Tools for Business Decision-Making Fourth Canadian Edition Financial Accounting: Prepared by: Peggy Coady Memorial University of Newfoundland & Catherine Seguin University of Toronto

Financial Statements – Framework, Presentation and Usage Chapter 2

Conceptual Framework of Accounting Guides choices about –what to present in financial statements –decisions about alternative ways of reporting economic events –the selection of appropriate ways of communicating such information Chapter 2 3

Conceptual Framework of Accounting Four main sections –Objective of financial reporting –Qualitative characteristics of accounting information –Elements of financial statements –Recognition and measurement criteria Chapter 2 4

5 Objective of Financial Reporting To provide information that is useful to individuals who are making investment and credit decisions

Chapter 2 6 Qualitative Characteristics To be useful for decision- making, information should have these qualitative characteristics –Relevance –Faithful representation –Comparability –Understandability

Chapter 2 7 Relevance –Information is relevant if it makes a difference in a decision. It is said to have predictive value, feedback value, and timeliness Faithful representation –Information should reflect economic reality. It must be verifiable, neutral, and complete Qualitative Characteristics of Accounting Information

Chapter 2 8 Qualitative Characteristics of Accounting Information Comparability –Accounting information can be compared when companies with similar circumstances use the same accounting standards consistently from year to year Understandability –Average user is assumed to understand the accounting information

Chapter 2 9 Discussion Question Why is a conceptual framework of accounting important?

Elements of Financial Statements Assets Liabilities Equity Revenues Expenses Chapter 2 10

Recognition and Measurement Criteria Accountants need detailed criteria to help them decide when and where an item is included in the financial statements. Includes –Assumptions –Principles –Constraints Chapter 2 11

Assumptions Monetary unit Economic entity Time period Going concern Chapter 2 12

Monetary Unit Assumption Only those things that can be expressed in terms of money should be included in the accounting records Important presumption is that the monetary unit remains stable over time and the effects of inflation are nominal Chapter 2 13

Chapter 2 14 Economic Entity Every economic entity can be separately identified and accounted for Personal items relating to shareholders are not accounted for by the business

Chapter 2 15 Time Period Assumption The economic life of a business can be divided into artificial time periods

Going Concern Assumption The business will continue operating in the foreseeable future Justifies the use of the cost principle Chapter 2 16

Generally Accepted Accounting Principles Cost Full disclosure Revenue recognition (covered in Chapter 4) Matching (covered in Chapter 4) Chapter 2 17

Chapter 2 18 Cost Principle Assets should be recorded at cost at the time of acquisition

Chapter 2 19 Discussion Question Which assumption is an important underpinning of the cost principle?

Chapter 2 20 Full Disclosure Principle Circumstances and events that make a difference to financial statement users should be disclosed

Chapter 2 21 Constraints in Accounting Materiality –An item is material if it is likely to influence the decision of a user Cost-benefit –Ensures that the value of the information is greater than the cost of providing it

Chapter 2 22 Classified Balance Sheet A classified balance sheet generally contains the following standard classifications: Assets Liabilities - Current assets - Current liabilities - Long-term investments - Long-term liabilities - Property, plant, and equipment - Intangible assets Shareholders’ Equity - Share capital - Retained earnings

Chapter 2 23 Current Assets Assets expected to be converted to cash or used in the business within the year Listed in order of liquidity Examples include cash, short- term investments, accounts receivable, inventories and prepaid expenses

Chapter 2 24 Long-Term Investments Investments in the debt or equity securities of other corporations These assets are normally not intended to be sold within the next year

Chapter 2 25 Property, Plant, and Equipment Tangible assets with relatively long useful lives Assets used in operating the business Examples include land, building, machinery, delivery equipment, furniture and fixtures

Chapter 2 26 Intangible Assets Noncurrent assets that do not have physical substance and represent a privilege or a right Examples include goodwill, patents, copyrights, trademarks, trade names and licenses

Chapter 2 27 Depreciation Allocation of an asset’s full purchase price to match cost to revenues over the entire estimated useful life instead of expensing full cost in the year of purchase The cost of long-lived assets with indefinite lives (e.g., land) is not depreciated

Chapter 2 28 Depreciation Accumulated depreciation account shows the total amount of depreciation taken to date The difference between the cost of the asset and its accumulated depreciation is referred to as the carrying amount of the asset

Chapter 2 29 CSU CORPORATION Balance Sheet December 31, 2009 Assets Cash Accounts receivable Supplies Equipment Less: Accumulated depreciation Total assets $24,000 8,000 $ 2,000 4,000 1,800 16,000 $23,800

Chapter 2 30 Liabilities Current liabilities –Obligations that are supposed to be paid within the coming year –Examples include accounts payable, notes payable, interest payable, etc.

Chapter 2 31 Liabilities Long-term liabilities –Debts expected to be paid after one year –Examples include bonds payable, mortgage payable, notes payable, lease liabilities, etc.

Shareholder’s Equity Share capital –Investment of cash (or other assets) in the business by the shareholders in exchange for preferred or common shares Retained earnings –Earnings kept for use in the business Chapter 2 32

Chapter 2 33 Discussion Question What do you think would be the main asset, liability, and equity items for a Tim Hortons franchise?

Chapter 2 34 Financial Ratio Classifications Profitability ratios –Measure the earnings or operating success of a company for a given period of time

Profitability Ratios Earnings per share = Net Earnings Available to Common Shareholders Weighted Average Number of Common Shares Chapter 2 35 Price- earnings ratio = Market Price per Share Earnings per Share

Chapter 2 36 Financial Ratio Classifications Liquidity ratios –Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

Liquidity Ratios Working capital = Current assets – Current liabilities Chapter 2 37 Current ratio = Current Assets Current Liabilities

Financial Ratio Classifications Solvency ratios –Measure the ability of a company to survive over a long period of time Chapter 2 38

Solvency Ratios Chapter 2 39 Free cash flow = Net cash provided (used) by operating activities – Net capital expenditures - dividends Debt to total assets = Total Liabilities Total Assets

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