PowerPoint Presentations for Finance for Non-Financial Managers: Seventh Edition Prepared by Pierre Bergeron University of Ottawa Copyright © 2014 Nelson Education Ltd. 2–1

Accounting and Financial Statements CHAPTER 2 Accounting and Financial Statements Copyright © 2014 Nelson Education Ltd. 2–2

Explain the activities related to bookkeeping. Learning Objectives Explain the activities related to bookkeeping. Describe the accounting function and outline the four financial statements. Examine the contents and the structure of the statement of income and the statement of comprehensive income, the statement of changes in equity, and the statement of financial position. Understand the meaning of analysis in financial management. Discuss the importance of decision making in financial management. Analyze the contents and structure of financial statements prepared for NFP organizations. Copyright © 2014 Nelson Education Ltd. 2–3

Financial Management includes Bookkeeping Accounting Analysis Financial Statements Decision-Making Copyright © 2014 Nelson Education Ltd. 2–4

Activities Related to Bookkeeping LO 1 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 © 2014 Nelson Education Ltd. 2–5

The Accounting Equation LO 1 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 © 2014 Nelson Education Ltd. 2–6

The Accounting Cycle LO 1 Transaction Document Journals Ledgers 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 © 2014 Nelson Education Ltd. 2–7

The Trial Balance (Warren Inc. Dec. 31, 2013) LO 1 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 SFP 50,000 SI 500,000 SFP SI 25,000 100,000 SFP 20,000 SCE 200,000 SFP $ 1,325,000 Total Copyright © 2014 Nelson Education Ltd. 2–8

An employee works for a week without being paid for $800 Accrued Expenses Accrued Expenses LO 1 Represent a bill that the company still owes during the current operating year (e.g., wages, rent, bonus, federal, provincial, or municipal taxes). December 24 December 31 January 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 © 2014 Nelson Education Ltd. 2–9

Prepaid Expenses Prepaid Expenses LO 1 Payments made on accounts for which services have not yet been provided (e.g., 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 © 2014 Nelson Education Ltd. 2–10

Accounting Function and Financial Statements LO 2 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. Copyright © 2014 Nelson Education Ltd. 2–11

Accounting Function and Financial Statements LO 2 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. Copyright © 2014 Nelson Education Ltd. 2–12

Accounting Function and Financial Statements LO 2 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 © 2014 Nelson Education Ltd. 2–13

Financial Statements: Structure & Contents LO 3 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 © 2014 Nelson Education Ltd. 2–14

Statement of Income (Operating Performance) LO 3 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 © 2014 Nelson Education Ltd. 2–15

Statement of Comprehensive Income LO 3 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 Copyright © 2014 Nelson Education Ltd. 2–16

Warren’s Financial Statements LO 3 Warren Inc. Statement of Income for the Period Ending December 31, 2013 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 Warren Inc. Statement of Retained Earnings as at December 31, 2013 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 © 2014 Nelson Education Ltd. 2–17

Warren’s Financial Statements LO 3 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 Copyright © 2014 Nelson Education Ltd. 2–18

Warren’s Financial Statements LO 3 Warren Inc. Statement of Changes in Equity for the Period Ending December 31 2013 2012 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 --- Copyright © 2014 Nelson Education Ltd. 2–19

Statement of Financial Position (Financial Structure) LO 3 Non-Current Assets Equity Long-term borrowings • Capital budgeting • Financial leverage • Cost of financing • Cost of capital Current Assets Current Liabilities Working capital Copyright © 2014 Nelson Education Ltd. 2–20

Warren’s Financial Statements LO 3 Warren’s Inc. Statement of Financial Position as at December 31, 2013 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 © 2014 Nelson Education Ltd. 2–21

Taxation, Depreciation, and CCA LO 3 Taxation, Depreciation, and CCA 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 © 2014 Nelson Education Ltd. 2–22

Depreciation (non-current assets) Amortization (intangible assets) LO 3 Depreciation (non-current 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 • Is an accounting entry • Represents the loss in value of an asset due to wear and tear • Cost of the asset is spread against revenue; it is more realistic • 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 depreciation for capital assets. Copyright © 2014 Nelson Education Ltd. 2–23

CCA and Depreciation LO 3 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 © 2014 Nelson Education Ltd. 2–24

Income Statement and P&L Statement LO 3 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 © 2014 Nelson Education Ltd. 2–25

Future Income Taxes Payable (Deferred Taxes) LO 3 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 © 2014 Nelson Education Ltd. 2–26

Canadian corporate law requires: The Auditor’s Report LO 3 Canadian corporate law requires: 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 has two paragraphs: LO 3 In Canada, the auditor’s report has two paragraphs: Scope of the examination (accounting procedures in use and tests of the accounting records); 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.

Accounting for Inflation and Changing Values LO 3 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 © 2014 Nelson Education Ltd. 2–29

Statement of cash flows Ratio analysis Break-even analysis Financial Analysis LO 4 Horizontal analysis Vertical analysis Statement of cash flows Ratio analysis Break-even analysis Leverage analysis Risk analysis Copyright © 2014 Nelson Education Ltd. 2–30

Working capital decisions Capital budgeting decisions Growth decisions Decision Making LO 5 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 © 2014 Nelson Education Ltd. 2–31

Not-For-Profit (NFP) Organizations LO 6 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 © 2014 Nelson Education Ltd. 2–32