Professional Documents
Culture Documents
Financial
Statements
Chapter 14
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The Nature of Accounting 1
Accountants
• CPA
• Accounting scandals
• Worldcom and Enron
• Sarbanes-Oxley Act / Bill 198
• Forensic accounting
• Certified fraud examiners
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Public Accounting Firms
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The Nature of Accounting 2
Accounting or Bookkeeping?
• Bookkeeping is typically limited to the routine, day-to-
day recording of business transactions
• Much narrower and far more mechanical than accounting
• Requires less training than accountants
• Responsible for obtaining and recording the information
accountants require to analyze a firm’s financial position
• Accountants usually have additional training that allow
them to record, understand, interpret, and develop
sophisticated accounting systems
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The Uses of Accounting Information 1
Managers and owners use financial statements
1. To aid in internal planning and control
2. For external purposes such as reporting to the
Canada Revenue Agency, shareholders, creditors,
customers, employees, and other interested parties.
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The Uses of Accounting Information 2
Internal Uses
• Managerial accounting
• Cash flow
• Budget
• Master budgets
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The Uses of Accounting Information 3
External Uses
• Accounting statements are used for filing income
taxes, obtaining credit, and reporting results to
shareholders and potential investors
• Annual report
• Audited financial statements
• Shareholders
• Banks and other lenders
• Labour unions and employees
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The Accounting Process 1
The Accounting Equation
Assets
• A firm’s economic resources, or items of value that it
owns, such as cash, inventory, land, equipment,
buildings, and other tangible and intangible things
Liabilities
• Debts that a firm owes to others
Owners’ Equity
• Equals assets minus liabilities
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The Accounting Process 2
Double-Entry Bookkeeping
• A system of recording and classifying business
transactions that maintains the balance of the
accounting equation
• To keep the accounting equation in balance, each
transaction must be recorded in two separate
accounts
• All business transactions are classified as either
assets, liabilities, or owner’s equity
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The Accounting Process 3
The Accounting Cycle
• The four-step procedure of an accounting system
• Step one: examine source documents
• Step two: record transactions
• Step three: post transactions
• Step four: prepare financial statements
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The Accounting Process 4
The Accounting Cycle continued
Journal
• A time-ordered list of account transactions
Ledger
• A book or computer file with separate sections for
each account
Trial balance
• A summary of the balances of all the accounts in the
general ledger
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Financial Statements 1
The end result of the accounting process is a
series of financial statements
• Income statement
• Balance sheet
• Statement of cash flows
Not all financial statements follow the same format
but must adhere to generally accepted accounting
principles (GAAP)
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Table 14.2 Equivalent Terms in Accounting
Term Equivalent Terms
Revenues Sales
Goods or services sold
Gross profit Gross income
Gross earnings
Operating income Operating profit
Earnings before interest and taxes (EBIT)
Income before interest and taxes (IBIT)
Income before taxes (IBT) Earnings before taxes (EBT)
Profit before taxes (PBT)
Net income (NI) Earnings after taxes (EAT)
Profit after taxes (PAT)
Income available to common Earnings available to common shareholders
shareholders
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Financial Statements 2
The Income Statement
• Shows an organization’s profitability over a period of
time
• Offers one of the clearest pictures of the company’s
overall revenues and costs incurred to generate that
revenue
Revenue
• The total amount of money received from the sale of
goods and services, as well as from related business
activities
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Financial Statements 3
Cost of Goods Sold (COGS)
• The amount of money spent to buy or produce the
products sold during the income statement period
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Financial Statements 4
Expenses
• The costs incurred in the day-to-day operations of an
organization
• Selling, general, and administrative expenses (including
depreciation)
• Research, development, and engineering expenses
• Interest expenses
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Financial Statements 5
Depreciation
• A process where the costs of long-lived assets are
spread out over the total number of accounting
periods in which they are expected to be used
• Depreciating items better match the cost of the item to the
years the item is used
Net Income
• The total profit (or loss) after all expenses, including
taxes have been deducted from revenue
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Financial Statements 6
Temporary Nature of Income Statement Accounts
• Gross profit, earnings before interest and taxes, and
net income are the results of calculations made from
the revenues and expenses accounts; they are not
actual accounts
• At the end of the accounting period, the dollar amount
in revenue and expense accounts are moved to
“retained earnings”
• This results in the owners’ equity account being equal
to net income; zeros out the accounts
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Financial Statements 7
The Balance Sheet
• A “snapshot” of an organization’s financial position at a
given moment
• Takes it name from its reliance on the accounting
equation: assets must equal liabilities plus owners’
equity
• Often presented in two different formats
• Traditional format
• Vertical format
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Financial Statements 8
The Balance Sheet continued
• Assets
• Current assets
• Assets used or converted into cash within the course of a calendar
year
• Accounts receivable
• Money owed a company by its clients or customers who have
promised to pay for the products at a later date
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Financial Statements 9
The Balance Sheet continued
• Liabilities
• Current liabilities
• A firm’s financial obligation to short-term creditors, which must be
repaid within one year
• Accounts payable
• The amount a company owes to suppliers for goods and services
purchased with credit
• Accrued expenses
• An account representing all unpaid financial obligations incurred by
the organization
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Financial Statements 10
The Balance Sheet continued
• Owners’ equity includes:
• The owners’ contribution to the organization
• Income earned by the organization and retained to finance
continued growth and development
• Accounts listed as owners’ equity vary dramatically
from company to company
• Stock shares represent ownership in a company
• Each type of stock must be represented by a separate owners’
equity account, called contributed capital
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Financial Statements 11
The Statement of Cash Flows
• Explains how the company’s cash changed from the
beginning of the accounting period to the end
• Cash from operating activities
• Cash from financing activities
• Cash from investing activities
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Ratio Analysis: Analyzing Financial Statements 1
Ratio Analysis
• Calculations that measure an organization’s financial
health
• Brings complex information from the income statement and
balance sheet into sharper focus
• Aids in measuring and comparing the organization’s
productivity, profitability, and financing mix with other similar
entities
• To be useful, ratios should be compared to:
• The previous years performance
• The company’s competitors
• The company’s stated goals
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Ratio Analysis: Analyzing Financial Statements 2
Profitability Ratios
• Measure how much operating income or net income
and organization is able to generate relative to its
assets, owners’ equity, and sales
• Common profitability ratios
• Profit margin
• Return on assets
• Return on equity
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Ratio Analysis: Analyzing Financial Statements 3
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Ratio Analysis: Analyzing Financial Statements 4
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Ratio Analysis: Analyzing Financial Statements 5
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Ratio Analysis: Analyzing Financial Statements 6
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Ratio Analysis: Analyzing Financial Statements 7
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Ratio Analysis: Analyzing Financial Statements 8
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Ratio Analysis: Analyzing Financial Statements 9
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Ratio Analysis: Analyzing Financial Statements 10
Liquidity Ratios
• Measure the speed with which a company can turn its
assets into cash to meet its debts as they fall due
• High liquidity ratios may satisfy a creditor’s need for
safety but may indicate the company is not using its
current assets efficiently
• Common liquidity ratios
• Current ratio
• Quick ratio
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Ratio Analysis: Analyzing Financial Statements 11
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Ratio Analysis: Analyzing Financial Statements 12
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Ratio Analysis: Analyzing Financial Statements 13
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Ratio Analysis: Analyzing Financial Statements 14
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Ratio Analysis: Analyzing Financial Statements 15
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Ratio Analysis: Analyzing Financial Statements 16
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Ratio Analysis: Analyzing Financial Statements 17
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Ratio Analysis: Analyzing Financial Statements 18
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Importance of Integrity in Accounting
The recent financial crisis and recession showed
another example of a failure in accounting
reporting
• Many firms attempted to exploit loopholes and
manipulate accounting processes and statements
Strong compliance to accounting principles creates
trust among stakeholders
• Transparency and accuracy in reporting revenue,
income, and assets develops trust from investors and
other stakeholders
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