2. 3
Financial Statements
3.1 Describe international financial reporting standards (IFRS) and state their significance for Canadian firms.
3.2 Organize a firm’s transactions, and explain what are the most important accounting principles related to this task.
3.3 Prepare a firm’s financial statements.
3.4 Analyze a firm’s financial statements.
3.5 Describe the Canadian tax system and explain the differences between how a corporation and an individual are taxed.

3. 3.1 ACCOUNTING PRINCIPLES
Accounting is an organized way of summarizing the activities of business.
Internal and external users of accounting information rely on it to make decisions.
Financial managers require a strong understanding of accounting because they use that information to make significant decisions that will affect the firm.
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4. 3.1 ACCOUNTING PRINCIPLES
A new set of accounting guidelines, International Financial Reporting Standards (IFRS), have been the primary accounting standards used for publicly accountable enterprises in Canada since January 2011, replacing Canadian generally accepted accounting principles (GAAP).
Reporting of financial performance in a consistent manner over time and between firms enhances the usefulness of those reports, allowing comparative analysis.
Booth • Cleary – 3rd Edition
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5. 3.1 ACCOUNTING PRINCIPLES
Private companies may report under IFRS or they may choose to report under Accounting Standards for Private Enterprises (ASPE).
Most small and mid-sized private Canadian companies have chosen to report under ASPE as it is similar to the former Canadian GAAP.
Larger private companies have opted to adopt IFRS.
The United States has not adopted IFRS; it uses U.S. GAAP.
Since March 2005, Canadian securities laws permit a public company whose stock is listed on both Canadian and U.S. stock exchanges to prepare its financial statements under U.S. GAAP.
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6. 3.1 ACCOUNTING PRINCIPLES
Figure 3-1 Accounting Options Available to Various Forms of Organizations
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7. 3.1 ACCOUNTING PRINCIPLES
The Impact of Accounting Scandals
The Enron bankruptcy, in addition to other scandals involving WorldCom, Tyco. and others demonstrate the need for reform.
Since investors use accounting information to make investing decisions and value firms, recent accounting scandals where financial statements were misleading have caused investors to lose confidence in financial markets.
The U.S. Congress passed the Sarbanes-Oxley Act (SOX) in in an attempt to restore investor confidence by imposing new requirements for financial disclosure and oversight.
Booth • Cleary – 3rd Edition
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8. 3.1 ACCOUNTING PRINCIPLES © John Wiley & Sons Canada, Ltd.
Main Provisions of Sarbanes-Oxley (2002)
A new Public Company Accounting Oversight Board
Register and inspect public accounting firms
Establish audit standards
Separation of the audit function from other services provided by auditing firms
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9. 3.1 ACCOUNTING PRINCIPLES © John Wiley & Sons Canada, Ltd.
Main Provisions of Sarbanes-Oxley (2002) (continued)
Improved standards for corporate governance
Separate board committees for finance and audit
Require external auditors to report to the audit committee
Require audit committee independence and financial expertise, with membership dominated by external directors
New requirement that annual reports indicate the state of a firm’s internal controls and assess their effectiveness
The CEO and CFO must certify that the firms financial statements “fairly present in all material respects the operations and financial condition of the issuer”
Booth • Cleary – 3rd Edition
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10. 3.2 ORGANIZING A FIRM’S TRANSACTIONS
Bookkeeping is the mechanical act of managing and recording transactions
Accounting is the application of generally accepted accounting principles (GAAP) and conventions to bookkeeping data to produce financial statements that fairly represent the financial condition and operations of the economic entity
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11. 3.2 ORGANIZING A FIRM’S TRANSACTIONS
The most basic accounting principles are:
The Entity Concept – accounting is for a specific economic entity
The Going Concern Principle – the statements are prepared on the basis that the economic entity will continue to operate into the future; therefore, liquidation values are irrelevant
A Period of Analysis – usually a fiscal year, although quarterly and monthly financial statements are also produced
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12. 3.2 ORGANIZING A FIRM’S TRANSACTIONS
Basic accounting principles (continued)
A Monetary Value – historical costs are traditionally used because of the objectivity inherent in arms-length transactions
The Matching Principle – expenses incurred must be matched to the revenue earned in the period of analysis
Revenue Recognition – revenue is recognized when it has been earned, even though the cash may not yet have been received
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13. 3.2 ORGANIZING A FIRM’S TRANSACTIONS
General Themes of IFRS:
Financial information should have:
Relevance: information is relevant if it could potentially affect users’ decisions and has predictive and/or confirmatory power.
Faithful representation: the information provided should be complete, bias-free, and error-free.
To enhance relevance and faithful representation, information should have the following characteristics:
Comparability: consistent comparisons can be made across entities and across time.
Verifiability: information can be verified by an independent knowledgeable party.
Timeliness: information is presented in a timely manner.
Understandability: the information presented is clear and concise.
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14. © John Wiley & Sons Canada, Ltd.
3.3 PREPARING ACCOUNTING STATEMENTS: The Balance Sheet and Income Statement
The balance sheet is a financial snapshot at one point in time and is usually dated for the last day of the firm’s fiscal year
It shows what the firm owns (assets) and how those assets were financed (liabilities and owners’ equity)
Assets (debit accounts) are usually shown on the left side with liabilities and equity (credit accounts) on the right side
Items are listed vertically in order of liquidity (e.g., cash is the first asset, while fixed assets like machinery are the last)
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15. © John Wiley & Sons Canada, Ltd.
3.3 PREPARING ACCOUNTING STATEMENTS: The Balance Sheet and Income Statement
The income statement is also known as the profit and loss statement
Reports the income earned over a given period of time, usually a year, quarter or month.
Applies the matching principle by reporting expenses incurred in order to earn the revenue recognized in that period
Revenue is always reported on the top line, with expenses below
Expenses are often reported separately by type: variable/direct, indirect/fixed, interest, amortization, income taxes, etc.
Booth • Cleary – 3rd Edition
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16. 3.3 PREPARING ACCOUNTING STATEMENTS: Changing Accounting Assumptions
GAAP provides flexibility in the accounting treatment of economic events, such as:
When to recognize revenue
When to capitalize an expense (as an asset)
What rate to use for depreciation
Managers often face considerable pressure to make the firm’s financial performance appear as good as possible.
As a result of this pressure, management may change accounting policies within the limits allowed by GAAP to suit their needs and the current circumstances facing the firm.
Any change in the application of GAAP must be disclosed in the audited financial statements and could jeopardize the audit opinion offered by the external auditors if it is not in compliance with GAAP.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.

17. 3.3 PREPARING ACCOUNTING STATEMENTS: Preparing Tax Statements
In Canada, firms must report to Canada Revenue Agency (CRA) and remit income taxes in accordance with the Income Tax Act (ITA).
CRA requires businesses to use capital cost allowance (CCA) rates for asset depreciation which are specified in the ITA’s Regulations.
Firms in Canada tend to produce two sets of financial statements: one prepared for shareholders and another for CRA prepared according to tax rules.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.

18. 3.3 PREPARING ACCOUNTING STATEMENTS: Preparing Tax Statements
Because capital cost allowance (CCA) is an accelerated method of amortization and assets are often replaced more frequently than they are fully depreciated:
Actual income tax liabilities based on the ITA and CCA is usually less than what is “estimated” when reporting to shareholders under GAAP
This creates a difference in tax liability called deferred taxes which is capitalized on balance sheets when reporting to shareholders
Deferred taxes does not mean the firm has an unpaid tax liability
Booth • Cleary – 3rd Edition
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19. 3.3 PREPARING ACCOUNTING STATEMENTS: Cash Flow Statements
Accounting profit may not reflect the firm’s actual cash flow
The cash flow statement helps to provide a clearer picture of sources and uses of cash
Analysts are very interested in cash flow because it indicates a firm’s solvency
Booth • Cleary – 3rd Edition
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20. 3.3 PREPARING ACCOUNTING STATEMENTS: Cash Flow Statements
Two methods to prepare a cash flow statement:
Examine the changes in the balance sheet accounts and reconcile them through the cash account
Add non-cash items to net income
SOURCES OF CASH
USES OF CASH
Asset Decreases
Asset Increases
Liability Increases
Liability Decreases
Common Stock Increases
Retained Earnings Increases
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21. 3.3 PREPARING ACCOUNTING STATEMENTS: Cash Flow Statements
Booth • Cleary – 3rd Edition
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22. 3.4 TIM HORTONS’ ACCOUNTING STATEMENTS
Figure 3-4 Tim Hortons Inc. Consolidated Balance Sheet
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23. 3.4 TIM HORTONS’ ACCOUNTING STATEMENTS
Figure 3-5 Tim Hortons Inc. Income Statement
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24. 3.4 TIM HORTONS’ ACCOUNTING STATEMENTS
Figure 3-6 Tim Hortons Inc. Consolidated Statement of Cash Flows
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25. 3.5 THE CANADIAN TAX SYSTEM
Federal and provincial governments in Canada tax individuals and corporations based on income earned
Corporations pay income taxes and then use after-tax income to distribute dividends to shareholders
Dividends received by shareholders are taxed again as one form of personal investment income
In recognition of this double-taxation of dividends, dividends from Canadian corporations are given some partial relief through the “dividend gross-up tax credit”
Dividends received from non-Canadian companies do not qualify for this special tax treatment
Booth • Cleary – 3rd Edition
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26. 3.5 THE CANADIAN TAX SYSTEM Corporate Taxes
Corporate tax is paid at a flat or fixed rate on taxable income
Small businesses are defined as those which earn income of $300,000 or less, and usually pay a lower rate of tax (depending on the province)
Companies are free to choose their own taxation (fiscal) year but, once established, cannot alter it without justification and approval
Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income
Booth • Cleary – 3rd Edition
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27. 3.5 THE CANADIAN TAX SYSTEM Corporate Taxes
The income statement shows that variable costs and period overhead costs can be subtracted to determine earnings before interest and taxes (EBIT)
For tax purposes the Income Tax Act requires that the capital cost allowance system be used instead of accounting amortization
Interest expenses on debt borrowed to earn income is generally deductible from taxable income
Booth • Cleary – 3rd Edition
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28. 3.5 THE CANADIAN TAX SYSTEM Corporate Taxes
Capital cost allowance (CCA) is the method of depreciation or amortization used by taxpayers in Canada when reporting business income to CRA for tax purposes
Since CCA affects a firm’s net income and its net cash flow, taxation issues must be addressed in each financial decision a firm makes and decision makers need to understand CCA
CCA gives rise to a tax-shield benefit
Booth • Cleary – 3rd Edition
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29. 3.5 THE CANADIAN TAX SYSTEM Corporate Taxes
CCA is a non-cash deduction from income that would otherwise be subject to income tax. Taxable income is reduced as a result of the deduction and the result is a savings in tax payable
Tax shield benefit = corporate tax rate × dollar amount of claimed CCA
Example: A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes
Because of the half-year rule, only one-half of the CCA rate can be applied to net acquisitions to an asset class in the year the assets are acquired; so the first year’s CCA is less than the second year’s CCA
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30. 3.5 THE CANADIAN TAX SYSTEM
CCA versus Accounting Depreciation
Accounting Depreciation
Firms choose the method that best represents the economic wastage of the asset
Assets are depreciated individually, not in a group
Estimates of useful life and salvage value are necessary
Capital Cost Allowance
Similar assets are grouped into pools or classes
Each asset class’s CCA rate is specified in the Regulations to the ITA and approximates the economic wastage of the asset
No estimate of useful life or salvage value is necessary
As long as the firm remains a going concern and assets remain in the pool, residual undepreciated capital cost (UCC) values remain in the pool
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31. 3.5 THE CANADIAN TAX SYSTEM
CCA, Capital Gains, Recapture And Terminal Loss
CCA is like a declining balance method and changes each year
The largest benefit occurs in the early years of an asset’s life
Residual values always remain in the pool, even after the asset is disposed
Booth • Cleary – 3rd Edition
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32. 3.5 THE CANADIAN TAX SYSTEM
CCA, Capital Gains, Recapture And Terminal Loss
A taxable capital gain would occur if the firm sold a depreciable asset for greater than its original cost
Capital Gain = Original Cost Base – Salvage Value
Recapture of Depreciation: if the salvage value of the asset exceeds the undepreciated capital cost (UCC) of the asset pool, there is a recapture of depreciation which is subject to tax
An asset pool is closed when the last physical asset in the pool is sold and not replaced
Terminal Loss: if there is a positive UCC balance remaining in the pool when it closes, that balance is called a terminal loss and is deductible from taxable income in the year the last asset is disposed; terminal losses are non-cash deductions just like CCA
Booth • Cleary – 3rd Edition
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33. 3.5 THE CANADIAN TAX SYSTEM Personal Tax
Canadians are taxed on their worldwide income
The taxation year is the calendar year: January 1st to December 31st
The personal tax system is progressive in most provinces, where tax rates increase as the amount of a person’s income increases
Investment income can be earned by investors in one of three different forms, each of which is taxed differently: interest, dividends, capital gains
Booth • Cleary – 3rd Edition
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34. 3.5 THE CANADIAN TAX SYSTEM Personal Tax—Interest
Interest income is taxed at the person’s marginal personal tax rate, which is the same rate at which employment and business income is taxed
Marginal personal tax rates depend on the amount of income earned in a progressive tax system
All sources of interest must be claimed in each calendar year, both cash interest payments received and interest that has accrued but not yet been paid (e.g., Canada Savings Bonds that have not yet been redeemed)
The marginal tax rates on interest income are usually (depending on a person’s circumstances) higher than those on dividends and capital gains
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35. 3.5 THE CANADIAN TAX SYSTEM Personal Tax—Dividends
Dividends from Canadian companies receive a special tax treatment called the “gross-up tax credit”
Cash dividends from eligible corporations are grossed up by 45% and this total amount is included in taxable income
Federal and provincial tax credits, which vary from province to province, are deducted from the grossed up amount
Federal tax credit: %
Provincial tax credits vary from a low 14.55% in Alberta to a high of 29.69% in Quebec
The tax credits reduce the marginal tax rate applied to dividend income
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36. 3.5 THE CANADIAN TAX SYSTEM Personal Tax—Capital Gains
Only realized capital gains are taxed which means that unrealized capital gains do not trigger tax until investments are sold. Investors can therefore defer capital gains taxes until funds are required.
Only one-half (50%) of a realized capital gain is subject to tax at the person’s marginal tax rate
Capital losses can be used to offset taxable capital gains
At higher marginal tax rates, investors prefer to receive investment income in the form of capital gains and dividends because these are often taxed at a lower marginal rate than interest income
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Booth • Cleary – 3rd Edition
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