Finance for Non-Financial Managers, 6th edition PowerPoint Slides to accompany Prepared by Pierre Bergeron, University of Ottawa Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 1

Finance for Non-Financial Managers, 6th edition CHAPTER 2 ACCOUNTING AND FINANCIAL STATEMENTS Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 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 statement of income, the statement of changes in equity and the statement of financial position. 4. Explain the meaning of analysis in financial management. 5. Discuss the importance of decision-making in financial management. 6. Draw a comparison between the GAAP and IFRS financial statements’ presentation format. 7. Explain the contents and structure of financial statements prepared for not-for-profit organizations. Chapter Reference Chapter 2: Accounting and Financial Statements Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 3

Financial Management Includes Bookkeeping Accounting Analysis Financial Statements Decision-Making Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 4

Copyright © 2011 Nelson Education Limited 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 equity, liability and revenue accounts have credit balances. Debit Credit Statement of Financial Position Accounts Assets Equity Liabilities Debit Credit Statement of Income Accounts Expenses Revenue Transfer (profit for the year) is made at the end of the accounting period Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 5

The Accounting Equation Statement of Financial Position Statement of Income A = E + L R - E Debit Increases Decreases Decreases Decreases Increases Credit Decreases Increases Increases Increases Decreases Profit for the year Statement of changes in equity Ends with the Trial Balance Debits = Credits Profit Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 6

Copyright © 2011 Nelson Education Limited The Accounting Cycle Business Business Activity is recorded in Activity is transferred to Transaction Document Journals Ledgers takes place is prepared 1. Cash account 3. House 2. VISA 4. Car Statement of Financial Position 1. Salary 3. Rent 2. Food 4. Clothing Statement of Income Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 7

The Trial Balance (Wiley Inc. Dec. 31, 2010) Debit Credit Cash and cash equivalents Revenue Prepaid expenses Finance costs Cost of sales Short-term borrowings Retained earnings (beginning of year) Trade receivables Accrued expenses Distribution costs Income tax expense Current income taxes payable Future income taxes payable (deferred taxes) Long-term borrowings Inventories Trade and other payables Current portion of long-term debt Administrative expenses Non-current assets (at cost) Depreciation Accumulated depreciation Dividends Share capital $25,000 SFP ______ $500,000 SI ______ 20,000 SFP 10,000 SI 300,000 SI 50,000 SFP 135,000 SCE 100,000 SFP 15,000 SFP 50,000 SI 25,000 SI 2,000 SFP 3,000 SFP 200,000 SFP 200,000 SFP 100,000 SFP 20,000 Copyright © 2011 Nelson Education Limited SFP 50,000 SI 500,000 SFP SI 25,000 100,000 SFP 20,000 SCE 200,000 SFP $ 1,325,000 Total Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 8

An employee works for a week without being paid for $800 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 Dec. 31 Jan.7 So, the company owes $800 (liability) to the employee when the books are closed An employee works for a week without being paid for $800 Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 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 December 31 June 30 …but, will also show in the closing statement of financial position an amount of $2,000 (asset) as a prepaid expense. Pay $4,000 for insurance this year and show $2,000 as an expense… Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 10

2. Financial Statements To determine the value or wealth of a business, look at the STATEMENT OF FINANCIAL POSITION (also known as the balance sheet) 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 STATEMENT OF INCOME (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 CHANGES IN EQUITY (statement of retained earnings section) since it shows the amount paid to the shareholders and the amount retained in the business. Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 11

3. Financial Statements - Structure and Contents Statement of Income Statement of Retained Earnings Revenue Cost of sales Gross profit Other income/expenses Profit for the year Retained earnings (beginning) Earnings for the year Less: dividends Retained earnings (ending) $900,000 $100,000 $ (20,000) $ 80,000 $80,000 $25,000 $150,000 $980,000 $100,000 Statement of Financial Position Statement of Cash Flows Assets • Non- current • Current Equity Liabilities • Long-term • Current Sources of funds (Where they come from) Uses of funds (Where they went) $100,000 $25,000 $150,000 Profit CL LT $230,000 $25,000 $20,000 $230,000 $25,000 Div. NCA CA Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 12

Statement of Income (Operating Performance) Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Finance costs Total other income and costs Profit before taxes Income tax expense Profit for the year 1 2 3 Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 13

Statement of Comprehensive Income Profit for the year Other comprehensive income/(loss) Exchange differences on translating foreign operations Gain or loss on property revaluation Actual gains (losses) on defined benefit pension plans Total other comprehensive income/(loss) for the year Total comprehensive income 4

Wiley’s Financial Statements Wiley Inc. Statement of Income for the Period Ending December 31, 2010 Revenue Cost of sales Distribution costs Administrative expenses Total operating expenses Finance costs Income tax expense $500,000 (300,000) 200,000 (125,000) 75,000 (10,000) 65,000 (25,000) $40,000 1 Gross profit ($50,000) (50,000) (25,000) Cash flow Depreciation $ 25,000 25,000 $100,000 $ 40,000 Operating income (E B I T) $ 65,000 $75,000 2 Profit before taxes 3 Profit for the year EBITDA Wiley Inc. Statement of Retained Earnings as at December 31, 2010 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 Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 15

Wiley’s Financial Statements Profit for the year Other comprehensive income/(loss) Exchange differences on translating foreign operations Gain or loss on property revaluation Actual gains (losses) on defined benefit pension plans Total other comprehensive income/(loss) for the year Total comprehensive income $40,000 --- --- --- --- --- 4 $40,000

Wiley’s Financial Statements Wiley Inc. Statement of Changes in Equity for the Period Ending December 31 2010 2009 Share capital Balance at beginning of year • Common shares issued • Dividend reinvestment and share purchase plan • Share issued on exercise of stock options Balance at end of year $185,000 15,000 --- $200,000 $180,000 5,000 --- $185,000 Contributed surplus Balance at beginning of year • Stock based compensation • Options exercised Balance at end of year --- Retained earnings Balance at beginning of year • Earnings for the year • Dividends paid to shareholders Balance at end of year $125,000 20,000 (10,000) $135,000 40,000 (20,000) $155,000 Total other comprehensive/(loss) for the year Balance at beginning of year • Change in currency translation • Change in property revaluation Balance at end of year ---

Statement of Financial Position (Financial Structure) Non-Current Assets Equity Long-term borrowings • Capital budgeting • Financial leverage • Cost of financing • Cost of capital Current Assets Current Liabilities Working capital Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 18

Wiley’s Financial Statements Wiley’s Inc. Statement of Financial Position as at December 31, 2010 Non-current assets • Accumulated depreciation $500,000 (100,000) 1 $400,000 Current assets • Inventories • Trade receivables • Prepaid expenses • Cash and cash equivalents Total current assets Total assets 200,000 100,000 20,000 25,000 2 345,000 $745,000 • Share capital • Retained earnings Total equity 200,000 155,000 3 355,000 • Long-term borrowings • Future income taxes payable Total non-current liabilities 200,000 3,000 4 203,000 Current liabilities • Trade and other payables • Short-term borrowings • Accrued expenses • Current portion of long-term debt • Current income taxes payable Total current liabilities Total equity and liabilities 100,000 50,000 15,000 20,000 2,000 5 187,000 $745,000 Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 19

Taxation, Depreciation and Capital Cost Allowance Corporate tax rate (varies from province to province) Taxation for small businesses (if taxable profit is less than they benefit from a small business deduction) Business expenses and deductions • Operating expenses (i.e., cost of sales, operating expenses) • Financing costs (interest on debt) • Business losses (carried over in future years) • Capital cost allowance (Canada Revenue Agency) $400,000 25% Depreciation Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 20

Depreciation (non-current assets) Amortization (intangible assets) A $100,000 asset with a 5-year life span. Revenue $ 200,000 Expenses Depreciation Other expenses 160,000 Total expenses 180,000 Profit before taxes 20,000 Income tax expense 10,000 Profit for the year 10,000 20,000 Add back depreciation 20,000 Cash flow $ 30,000 • 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 depreciation” (accumulated). 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. Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 21

CCA and Depreciation CCA @ 50% Depreciation Declining Straight line 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 * Income tax regulations allow only half of the CCA rate during the first year. Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 22

Income Statement and P&L Statement Year 1 Accountant’s worksheet $300,000 150,000 50,000 75,000 40,000 $35,000 $300,000 150,000 50,000 70,000 80,000 40,000 $40,000 Statement of income P & L statement Revenue Cost of sales Gross profit Operating expenses CCA/Depreciation Total expenses Profit before taxes Taxes - Current (50%) Future Profit for the year $300,000 150,000 50,000 70,000 80,000 40,000 $40,000 25,000 20,000 20,000 37,500 2,500 37,500 2,500 40,000 *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). Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 23

Future Income Taxes Payable (Deferred Taxes) Difference in annual future income taxes @ 50% Difference in cumulative future income taxes Depreciation @ 20% Difference between CCA & depreciation CCA @ 50% Years $25,000 $ 20,000 $ 5,000 $ 2,500 $ 2,500 $37,500 $ 20,000 $17,500 $ 8,750 $ 11,250 $18,750 $ 20,000 - $ 1,250 - $ 625 $ 10,625 $ 9,375 $ 20,000 - $ 10,625 - $ 5,312 $ 5,313 $ 4,687 $ 20,000 - $ 15,313 - $ 7,656 ----- Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 24

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. Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 25

Accounting for Inflation and Changing Values 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? Suggested Solutions Price level accounting Restating all figures in financial statements in terms of current purchasing power. Current value accounting What it would currently cost to acquire an asset with the same capability or capacity as the one presently owned. 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. Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 26

4. Financial Analysis Horizontal analysis Vertical analysis Statement of cash flows Ratio analysis Break-even analysis Leverage analysis Risk analysis Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 27

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 Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 28

6. Financial Statements – GAAP versus IFRS Statement of Income and Statement of Comprehensive Income Income Statement Sales revenue Cost of sales Gross profit Operating expenses Selling expenses Administrative expenses Total operating expenses Operating income (EBIT) Other income Other expenses Extraordinary expenses Income before taxes Income taxes Net income Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Finance costs Total Profit before taxes Income tax expense Profit for the year Total other comprehensive income/(loss) for the year Total comprehensive income 1 2 3 4

Financial Statements – GAAP versus IFRS Balance Sheet Statement of Financial Position Assets Current assets Capital assets Intangible assets Total assets Liabilities Current liabilities Long-term debts Total liabilities Shareholders’ equity Total liabilities and equity Assets Non-current assets Intangible assets Current assets Total assets Equity Liabilities Non-current liabilities Current liabilities Total liabilities Total equity and liabilities

Financial Statements – GAAP versus IFRS Statement of Changes in Equity Statement of Changes in Equity Share capital • Preferred shares • Common shares • Contributed surplus • Retained earnings Total shareholders’ equity Share capital • Preferred shares • Common shares • Contributed surplus • Retained earnings • Total other comprehensive income/(loss) for the year Total shareholders’ equity

7. Not-For-Profit Organizations Statement of Operations Revenue Less expenses Equals excess of revenues over expenses Statement of Changes in Net Assets Excess (deficiency) or revenue over expenses and net change in investment in capital assets Statement of Financial Position Assets minus liabilities equals net assets Statement of Cash Flows Operating activities Financing and investing activities Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited Copyright © 2011 Nelson Education Limited 32