1. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

2. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.2 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 income statement, the statement of retained earnings and the balance sheet. 4. Explain the meaning of analysis in financial management. 5. Discuss the importance of decision-making making in financial management. 6. Explain the contents and structure of the financial statements prepared for not-for-profit organizations. Chapter Reference Chapter 2: Accounting and Financial Statements

3. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.3 Financial Management Includes Bookkeeping Accounting Analysis Decision-Making

4. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.4 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 liability, equity and revenue accounts have credit balances. Debit Balance Sheet Accounts Credit Assets Transfer (net income / profit) is made at the end of the accounting period Liabilities Equity Debit Income Statement Accounts Credit Expenses Revenue

5. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.5 The Accounting Equation Balance Sheet Statement of retained earnings Income Statement Credit Decreases Increases Increases Increases Decreases Debit Increases Decreases Decreases Decreases Increases A = L + E R-ER-E Ends with the Trial Balance Debits = Credits Earnings Net income

6. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.6 The Accounting Cycle Business Business Activity is Entry is recorded in transferred to Transaction Document takes place is prepared 1. Cash account 3. House 2. VISA 4. Car Balance Sheet 1. Salary 3. Rent 2. Food 4. Clothing Income Statement Journals Ledgers

7. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.7 The Trial Balance (Wiley Inc. Dec. 31, 2006) Debit Credit Cash$25,000 Sales revenue$500,000 Prepaid expenses 20,000 Interest on debt 10,000 Cost of sales300,000 Bank loan 50,000 Retained earnings (beginning of year)135,000 Accounts receivable 100,000 Accrued expenses 15,000 Selling expenses 50,000 Income taxes 25,000 Current income taxes payable 2,000 Future income taxes payable (Deferred taxes) 3,000 Mortgage200,000 Inventories200,000 Accounts payable 100,000 Current portion of long-term debt 20,000 Administrative expenses 50,000 Capital assets (at cost)500,000 Amortization 25,000 Accumulated amortization100,000 Dividends 20,000 Capital Stock200,000 BS IS BS SRE BS SRE IS BS $ 1,325,000 Total

8. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.8 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 An employee works for a week without being paid for $800 Dec. 31Jan.7 So, the company owes $800 (liability) to the employee when the books are closed

9. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.9 Prepaid Expenses Payments made on accounts for which services have not yet been provided (i.e., rent, insurance, office supplies, property taxes). June 30 Pay $4,000 for insurance this year and show $2,000 as an expense, December 31June 30 But, will also show in the closing balance sheet an amount of $2,000 (asset) as a prepaid expense.

10. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.10 2. Financial Statements To determine the value or wealth of a business, look at the BALANCE SHEET (also known as the statement of financial position) 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 INCOME STATEMENT (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 RETAINED EARNINGS since it shows the amount paid to the shareholders and the amount retained in the business.

11. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.11 Financial Statements - Structure and Contents Sales revenue Cost of sales Gross profit Operating expenses Net income Retained earnings (beginning) Earnings for the year Less: dividends Retained earnings (ending) Assets Current Capital Liabilities Current Long-term Equity Sources of funds (Where they come from) Uses of funds (Where they went) Income Statement Statement of Retained Earnings Balance Sheet Cash Flow Statement $100,000 $230,000 $25,000 $100,000 $25,000 $150,000 Inc. C.L. L.T.D. $ 20,000 $ 80,000 $20,000 $230,000 $25,000 Div. C.A. C.A. $100,000 $80,000 $150,000 $25,000

12. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.12 Income Statement (Operating Performance) Sales revenue Cost of sales Gross profit Operating expenses Selling expenses Administrative expenses Total operating expenses Operating income (EBIT) Interest income (charges) Income before taxes Income taxes Net income 1 2 3 Operating section Non- operating section Owner’s section

13. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.13 Wiley’s Financial Statements Wiley Inc. Income Statement for the Period Ending December 31, 2006 Sales revenue$ 500,000 Cost of sales 300,000 200,000 Selling expenses$ 50,000 Administrative expenses 50,000 25,000 Total expenses 125,000 75,000 Interest on debt 10,000 Income before taxes 65,000 Income taxes 25,000 $ 40,000 Wiley Inc. Statement of Retained Earnings as at December 31, 2006 Retained earnings (beginning of year)$ 135,000 Earnings for the current year$ 40,000 Dividends 20,000 20,000 Retained earnings (end of year)$ 155,000 1 Gross profit Amortization Cash flow $ 25,000 $ 65,000 $ 40,000 2 Operating income (E B I T) 3 Net income EBITDA $75,000 25,000 $100,000

14. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.14 Balance Sheet (Financial Structure) Current AssetsCurrent Liabilities Capital Assets Long-Term Debts Equity Working capital Capital budgeting Financial leverage Cost of financing Cost of capital

15. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.15 Wiley’s Financial Statements 1 2 3 4 5 Wiley’s Inc. Balance Sheet as at December 31, 2006 Current assets Cash$25,000 Accounts receivable 100,000 Inventories200,000 Prepaid expenses 20,000 Total current assets$345,000 Capital assets (at cost)500,000 100,000 400,000 Total assets$745,000 Current liabilities Bank loan 50,000 Accounts payable 100,000 Accrued expenses 15,000 Current income taxes payable 2,000 Current portion of long-term debt 20,000 Total current liabilities$187,000 Mortgage200,000 Future income taxes payable 3,000 Total long-term debts$203,000 Capital stock200,000 155,000 Shareholders’ equity 355,000 Total liabilities and shareholders’ equity$745,000 Accumulated amortization Retained earnings

16. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.16 Taxation, Amortization, and Capital Cost Allowance 1.Corporate tax rate (varies from province to province) 2.Taxation for small businesses (if taxable income is less than they benefit from a small business deduction) 3.Business expenses and deductions Operating expenses (i.e., cost of sales, operating expenses) Financing charges (interest on debt) Business losses (carried over in future years) Capital cost allowance (Canada Revenue Agency) $200,000 25% Amortization

17. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.17 Amortization Amortization (capital assets) A $100,000 asset with a 5-year life span. Revenue$ 200,000 Expenses Amortization Other expenses 160,000 Total expenses 180,000 Income before taxes 20,000 Income taxes 10,000 Net income 10,000 Goodwill Patents Franchise Trademarks Legal and architectural fees Research and development Amortization (intangible assets) These costs can also be capitalized and amortized over a period of time (years) just like amortization for capital assets. It is an accounting entry. It represents the loss in value of an asset 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 amortization” (accumulated). Add back amortization 20,000 Cash flow $ 30,000 20,000

18. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.18 CCA and Amortization 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 CCA @ 50% Amortization Declining * Income tax regulations allow only half of the CCA rate during the first year. Straight line

19. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.19 Income Statement and P&L Statement Year 1 *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). Accountant’s worksheet $300,000 150,000 50,000 75,000 40,000 $35,000 Sales revenue Cost of sales Gross profit Operating expenses CCA/Amortization Total expenses Income before taxes Taxes - Current (50%) Future Income/Profit after taxes $300,000 150,000 50,000 70,000 80,000 40,000 $40,000 25,000 37,500 2,500 20,000 40,000 $300,000 150,000 50,000 70,000 80,000 40,000 $40,000 Income statement P & L statement 20,000 37,500 2,500

20. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.20 Future Income Taxes Payable (Deferred Taxes) 1$25,000$ 20,000$ 5,000$ 2,500 $ 2,500 2$37,500$ 20,000$17,500 $ 8,750 $ 11,250 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 ----- Years CCA @ 50% Amortization @ 20% Difference between CCA & amortization Difference in annual future income taxes @ 50% Difference in cumulative future income taxes

21. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.21 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.

22. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.22 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.

23. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.23 4. Financial Analysis Horizontal analysis Vertical analysis Statement of sources and uses of funds Ratio analysis Break-even analysis Leverage analysis Risk analysis

24. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.24 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

25. © 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.25 6. Not-For-Profit Organizations Statement of financial position Assets minus liabilities equals net assets. Statement of operations Revenues Less expenses Equals excess of revenues over expenses.