CHAPTER

2
Review of
Accounting

Microsoft® PowerPoint® Presentation

Prepared by Kathy Faber, Conestoga College

© 2021 MCGRAW HILL 1

  Accounting and Finance
 Income Statement
 Income and Value
 Balance Sheet (with IFRS impact)
Chapter 2
Outline  Income and Cash Flow
 Statement of Cash Flows
 Free Cash Flow
 Tax and Financial Decision
 Summary and Conclusions

© 2021 MCGRAW HILL 2

Learning Objectives
Prepare • Prepare and analyze the four basic financial
statements. (LO1)

Examine • Examine the limitations of the income statement

as a measure of a firm’s profitability. (LO2)

Examine • Examine the limitations of the balance sheet as a

measure of a firm’s financial position. (LO3)

Explain • Explain the importance of cash flows as identified

in the statement of cash flows. (LO4)

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Learning Objectives – Part 2
Identify • Identify the effects of IFRS (International Financial
Reporting Standards) on financial analysis. (LO5)

Outline • Outline the effect of corporate tax considerations

on after-tax cash flow. (LO6)

Identify • Identify the different forms of investment income

and the effects on investors’ taxes payable. (LO7)

Explain • Explain the concept of tax savings for companies.

(LO8)

© 2021 MCGRAW HILL 4

 Finance is about making decisions
to produce value
It is important to understand a
firm’s past and present financial
position
Accounting
Accounting provides such
and Finance
information, organized into 4
financial statements:
1. Income Statement
2. Statement of Retained Earnings
3. Balance Sheet
4. Statement of Cash Flows

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  An Income Statement measures
profitability for a time period
(e.g., 1 year)
 Revenues - Expenses = Net
Income
Income  Revenues from customers for
Statement services or merchandise
 Expenses from vendors for
merchandise, services or
supplies

© 2021 MCGRAW HILL 6

 KRAMER CORPORATION
Income Statement
For the Year Ended December 31, 20XX
1.Sales $ 2,000,000
2. Cost of goods sold 1,500,000
3. Gross profit $ 500,000
4. Selling and administrative expense 279,500
5. Depreciation expense 50,000
Table 2-1 6. Operating profit (EBIT)* $ 170,500
Income 7. Interest expense 20,000
Statement 8. Earnings before taxes (EBT) $ 150,500
9. Taxes 40,000
10. Earnings after taxes (EAT) $ 110,500
11. Preferred stock dividends 10,500
12. Earnings available to common $ 100,000
stockholders
13. Common shares outstanding 100,000
14. Earnings per share $ 1.00
*Earnings before interest and taxes.

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 We should note the return on capital to
the three primary sources provided by
investors:
Creditors (Bonds, etc.)
 $20,000 in interest
Return on
Capital Preferred Shareholders:
 $10,500 in dividends

Common Shareholders
 $100,000 of earnings available

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Table 2-2
Statement of retained earnings
The statement of retained earnings is the link between the income
statement (profit/loss) and the balance sheet

STATEMENT OF RETAINED EARNINGS

For the Year Ended December 31, 20XX
Retained earnings, balance, January 1, 20XX $ 250,000
Add: Earnings available to common stockholders, 20XX 100,000
Deduct: Cash dividends declared in 20XX 50,000
Retained earnings, balance, December 31, 20XX $ 300,000

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 Shareholders’ claim on earnings is
a fundamental measure of value
Valuation
Basics from
the Income Earnings per share (EPS) =
Statement

EPS = = $1

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 The payout ratio measures the
percentage of earnings paid out
Valuation immediately in dividends:
Basics from
the Income
Statement – Payout ratio =
Part 2
Payout ratio = = 0.50 or 50%

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 Shareholders’ reliance on earnings
will influence the price they are
Valuation prepared to pay for shares of the
Basics from firm:
the Income
Statement –
Part 3 P/E ratio =

P/E ratio = = 12

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Table 2-3
Price-earnings ratios for selected companies
P/E Ratio
Corporation Industry 1992 2001 2008 2017 2019
BCE (BCE) Telecommunications 11.2 24.8 7.2 18.4 19.3
Bank of Montreal (BMO) Banking 8.8 11.0 11.2 14.4 10.8
Loblaw (L) Grocery chain 18.5 27.8 25.1 30.8 25.4
MolsonCoors (TPX.b) Brewery 13.5 21.3 17.7 37.7 253.4
Open Text (OTEX) Technology software n.a. 43.5 50.0 7.3 36.4
Encana (ECA)(Ovintiv) Petroleum 143.4 7.0 13.6 n.a. 3.2
TSX Composite* Index 110.2 -81.9 17.7 25.1 18.6
*No P/E ratios are report on negative earnings that would result in a negative stock price. A general
average for P/E ratio is about 15 times. The TSX Composite Index is the exception in 2001 due to huge
losses at Nortel and JDS.

© 2021 MCGRAW HILL 13

 Measures the percentage of earnings
paid out immediately in dividends:
Valuation
Basics from
the Income Dividend yield =
Statement –
Part 4
Dividend yield = = 0.0417 or 4.17%

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 Income statement records past
events, which are irrelevant for
valuation purposes

Limitations of Accountants focus on income

the income while financial managers/analysts
statement are interested in value

Accountants have some flexibility

in reporting transactions and
resultant income

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 The Balance Sheet (statement of
financial position) is a “snap-shot
picture” that indicates the firm’s:

 Holdings (what the firm owns)

Balance  Obligations (financing as
Sheet liabilities or equity[ownership
interest])
 Measure of its value at a point
in time (cost basis compared to
various IFRS valuation methods

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 Assets: what a business owns
Current Assets
 e.g., Accounts receivable,
Inventory
Classification  Will be sold or used up within 1
s on the year
Balance Sheet Capital Assets
 e.g., Building, Equipment

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 Liabilities: what a business owes
Current Liabilities
 e.g., Accounts payable
 Due within 1 year
Classification
s on the Long-term Liabilities
Balance Sheet  Due some time after 1 year
– Part 2

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 Equity: what the owner(s) have
invested in the business
Shareholders’ Equity
 Capital stock
Classification  Retained Earnings
s on the
Balance Sheet
– Part 3

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 Most countries, including Canada have
accepted the International Financial
Reporting Standards (IFRS)
Effects of Public companies now report their
IFRS on annual financial statements applying
IFRS, along with comparative previous-
Financial years figures.
Analysis It makes the financial statements
completed under the IFRS comparable
to other companies worldwide using
similar IFRS standards

© 2021 MCGRAW HILL 20

 Most financial topics will be
affected by IFRS applications,
especially:
Effects of
IFRS on  Financial statements values
Financial  Ratio analysis
Analysis –  Determination of cost of capital
Part 2  Capital Budgeting decisions

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 Asset accounts are listed in order
of liquidity:
 Marketable securities
The Balance
Sheet: Assets  Accounts receivable (less
allowance for bad debt
 Inventory valued at cost
 Prepaid expenses

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 Longer term assets will be:

The Balance
Sheet: Assets  Investments (held longer than
– Part 2 marketable securities
 Plant and equipment (less
accumulated amortization)

© 2021 MCGRAW HILL 23

 KRAMER CORPORATION
Balance Sheet
December 31, 20XX
Assets
Current assets:
Cash $ 40,000
Marketable securities 10,000
Accounts receivable $ 220,000
Less: Allowance for bad debts 20,000 200,000
Table 2-4A Inventory 180,000
Balance sheet Prepaid expenses 20,000
(GAAP Total current assets $ 450,000
Presentation) Other assets:
Investments 50,000
Capital assets:
Plant and equipment, original cost $ 2,100,000
Less: Accumulated amortization 600,000
Net plant and equipment
1,500,000
Total assets $ 1,000,000

© 2021 MCGRAW HILL 24

 KRAMER CORPORATION
Balance Sheet
December 31, 20XX
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable $ 80,000
Notes payable (bank indebtedness) 100,000
Table 2-4A Accrued expenses 30,000
Balance sheet Total current liabilities $ 210,000
(GAAP Long-term liabilities:
Bonds payable, 2030 90,000
Presentation) – Total liabilities $ 300,000
Part 2 Stockholders’ equity:
Preferred stock, 500 shares $ 50,000
Common stock, 100,000 shares 350,000
Retained earnings 300,000
Total shareholders’ equity $ 700,000
Total liabilities and stockholders’ equity $ 1,000,000

© 2021 MCGRAW HILL 25

 KRAMER CORPORATION
Statement of Financial Position
December 31, 20XX
Assets
Capital assets (non-current assets):
Plant and equipment, appraised
values $ 2,100,000
Table 2-4B Less: Accumulated amortization 600,000 $1,500,000
Balance sheet Current assets:
Prepaid expenses 20,000
(IFRS Inventory 180,000
Presentation) Marketable securities 10,000
Accounts receivable 220,000
Less: Allowance for bad debts 20,000 200,000
Cash 40,000
Total current assets 450,000
Other assets: 50,000
Total assets $ 2,000,000

© 2021 MCGRAW HILL 26

 KRAMER CORPORATION
Statement of Financial Position
December 31, 20XX
Shareholders’ equity:
Preferred stock, 500 shares $ 50,000
Common stock, 100,000 shares 350,000
Retained Earnings 300,000
Unrealized Gains 1,000,000
Table 2-4B Total shareholders’ equity $ 1,700,000
Balance sheet Long-term liabilities:
(IFRS Bonds payable 90,000
Presentation) – Current liabilities:
Part 2 Notes payable, short term 100,000
Accrued expenses
30,000
Accounts payable $ 80,000
Total current liabilities $ 210,000
Total liabilities and
shareholders’ equity $ 1,000,000

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 Current Liabilities
Short-term obligations due within one
year:
 Accounts payable

The Balance  Notes Payable

Sheet -  Accrued expenses
Liabilities Longer term liabilities
Obligations due more than one year:
 Bonds Payable

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Valuation Basics from the Balance Sheet
One number related to a firm’s value on the balance
sheet is net worth or book value, which is defined
as:
Shareholders’ Equity minus Preferred Stock
It represents common shareholders’ original
investment plus all earnings reinvested in the firm
so far.

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Valuation Basics from the Balance Sheet – Part
2
Analysts often calculate the relationship between
market value per share and historical book value
per share:

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Table 2-5
Comparison of market value to book value per
share, December 2019
Market Value Book Value Ratio of Market
Corporation
per Share per Share Value to Book Value
BCE (BCE) 63.94 22.67 2.82
Bank of Montreal (BMO) 102.22 71.51 1.43
Encana (ECA)(Ovintiv) 5.21 10.38 0.50
Loblaw (L) 71.60 32.60 2.20
Open Text (OTEX) 57.83 19.11 3.03
Shopify (SHOP) 445.45 25.14 17.72
Teck.B (TECK.B) 20.80 40.10 0.52

© 2021 MCGRAW HILL 31

  Values are stated on a historic or
original cost basis for private
companies, but public companies
must report IFRS at market
values
Limitations of
the Balance  Accounting policies and methods
Sheet used (ex: amortization, inventory
valuation) will influence the
recorded values

 Contingent liabilities are omitted

from the balance sheet

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  A profitable firm does not
necessarily generate high cash
flow probably because it sells on
credit.

 Accrual accounting attempts to

Income and match revenues and expenses
Cash Flow even if the related cash flows
occur at quite different times.

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  Financial managers are only
concerned with cash flow
because only cash can be spent.

 The statement of cash flows

Income and reports changes in cash and cash
Cash Flow equivalents resulting from
– Part 2 activities of the firm during a
given period.

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The Operating Cash Flows from operating
activities +
Statement of
Cash Flows
Cash Flows from financing
Financing activities +
The Statement of
Cash Flows
measures the
flow of cash into Investing Cash Flows from investing
activities =
and out of a firm:

Cash Net increase (decrease) in

Flow cash

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 Figure 2-1
Illustration of concepts behind the statement of cash flows

© 2021 MCGRAW HILL 2-36

 Operations
 cash paid and received from buying
and selling of goods and services
Investments
Sources  cash paid and received from
(Uses) of investment activities (bonds, stocks,
Cash property, equipment)
Financing
 cash paid and received from
financing activities (dividends,
borrowing or issuing stocks,
repayment or issuing debt)

© 2021 MCGRAW HILL 2-37

Figure 2-2
Steps in
computing
cash provided
by operating
activities
using the
indirect
method

© 2021 MCGRAW HILL 2-38

 KRAMER CORPORATION
Comparative Balance Sheets
Dec. 31 Dec. 31
20XX 20XW
Assets
Current assets:
Table 2-6 Cash $ 40,000 $ 30,000
Comparative Marketable securities 10,000 10,000
Accounts receivable (net) 200,000 170,000
balance Inventory 180,000 160,000
sheets Prepaid expenses 20,000 30,000
Total current assets 450,000 400,000
(ASPE,GAA Investments (long-term) 50,000 20,000
P) Plant and equipment 1,100,000 1,000,000
Less: Accumulated
amortization 600,000 550,000
Net plant and equipment 500,000 450,000
Total assets $ 1,000,000 $ 870,000

© 2021 MCGRAW HILL 2-39

 KRAMER CORPORATION
Comparative Balance Sheets
Dec. 31 Dec. 31
20XX 20XW
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable $80,000 $45,000
Table 2-6 Notes payable
Accrued expenses
100,000
30,000
100,000
35,000
Comparative Total current liabilities 210,000 180,000
balance Long-term liabilities:
Bonds payable, 2020 90,000 40,000
sheets Total liabilities 300,000 220,000
(ASPE,GAA Shareholder’s equity:
Preferred stock 50,000 50,000
P) – Part 2 Common stock 350,000 350,000
Retained earnings 300,000 250,000
Total shareholder’s equity 700,000 650,000
Total liabilities and
shareholder’s equity $1,000,000 $870,000

© 2021 MCGRAW HILL 2-40

Table 2-7
Cash flows from investing activities
Operating Activities
Net income (earnings after taxes) (Table 2-1) $ 110,500
Add items not requiring an outlay of cash:
Add back amortization (Table 2-1) $ 50,000
Cash flow from operations 160,500
Changes in noncash working capital:
Increase in accounts receivable (Table 2-6) (30,000)
Increase in inventory (Table 2-6) (20,000)
Decrease in prepaid expenses (Table 2-6) 10,000
Increase in accounts payable (Table 2-6) 35,000
Decrease in accrued expenses (Table 2-6) (5,000)
Net change in noncash working capital (10,000)
Cash provided by operating activities $ 150,500

© 2021 MCGRAW HILL 2-41

Table 2-8
Cash flows from investing activities

Investing Activities
Increase in investments (long-term securities) (Table 2-6) ($30,000)
Increase in plant and equipment (Table 2-6) (100,000)
Cash used in investing activities ($130,000)

© 2021 MCGRAW HILL 2-42

Table 2-9
Cash flows from financing activities

Financing Activities
Increase in bonds payable (Table 2-6) $ 50,000
Preferred stock dividends paid (Table 2-1) (10,500)
Common stock dividends paid (Table 2-2) (50,000)
Cash used in financing activities ($10,500)

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Table 2-10
Statement of Cash Flows
KRAMER CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 20XX
Operating Activities
Net income (earnings after taxes) $ 110,500
Add items not requiring an outlay of cash:
Amortization 50,000 50,000
Cash flow from operations 160,500
Changes in noncash working capital:
Increase in accounts receivable (30,000)
Increase in inventory (20,000)
Decrease in prepaid expenses 10,000
Increase in accounts payable 35,000
Decrease in accrued expenses (5,000)
Net change in noncash working capital (10,000)
Cash provided by (used in) operating activities $ 150,500

© 2021 MCGRAW HILL 2-44

 KRAMER CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 20XX
Operating Activities
Net income (earnings after taxes) $ 110,500
Add items not requiring an outlay of cash:
Amortization 50,000 50,000
Cash flow from operations 160,500
Changes in noncash working capital:
Increase in accounts receivable (30,000)
Increase in inventory (20,000)
Decrease in prepaid expenses 10,000
Increase in accounts payable 35,000

Table 2-10 Decrease in accrued expenses

Net change in noncash working capital
(5,000)
(10,000)

Statement of Cash provided by (used in) operating activities $ 150,500

cash flows Investing Activities

Increase in investments (long-term securities) (30,000)
Increase in plant and equipment (100,000)
Cash used in investing activities ($130,000)
Financing Activities
Increase in bonds payable 50,000
Preferred stock dividends paid (10,500)
Common stock dividends paid (50,000)
Cash used in financing activities (10,500)
Net increase (decrease) in cash during the year 10,000
Cash, beginning of year 30,000
Cash, end of year $40,000

© 2021 MCGRAW HILL 2-45

 Year 1 Year 1
(A) (B)
Accounting Cash
Flows Flows
Earnings before amortization and taxes $ 1,000 $ 1,000
(EBAT)
Amortization 100 100
Earnings before taxes (EBT) $ 900 $ 900
Taxes 300 300
Earnings after taxes (EAT) $ 600 $ 600

Table 2-11a Purchase of equipment

Amortization charged without cash outlay
(500)
100
Comparison Cash flow
Year 2
$ 200
Year 2
of accounting (A)
Accounting Flows
(B)
Cash Flows
and cash Earnings before amortization and taxes
(EBAT)
$ 1,000 $ 1,000

flows Amortization 100 100

Earnings before taxes (EBT) $ 900 $ 900
Taxes 300 300
Earnings after taxes (EAT) $ 600 $ 600
Amortization charged without cash outlay 100
Cash flow $ 700

© 2021 MCGRAW HILL 2-46

 Free Cash Flow (FCF) can be calculated
as:

Cash Flow from Operating Activities

Minus: Capital Expenditures (required

to maintain the productive capacity of
Free Cash the firm)
Flow
Minus: Dividends (needed to maintain
the necessary payout on common stock
and to cover any preferred stock
obligation)

© 2021 MCGRAW HILL 2-47

 FCF represents cash available
for special financial activities:
leveraged buyouts
share buyback
Free Cash mergers and acquisitions
Flow – Part 2 Free cash flow is reviewed to
determine if there are
sufficient excess funds to pay
back the loan associated with
leveraged buy-outs

© 2021 MCGRAW HILL 2-48

  Income taxes affect financial decisions
 Corporate taxes vary by province, by
type of business and by size of
business
 Cash flows after-tax are most relevant
Income Tax for decision-making
Considerations
 After-tax investment income paid to
shareholders or other individuals
varies depending upon the form of the
income
 Expenses deductible from taxable
income provide a tax shield (tax
savings)

© 2021 MCGRAW HILL 2-49

 Example of two corporations
 Corporation A pays $100,000 in interest
payments
 Corporation B has no interest payments
Corp. A Corp. B
Cost of a Tax- Earnings before
$400,000 $400,000
interest and taxes
Deductible Interest 100,000 0
Expense Earnings before taxes
300,000 400,000
(taxable income)
Taxes (30%) 90,000 120,000
Difference in earnings
after taxes: $70,000 $210,000 $280,000

© 2021 MCGRAW HILL 2-50

 Example of two corporations
 Corporation A deducts $100,000 in
amortization
 Corporation B does not claim any CCA
Amortization Corp. A Corp. B

(Capital Cost Earnings before CCA and

taxes
$400,000 $400,000
Allowance) CCA 100,000 0
as a Tax Earnings before taxes
(taxable income)
300,000 400,000
Shield Taxes (30%) 90,000 120,000
Earnings after taxes 210,000 280,000
Add: Amortization deducted
100,000 0
without cash outlay
Difference – Corp. A has
$310,000 $280,000
$30,000 higher cash flow

© 2021 MCGRAW HILL 2-51

  Financial statements provide
financial managers with
information about the firm’s
profit, assets, liabilities, equity
and cash flow.
Summary and  Financial managers should be
Conclusions aware of the limitations of
financial statements.
 International Financial Reporting
Standards most significant
impact is on the format of the
Balance Sheet, the valuation of
assets and ratio analysis.
© 2021 MCGRAW HILL 52
  Financial managers should focus
on cash flow as only cash can be
spent.
 The statement of cash flows
gives a rough picture of
Summary and operating cash flows and the
Conclusions nature of the firm’s investment
– Part 2 and financing activities.
 Tax affects individual and
corporate decision making.

© 2021 MCGRAW HILL 53