash working capital Increase in accounts receivable (30,000) Increase in inventory (20,000) Decrease in prepaid expenses ,000 Increase in accounts payable ,000 Decrease in accrued expenses (5,000) Net change in non-cash working capital..... (10,000) Cash provided by (used in) operating activities...$ 150,500 PPT 2-22 Table 2-10a

© 2003 McGraw-Hill Ryerson Limited Investing Activities: Increase in investments (long-term securities). ( 30,000) Increase in plant and equipment (100,000) Cash used in investing activities ($130,000) Financing Activities: Increase in bonds payable ,000 Preferred stock dividends paid (10,500) Common stock dividends paid (50,000) Cash used in financing activities (10,500) Net increase (decrease) in cash and cash equivalents during the year ,000 *Cash, beginning of year ,000 *Cash, end of year $ 40,000 *This would include cash equivalents, if there were any PPT 2-23 Table 2-10b

© 2003 McGraw-Hill Ryerson Limited Income Tax Considerations  Income taxes affect financial decisions  Corporate taxes vary by province, by type of business and by size of business (For Current Tax Facts and Figures, visit DFD01AB )  Cash flows aftertax are most relevant for decision-making  Aftertax investment income paid to shareholders or other individuals varies depending upon the form of the income (eg. Dividend income, interest income, capital gains.  Expenses deductible from taxable income provide a tax shield (tax savings) PPT 2-26

© 2003 McGraw-Hill Ryerson Limited Tax Shield on Tax-Deductible Expense Scenario A Scenario B Earnings Before Interest and Taxes …………. $400,000 $400,000 Interest ………………………………………… 100, Earnings Before Taxes ……………………….. 300, ,000 Taxes (40%) ………………………………… , , Earnings After Taxes ………………………… $180,000 $240,000 Difference in Earnings After Taxes - $60,000

© 2003 McGraw-Hill Ryerson Limited Tax Shield on Amortization (Capital Cost Allowance) PPT 2-28

© 2003 McGraw-Hill Ryerson Limited Taxation of Business Income  Corporations can earn the following types of income:  Active Business Income  Passive Income  Capital Gains  Types of Corporations for tax purposes:  Non-Manufacturing  Manufacturing or Processing  Canadian-controlled private corporation (CCPC)

© 2003 McGraw-Hill Ryerson Limited Summary and Conclusions  The 4 basic financial statements are the income statement, the balance sheet, statement of Retained Earnings, and the statement of cash flows  There are inherent limitations in the income statement and balance sheet as to reporting current values and economic events  Cash flows aftertax are essential information for business decision-making PPT 2-29