Chapter 6.

A: Accounting for Financial Success

 Learning Outcomes

• Explain the importance of financial reports and accounting

information the targeted users.
• Identify the six steps in the accounting cycle.
• Examine the composition of the balance sheet and how it describes
the financial condition of a company.
• Examine the composition and purpose of the income statement.
• Examine the composition and purpose of the cash flow statement.
• Explain how ratio analysis is used to identify a company’s financial
strengths and weaknesses.
• Examine some of the major trends that are affecting the accounting
industry.
 What is Accounting?

Accounting: systematically collecting,

recording, classifying, reporting, and
analyzing financial activities.

Financial accounting: focuses on

preparing external financial reports used
by outside stakeholders.

Managerial accounting: provides

financial information that managers
inside the organization can use to
evaluate and make decisions (costs,
budgets, financing, investing, operating).
The Accounting System
 Who is Accounting for?

Internal Users:
• Owners, managers, decision makers

External Stakeholders:
• Shareholders and non-active owners,
creditors, suppliers, employees,
investors, government (taxation
purposes)
• Main communication is the Annual
Report (current condition, progress,
future expectations of the organization)
The Accounting System
 Who is Accounting for?

Creditors and suppliers want to know:

• Can they pay the bills?

Customers want to know…

• Can they honour warranties and provide future service?

Employees want to know:

• Can they pay for salaries and benefits?

Managers want to know:

• Can we pay our bills?
 Accounting Designations

Certified
Management
Accountant
(CMA)
Certified
Chartered
General
Accountant
Accountant
(CA)
(CGA)

Chartered
Professional
Accountant
(CPA)
 Governing Bodies

• Generally Accepted Accounting Principles

(GAAP) until 2011
• International Financial Reporting Standards
(IFRS)
• Accounting Standards for Private Enterprises
(ASPE)
The Accounting Cycle
 The Accounting Cycle

Bookkeeping Accounting
• Start of Accounting • Classify
• Categorize • Analyze
• Record/Journalize • Interpret
• Must be Organized • Recommend
 Financial Statements

1. Balance Sheet (Statement of Financial Position)

• Financial position/condition at a specific point in time.
• What you own and what you owe on a certain day
2. Income Statement (Statement of Income)
• Revenue, expenses, net income, taxes
• Profit/loss statement
• Changes in sales and costs over a period
3. Statement of Cash Flows (Cash Flow Statement)
• Tracks flow of money (in and out)
• Receipts and payments
• Cash is king
• The difference between cash coming in and going out
 The Accounting Equation

Assets = Liabilities + Net Worth (Personal)

or
Net Worth (Personal) = Assets - Liabilities

Business Net Worth statement:

Assets = Liabilities + Net Worth (Business)

Business Net Worth is called Owner’s Equity

 Fundamental Accounting Equation
Assets = Liabilities + Owner’s Equity
A = L + NWB (Owner’s Equity)

A = L + OE
Assets = things of value owned by a firm
Liabilities = what a firm owes to it’s creditors
Owner’s Equity = net worth of the business (portion of the
assets that belong to owners after debts are paid)

Owner’s
Liabilities Assets
Equity
 1. Balance Sheet (Statement of Financial Position)

Assets Liabilities Owner’s Equity

• Current • Current • Common Stock
• Capital • Long Term • Retained Earnings
• Intangible
 Balance Sheet: Assets

Current Assets Fixed Assets Intangible Assets

• Will be • Will generate • Assets of

converted to revenues for value, but
cash within more than have no
the next 12 one year physical
months. (Capital existence
Assets or
PP&E)

Liquidity - The ease at which an asset can be converted to cash

 Balance Sheet: Assets

Current Assets
• Cash, Marketable securities, Accounts receivable and
Inventory.

Fixed or Capital Assets

• Land and Buildings, Machinery and Equipment, Furniture

and Fixtures.

Intangible Assets
• Patents, Copyrights, Trademarks, and Goodwill.
 Intangible Assets

• What are Intangible Assets?

o What is goodwill?
o How do you value intangible assets???
• Brand Names
o Coca Cola, Canadian Tire, IPod
• Intellectual Property
o Patents, Trademarks, Goodwill and Copyrights
 Balance Sheet: Liabilities

Current Liabilities Long-Term Liabilities

• Will be paid • Will take

off within the longer than
next 12 one year to
months. pay off.
 Balanace Sheet: Liabilities

Current Liabilities
• Accounts payable, Notes payable, Accrued expenses,
Income taxes payable, and Current portion of long term
debt.

Long-term Liabilities

• Bank loans, Mortgages on buildings, and Company’s bonds

sold to others.
 Balance Sheet: Owners’ Equity

Long-term Liabilities

• Bank loans, Mortgages on buildings, and Company’s bonds

sold to others.

Examples for a Corporation Examples for a Proprietorship

• Common Shares • Paid-in capital

• Preferred Shares • Retained earnings
• Retained Earnings
 2. Income Statement (Statement of Income)

Revenue
Cost of Goods Sold

Gross Profit
Operating Expenses

Operating Income
Taxes

Net Income/Loss
 Income Statement

Net
Revenues Expenses Profit
(Loss)

Costs to
Sales generate Profit
sales

Also known as:

• Statement of comprehensive income
• Statement of earnings
• Profit and loss statement
 Income Statement: Revenues

Gross Sales

• The total dollar value of a company’s sales.

Net Sales

• Gross sales less discounts, returns and allowances.

 Income Statement: Expenses

Cost of Goods Sold

• The total expense of buying or producing the firm’s goods or services (ex. Raw
Materials). What about Service Firms?
• Variable costs that vary directly with sales volume or production volume

Operating Expenses
• The expenses of running a business that are not directly related to producing or
buying its products (ex. Utilities).
• Fixed costs as they do not change in direct relation to sales volume

Taxes are not an expense but an obligation. Taxes are subtracted

after all expenses have been subtracted.
 Income Statement: Net Profit or Loss

Net Income

• Obtained by subtracting a company’s expenses from

revenues, shown in black. (When revenues are more than
expenses)

Net Loss

• Obtained by subtracting a company’s expenses from

revenues, shown in red and/or (). (When expenses are
more than revenues)
 3. Cash Flow Statement

Cash from Operating Activities

• Revenues in: from customers (sales, commissions, fees)
• Interest and dividends received in

• Expenses out: suppliers and employees (salaries, inventories)

• Interest out
• Taxes out

Cash from Investing Activities

• Proceeds from sale of long term operational assets in
• Payments for purchasing long term operational assets out
• Investments in other companies out

Cash from Financing Activities

• Raised in: new debt or equity capital
• Paid out : business expenses, past debts, company dividends
 Statement of Cash Flows

Operating Activities

• Cash related to the production of goods and services.

Investment Activities

• Cash related to the purchase and sale of fixed assets.

Financing Activities
• Cash related to debt and equity financing.
 Cash Flow Concerns: Examples

• Ski Resorts – Income is derived during the winter ski season

while hill maintenance occurs in the summer off-season.
• Farms – Immense input expenses in the spring while income is
not realized until the sale of commodities in the fall or beyond.
• Air Canada – Had to restructure its operations to survive.

Must focus on running the business not just the product/service

Successful businesses can have cash flow problems
 Ratio Analysis

• The assessment of a firm’s financial condition and

performance through calculations and interpretations of
financial ratios developed from the firm’s financial statements.
• Financial ratio: a number that shows the relationship between
two elements of a company’s financial statements.
• Ratios are merely tools for analysis are not the sole indicators.
• Comparisons to other firms in the same industry or from year
to year are always important.
• Accurate financial information is key.

Net
Current Quick Profit Activity Debt
Working
Ratio Ratio Ratio Ratio Ratio
Capital
 Ratio Analysis Classifications

Measures a company’s ability to convert

Liquidity assets into cash and pay short-term debts.

Measures how effectively a firm is using

Profitability its various resources to achieve profits.

Measures the effectiveness of a firms

Activity management in using assets available.

Debt Measures the degree to which a firm relies

(Leverage) on borrowed funds in its operations.
 Liquidity Ratios: Current Ratio

• Ratio of total current assets to total current liabilities.

• How quickly assets can be turned into cash

Current Ratio = Current Assets

Current Liabilities

• Compare with previous years and other firms at the same time
• Should be > 2
• Information from Balance Sheet
 Liquidity Ratios: Quick Ratio

• Ratio of total current assets excluding inventory to total current

liabilities.
• How quickly assets can be turned into cash

Quick Ratio = Cash + A/R + Mkt. Securities

Current Liabilities

• Also called the ‘Acid Test’

• Usually between 0.5 and 1.0
• Important to firms with large inventory
 Liquidity Ratios: Net Working Capital

• The amount obtained by subtracting

current liabilities from total current assets
• Used to measure liquidity

Net Working Capital= total current assets –

total current liabilities

• Important to compare over time.

 Profitability Ratios

Earnings per share = Net Income

# of Common Shares
Net Profit Margin = Net Income
Revenue
Return on Equity = Net Income
Total Owner’s Equity
• How effectively a firm uses its resources to achieve profits
• ROE: measures how much was earned for each dollar invested
by owners
 Activity Ratio

Inventory Turnover = Cost of Goods Sold

Average Inventory

• Measures speed of inventory moving through the firm and is

turned into sales

• Acceptable ratio depends on the industry

 Debt (Leverage) Ratio

• Measures the degree and effect of a company’s

use of borrowed funds to finance its operations.

Debt to Equity = Total Liabilities

Owner’s Equity

• Relationship between the amount of debt capital

and equity capital.
• Ratio above 1 (or 100%) is more risky
• Information from Balance Sheet
 The Future of Accounting

Accountants expand their role

• Increased collaboration
• Changing revenue streams
Valuing knowledge assets.
• Valuing social media companies
• Technology companies
Triple bottom line not just financial
• Sustainability reporting