Financial Statements and Decision Making: Cornerstones of Financial Accounting, Second Canadian Edition

Chapter 1:
Financial Statements and

Decision Making
Cornerstones of Financial Accounting,
Second Canadian Edition
Copyright © 2017 by Nelson Education Ltd. 1-1
Learning Objectives
1. Identify who the different users of financial statements are
and how they use financial statements.
2. Identify different forms of business organization and
business activities.
3. Understand the periods of time covered by the basic four
financial statements and the underlying basic accounting
equation.
4. Understand how a statement of financial position is
prepared and used by different decision makers.
5. Understand how a statement of earnings is prepared and
used by different decision makers.
6. Understand how a statement of changes in equity is
prepared and used by different decision makers.
Learning Objectives
(Continued)
7. Identify the components of a statement of cash flows and
understand how it is used by different decision makers.
8. Describe the relationships among the four basic financial
statements and how management uses financial statements.
9. Describe information contained in the annual report.
10. Understand the role of International Accounting Standards in
determining the content of financial statements.
11. Understand the importance of ethics and legal liability in
accounting.

What Is Accounting and
1
Who Uses Accounting
Information?
► Accounting is the process of identifying, measuring,
recording, and communicating financial information about a
company's business activities so that decision makers can
make informed decisions.
► Accounting information is useful because it helps people
answer questions and make better decisions.

The Demand for Accounting
1
Information and Typical
Questions

2 Businesses:
Forms and Activities

2 Sole Proprietorship
► A sole proprietorship is an unincorporated business owned by
one person.
► Sole proprietorships are usually small, local businesses such as
restaurants, photography studios, retail stores, website
providers, and professionals.
► This organizational form is popular because it is simple to set
up and gives the owner (proprietor) control over the business.
► While a sole proprietorship is an accounting entity separate
from its owner, the owner is personally responsible for the
debt of the business.
► Sole proprietorships can be formed or dissolved at the wishes
of the owner.

2 Partnership
► A partnership is a business owned jointly by two or more
individuals or corporations.
► Small businesses and many professional practices of physicians,
lawyers, and accountants are often organized as partnerships.
► Relative to sole proprietorships, partnerships provide increased
access to financial resources as well as access to the individual skills
of each of the partners.
► Similar to sole proprietorships, partnerships are accounting entities
separate from the partners; however, the partners are jointly
responsible for all the debt of the partnership.
► A partnership is automatically dissolved when any partner leaves
the partnership; of course, the remaining partners may form a new
partnership and continue to operate.

2 Corporation
► A corporation is a business organized under the laws of a particular
province.
► A corporation is owned by one or more persons called shareholders,
whose ownership interests are represented by shares of stock.
► A primary advantage of the corporate form is the ability to raise large
amounts of money (capital) by issuing shares of stock.
► Unlike a sole proprietorship or a partnership, a corporation is an “artificial
person” and the shareholders' legal responsibility for the debt of the
business is limited to the amount they invested in the business.
► Shares of stock of a public company listed on a stock exchange can be
easily transferred without affecting the corporation.
► The ability of publicly listed corporations to raise capital by selling new
shares, the limited legal liability of owners, and the transferability of the
shares give the corporation an advantage over other business forms.

2 Corporation
(Continued)
► One of the disadvantages of this organizational form is that
the requirements to start a corporation are more complex
than for the other forms of business organizations.
► In addition, corporations may pay more taxes than owners of
sole proprietorships or partnerships for two reasons:
► The corporate income tax rate may be greater than the individual
income tax rate.
► A corporation's income is taxed twice—at the corporate level as
income is earned, and at the individual level as earnings are
distributed to shareholders. This is known as double taxation.

2 Business Activities

2 Financing Activities
► A company's financing activities include obtaining the funds
necessary to begin and operate a business.
► These funds come from either issuing shares (equity) or
borrowing money (debt).
► Most companies use both types of financing to obtain funds.
►The person to whom the corporation owes money is
called a creditor.
►This obligation to repay a creditor is termed a liability.
►Claims of the shareholders are called shareholders'
equity.
Copyright © 2017 by Nelson Education Ltd.

1-12
2 Investing Activities
► Once a corporation has obtained funds through its financing

activities, it buys assets that enable it to operate.
► The purchase (and sale) of the assets that are used in
operations (commonly referred to as property, plant, and
equipment) are a corporation's investing activities.

2 Operating Activities
► Once a corporation has acquired the assets that it needs, it

can begin to operate.
► While different businesses have different purposes, they all
want to generate revenue.
► Revenue is the increase in assets that results from the sale of
products or services.
► To earn revenue, a corporation will incur various costs or
expenses.
► Expenses are the cost of assets used, or liabilities created, in
the operation of the business.

2 Operating Activities
(Continued)
► The results of a company's operating activities can be

determined by comparing revenues to expenses.
► If revenues are greater than expenses, a corporation has
earned net income.
► If expenses are greater than revenues, a corporation has
incurred a net loss.

2 You Decide
Choice of Organizational Form

3 Communication of
Accounting Information
► To effectively communicate a company's activities to decision makers,
detailed transactions are summarized and reported in a set of
standardized reports called financial statements.

3 Financial Statements
► Companies prepare four basic financial statements:
► The statement of financial position reports the resources (assets)
owned by a company and the claims against those resources
(liabilities and shareholders' equity) at a specific point in time.
► The statement of comprehensive income reports how well a
company has performed its operations (revenues, expenses, and
income) over a period of time.
► The statement of changes in equity reports how much of the
company's net earnings was retained in the business, dividend
distributions to owners, the dollar amount of shares issued and
repurchased, and other changes in equity over a period of time.
► The statement of cash flows reports the sources and uses of a
company's cash over a period of time.

Timing of Financial
3
Statements

The Basic Accounting
3
Equation
The right side of the accounting
The left side of the equation indicates who has a claim
accounting equation shows on the company's assets.
the assets, or economic
resources, of a company. Creditor claims Owner claims in the form
are liabilities. of shareholders' equity.
► The basic accounting equation captures two basic features of

any company.
► The implication of the basic accounting equation is that what
a company owns (its assets) must always be equal to what it
owes (its liabilities and shareholders' equity).
Cornerstone 1-1
3 Using the Basic
Accounting Equation

Cornerstone 1-1
3 Using the Basic
Accounting Equation
(Continued)

The Classified Statement of
4
Financial Position
► The purpose of the statement of financial position is to report the financial
position of a company (its assets, liabilities, and shareholders' equity) at a specific
point in time.
► The relationship between the elements of the statement of financial position is
given by the basic accounting equation.
► The statement of financial position is organized, or classified, to help users identify
the basic economic similarities and differences between the various items within
the statement of financial position.

The
4 Operating Cycle’s Role
in Classification
► The basic classification of a company's assets is between
current and noncurrent items.
► In a typical company, it is reasonable to designate one year
as the dividing line between current and noncurrent items.
► However, if the operating cycle of a company is longer than
one year, it may be necessary to extend this dividing line
beyond one year so that it corresponds to the length of the
operating cycle.
► The operating cycle of a company is the average time that it
takes a company to purchase goods, resell the goods, and
collect the cash from customers.

4 Current Assets
► Current assets consist of cash and other assets that are
reasonably expected to be converted into cash within one
year or one operating cycle, whichever is longer.
► Current assets are listed on the statement of financial
position in order of liquidity or nearness to cash.
► Common types of current assets are:
► Cash
► Short-term investments or marketable securities—investments in the
debt and shares of other companies as well as government securities
► Accounts receivable—the right to collect an amount due from
customers
► Inventories—goods or product held for resale to customers
► Other current assets—a ‘‘catch-all’’ category that includes items such
as prepaid expenses and supplies

4 Noncurrent Assets
► Assets that are not classified as current are classified as long-
term or noncurrent assets.
► These include long-term investments; property, plant, and
equipment; intangible assets; and other noncurrent assets.
►Long-term investments are similar to short-term
investments except for the duration of holding; they can
include land and buildings not currently used in operations.
►Property, plant, and equipment includes tangible
productive assets used in operations, like land, buildings,
equipment, and furniture.
►Intangible assets lack physical substance and include
patent, trademarks, copyrights, and goodwill.

4 Current Liabilities
► Current liabilities consist of obligations that will be satisfied,
through the payment of cash or by providing goods or services,
within one year or the operating cycle, whichever is longer.
► Current liabilities are typically listed in the order in which they
will be paid and include:
► Accounts payable—an obligation to repay a vendor or supplier for
merchandise supplied to the company
► Salaries payable—an obligation to pay an employee for services
performed
► Unearned revenue—an obligation to deliver goods or perform a
service for which a company has already been paid
► Interest payable—an obligation to pay interest on money that a
company has borrowed
► Income taxes payable—an obligation to pay taxes on income

Long-Term Liabilities and
4
Shareholders' Equity
► Long-term liabilities are the obligations of the company that will require
payment beyond one year or the operating cycle, whichever is longer.
► Common examples are:
► Loans or notes payable—an obligation to repay cash borrowed at a
future date
► Bonds payable—a form of an interest-bearing note payable issued by
corporations in an effort to attract a large amount of investors
► Shareholders' equity is the last major classification on a company's
statement of financial position.
► Shareholders' equity arises primarily from two sources:
► Contributed capital—the owners' contributions of cash and other assets
to the company (includes the common and preferred share of a
company)
► Retained earnings—the accumulated net income of a company that has
not been distributed to owners in the form of dividends

4 Preparing a Classified
Statement
of Financial
► The preparation Position
of a classified statement of financial
position involves five steps:
► Step 1. Prepare a heading that includes the name of the company,
the title of the financial statement, the date of the statement, and
the unit of measure.
► Step 2. List the assets of the company in decreasing order of their
liquidity or nearness to cash. Use appropriate classifications. Add the
assets and double-underline the total.
► Step 3. List the liabilities of the company in increasing order of their
time to maturity. Use appropriate classifications.
► Step 4. List the shareholders' equity balances with appropriate
classifications.
► Step 5. Add the liabilities and shareholders' equity and double-
underline the total.
Cornerstone 1-2
4
Preparing a Classified
Statement
of Financial Position

Cornerstone 1-2
4
Preparing a Classified
Statement
of Financial Position (Continued)

Cornerstone 1-2
4 Preparing a Classified
Statement
of Financial Position (Continued)

Using Statement of
4 Financial Position
Information
► The statement of financial position conveys important
information about the structure of assets, liabilities, and
shareholders' equity, which is used to judge a company's
financial health.
► For example, the relationship between current assets and
current liabilities gives investors and creditors insights into a
company's liquidity—that is, the ability to pay obligations as
they become due.
► Two useful measures of liquidity are working capital and the
current ratio.
► Working capital and the current ratio for a company are helpful
when they are compared to other companies in the same
industry.
4 Working Capital
► Working capital is a measure of liquidity, computed as:
Working capital = Current assets – Current liabilities
► Working capital signals that a company has adequate funds

with which to pay its current obligations and is expressed in
dollar amounts.

4 Current Ratio
► The current ratio is an alternative measure of liquidity that
allows comparisons to be made between different companies
and is computed as:
Current ratio = Current assets ÷ Current liabilities

4 You Decide
Assessing the Creditworthiness
of a Prospective Customer

5 Statement of
Comprehensive Income
► The statement of comprehensive income under IFRS is a
two-part statement that reports the changes that have
occurred in shareholders' equity over a period of time from
all business activities other than investments by
shareholders and distributions to shareholders.
► The first part of this statement reports the excess of
revenues over expenses during an accounting period; this
excess is referred to as “profit” or “net earnings.”
► The second part of this statement reports comprehensive
income, which consists of income and expense components
that are not recorded in the statement of earnings under
IFRS.
5 Statement of Earnings
► The statement of earnings reports the results of a company's
operations—the sale of goods and services and the
associated expenses of operating the company—for a given
period.
► The long-term survival of a company depends on its ability to
produce net earnings, or net income, by earning revenues in
excess of expenses.
► The past net earnings or net income reported on a
company's statement of earnings provides investors with
information about a company's ability to earn future income.

5 Elements of the
Statement of Earnings
► The statement of earnings consists of two major elements:
revenues and expenses.
► Revenues are the increase in assets that results from the
sale of products or services.
► They include:
► Sales revenue from products or services
► Interest revenue from investments
► Expenses are the cost of resources used to earn revenues
during a period. They include:
► Cost of goods sold or cost of sales—the cost to the seller of all goods
sold
► Selling and general administrative expenses—expenses to manage
the company that are not direct product or service costs
► Research and development expense—the cost of developing new
products
Preparing a
5
►The preparation of a statement of earnings involves
four steps:
► Step 1. Prepare a heading that includes the name of the company,
the title of the financial statement, the time period covered, and
the unit of measure.
► Step 2. List the revenues of the company, starting with sales
revenue (or service revenue), and then listing other revenue
items. Add the revenues to obtain total revenue.
► Step 3. List the expenses of the company, usually starting with
cost of goods sold. Add the expenses to get total expenses.
► Step 4. Subtract the expenses from the revenues to get net
income (or net loss if expenses exceed revenues). Double-
underline net income.

5 Cornerstone 1-3
Preparing a Statement of
Earnings

Cornerstone 1-3
5
Earnings (Continued)

5
Formats
► Companies prepare their statement of earnings in one of two
different formats: single-step or multiple-step.
►In a single-step statement of earnings, there are only two
categories: total revenues and total expenses.
►The multiple-step statement of earnings provides
classifications of revenues and expenses that financial
statement users find useful, with three important subtotals:
►Gross margin (gross profit) = Net sales – Cost of goods sold
►Income from operations = Gross margin – Operating expenses
►Net income = Income from operations – (Nonoperating revenues –
Nonoperating expenses)

5
Formats
(Continued)

Using Statement of
5
Earnings
Information
► A company's ability to generate current income is useful in
predicting its ability to generate future income.
► When investors believe that future income will improve, they
will buy shares.
► Investors' and creditors' estimates of the future profitability
and growth of a company are aided by a careful examination of
how a company has earned its revenue and managed its
expenses.
► A useful measure of a company's ability to generate profit is
the net profit margin (sometimes called return on sales). Net
profit margin shows the percentage of profit in each dollar of
sales computed as:
Net profit margin = Net income ÷ Sales revenue
5 You Decide
Assessing Future Profitability

Statement of Changes in
6
Equity
► Public companies prepare a statement of changes in equity,
which reports how profit, dividends, share capital increases
(decreases), and other changes in shareholders' equity have
affected the company's statement of financial position.
► Private companies prepare a statement of retained earnings,
which presents only the changes in the retained earnings
account during the period.

Statement of Retained
6
Earnings
► The owners of a company contribute capital in one of two
ways:
► Directly, though purchases of common shares from the company, and
► Indirectly, by the company retaining some or all of the net income
earned each year rather than paying it out in dividends.
► Net income earned by the company but not paid out in the
form of dividends is called retained earnings.
► The statement of retained earnings summarizes and explains
the changes in retained earnings during the accounting
period.

6
Changes in Equity
► The preparation of the statement of changes in equity involves four
steps:
► Step 1. Prepare a heading that includes the name of the company, the title
of the financial statement, the time period covered, and the unit of
measure.
► Step 2. List the balances for each equity component at the beginning of
the period obtained from the previous year's statement of financial
position.
► Step 3. Add net income obtained from the statement of earnings and
other comprehensive income from the statement of comprehensive
income.
► Step 4. Subtract any dividends declared during the period and add
(deduct) any other items affecting the equity components of the business.
Double-underline the totals, which should equal the balances of each
equity component at the end of the period as reported on the statement
of financial position.
Cornerstone 1-4
6
Retained Earnings

Cornerstone 1-4
6
Retained Earnings (Continued)

6 Use of the Statement of
Retained Earnings
► The statement of retained earnings is used to monitor and
evaluate a company's dividend payouts to its shareholders.
► For example, some older investors seek out companies with high
dividend payouts so that they will receive cash during the year.
► Other investors are more interested in companies that are
reinvesting a sufficient amount of earnings that will enable them
to pursue profitable growth opportunities.
► Also, creditors are interested in a company's dividend payouts.
► If a company pays out too much in dividends, the company may
not have enough cash on hand to repay its debt when it becomes
due.

6 You Decide
Dividend Policy Decisions

7
Statement of Cash Flows
and Its Elements
► The fourth major financial statements, the statement of cash flows,
describes the company's cash receipts (cash inflows) and cash
payments (cash outflows) for a period of time.
► Cash flows are classified into one of three categories:
► Cash flows from operating activities—any cash flows directly related
to earning income. This category includes cash sales and collections of
accounts receivable as well as cash payments for goods, services,
salaries, and interest.
► Cash flows from investing activities—any cash flow related to the
acquisition or sale of investments and long-term assets such as
property, plant, and equipment.
► Cash flows from financing activities—any cash flow related to
obtaining capital of the company. This category includes the issuance
and repayment of debt, common share transactions, and the payment
of dividends.
7 Use of the
Statement of Cash Flows
► Because cash is the lifeblood of any company and is critical to success,
the statement of cash flows can be an important source of
information as users attempt to answer how a company generated
and used cash during a period.
► Such information is helpful as users assess the company's ability to
generate cash in the future.
► Creditors can use the statement of cash flows to assess the
creditworthiness of a company.
► A company with healthy cash flow—particularly if it comes from
operating activities—is in a good position to repay debts as they come
due and is usually a low-risk borrower.
► Shareholders are also interested in the adequacy of cash flows as an
indicator of the company's ability to pay dividends and to expand its
business.
8 Relationships among the
Four Financial Statements

9 Components of the
Annual Report
► The four financial statement are reported to users in an annual
report.
► The notes to the financial statements (or footnotes) clarify and
expand upon the information presented in the financial
statements.
► The information contained in the notes can be either quantitative
(numerical) or qualitative (nonnumerical).
► Management's Discussion and Analysis, also presented in the
annual report, is management's explanation used to highlight
favourable and unfavourable trends and significant risks facing
the company.
► The auditor's opinion of the financial statements is presented in
the form of an audit report.
9 You Decide
The Business Need for
Accountants and Career Choices

10 International Financial
Reporting Standards
► In order to make it easier to use financial statements over time and
across companies, common rules and conventions have been developed
to guide the preparation of financial statements.
► These rules and conventions, called generally accepted accounting
principles (GAAP), were developed by several different organizations
over a number of years.
► In Canada, the provincial securities commissions work closely with the
Accounting Standards Board (AcSB) of the Canadian Institute of
Chartered Accountants (CICA) now part of CPA Canada.
► The AcSB in Canada establishes accounting principles for publicly
accountable enterprises, private enterprises, government entities, and
not-for-profit organizations.
► The use of international financial reporting standards (IFRS) in Canada is
now mandatory for all publicly accountable enterprises.
11 Guidelines in
Ethical Decision Making

11 Ethics and Legal
Liabilities in Accounting
► Confidence that standards of ethical behaviour will be
maintained—even when individuals have incentives to violate
those standards—is essential to the conduct of any business
activity.
► Owners of businesses must trust their managers, managers
must trust each other and their employees, and the investing
public must trust accountants to behave according to
accepted ethical standards, which may or may not be
reflected in formal written codes.
► The violation of ethical standards may bring clear and direct
penalties but more often brings subtle and long-
lasting negative consequences for individuals and companies.

11 Significant Differences
between IFRS and ASPE
► Public corporations whose securities trade on a stock exchange must use
IFRS. Private corporations can choose to follow IFRS or ASPE, but the choice,
once made, must be applied consistently each year.
► Under IFRS, the statement of financial position title is used by most. Under
ASPE, most private companies, and some public companies, use the title of
“balance sheet” to refer to this same financial statement.
► IRFS requires that a statement of changes in equity be prepared detailing
the changes in each component of shareholders' equity for the period.
ASPE requires that a statement of retained earnings be prepared detailing
only the changes in the retained earnings account for the period.
► Public companies prepare a statement of comprehensive income. Private
companies prepare a statement of earnings, which includes all revenues,
expenses, gains, and losses for the period. Comprehensive income or loss is
not reported by private companies.

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Chapter 1:

Financial Statements and

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► Once a corporation has obtained funds through its financing

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► Once a corporation has acquired the assets that it needs, it

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► The results of a company's operating activities can be

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► The basic accounting equation captures two basic features of

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Working capital = Current assets – Current liabilities

► Working capital signals that a company has adequate funds

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Current ratio = Current assets ÷ Current liabilities

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