Introduction to Corporate

Finance
Fifth Canadian Edition
Booth, Cleary, Rakita

Chapter 3

Financial Statements

Copyright ©2020 John Wiley & Sons, Inc.

Learning Objectives

3.1 Define what International Financial Reporting Standards

(IFRS) are and state their significance for Canadian firms.
3.2 Organize a firm’s transactions, and explain what are the most
important accounting principles related to this task.
3.3 Prepare a firm’s financial statements.
3.4 Analyze a firm’s financial statements.
3.5 Describe the Canadian tax system and explain the differences
between how a corporation and an individual are taxed.

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3.1 ACCOUNTING PRINCIPLES

• Accounting is an organized way of summarizing the activities of business.

• Internal and external users of accounting information rely on it to make decisions.
• Financial managers require a strong understanding of accounting because they use that
information to make significant decisions that will affect the firm.
• International Financial Reporting Standards (IFRS) an internationally recognized set of
accounting guidelines adopted by many countries around the world (including Canada as of
2011)
• Generally Accepted Accounting Principles (GAAP) are contained in the CICA Handbook and have
the force of law in Canada
• The Income Tax Act (ITA) requires the use of the CICA Handbook, except where specifically the
Act requires other treatment. This has led to the practice of Canadian firms reporting to
shareholders using CICA GAAP and preparing separate financial statements for CRA.
• Reporting of financial performance in a consistent manner over time and between firms
enhances the usefulness of those reports, allowing comparative analysis.

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Figure 3-1. Accounting Options Available to
Various Forms of Organizations

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INTERNATIONAL CONVERGENCE

• Different countries have different accounting standards set by

professional organizations that regulate the profession:
o Canada: CICA, the Canadian Institute of Chartered Accountants
o USA: FASB, Financial Accounting Standards Board
o Japan: ASBJ, Accounting Standards Board of Japan
• Given the growing importance of international trade and the
integration of product and financial markets, there is a need for
countries to move to a common set of accounting standards.
• The London-based International Accounting Standards Board
(IASB) has been working to achieve a common standard.
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IMPACT OF ACCOUNTING SCANDALS

• The Enron bankruptcy, in addition to other scandals involving

WorldCom, Tyco. and others demonstrated the need for reform.
• Since investors use accounting information to make investing
decisions and value firms, accounting scandals where financial
statements were misleading have caused investors to lose
confidence in financial markets.
• The U.S. Congress passed the Sarbanes-Oxley Act (SOX) in 2002 in
an attempt to restore investor confidence by imposing new
requirements for financial disclosure and oversight.

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MAIN PROVISIONS OF SARBANES-OXLEY (2002)

• A new Public Company Accounting Oversight Board

o Register and inspect public accounting firms
o Establish audit standards
• Separation of the audit function from other services provided by auditing firms
• Improved standards for corporate governance
o Separate board committees for finance and audit
o Require external auditors to report to the audit committee
o Require audit committee independence and financial expertise, with membership dominated by
external directors
• New requirement that annual reports indicate the state of a firm’s internal controls and assess
their effectiveness
• The CEO and CFO must certify that the firms financial statements “fairly present in all material
respects the operations and financial condition of the issuer”

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3.2 ORGANIZING A FIRM’S TRANSACTIONS

• Bookkeeping is the mechanical act of managing and recording

transactions
TABLE 3.1 Jim’s Widget Business
1. December 1: Jim opens a business account with a $50,000 deposit.
2. December 5: Jim purchases a lathe for $30,000 using $20,000 cash and a $10,000 loan.
3. December 10: Jim buys $10,000 worth of inventory on credit.
4. December 11: Jim pays $5,000 to suppliers (creditors).
5. December 31: Jim sells $20,000 worth of widgets, $15,000 in cash and $5,000 on credit.
6. December 31: Jim recognizes cost of sales (inventory decline) of $8,000.
7. December 31: Jim pays hydro of $2,600 and rent of $2,400.
8. December 31: Jim withdraws $10,000 for himself.
9. January 5: Jim pays a further $5,000 to creditors.

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ORGANIZING A FIRM’S TRANSACTIONS (1 of 3)

• Accounting is the application of generally accepted accounting

principles (GAAP) and conventions to bookkeeping data to produce
financial statements that fairly represent the financial condition and
operations of the economic entity
• The most basic principles of Canadian GAAP are:
1. The Entity Concept – accounting is for a specific economic entity
2. The Going Concern Principle – the statements are prepared on the
basis that the economic entity will continue to operate into the
future; therefore, liquidation values are irrelevant
3. A Period of Analysis – usually a fiscal year, although quarterly and
monthly financial statements are also produced
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ORGANIZING A FIRM’S TRANSACTIONS (2 of 3)

• Basic principles of Canadian GAAP

4. A Monetary Value – historical costs are traditionally used
because of the objectivity inherent in arms-length
transactions
5. The Matching Principle – expenses incurred must be
matched to the revenue earned in the period of analysis
6. Revenue Recognition – revenue is recognized when it has
been earned, even though the cash may not yet have been
received

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ORGANIZING A FIRM’S TRANSACTIONS (3 of 3)

• The major conventions of Canadian GAAP are:

1. Procedures – the debit and credit convention
2. Standards – CICA Handbook
3. Consistency – accounting principles should be applied consistently
over time to ensure that the comparison of financial statements
from different periods illustrates economic differences not just
policy differences
4. Materiality – all significant information is disclosed
5. Disclosure – the firm’s financial condition is fully and fairly disclosed;
objectivity, consistency and conformity to GAAP are all aspects of
full disclosure
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3.3 PREPARING ACCOUNTING STATEMENTS: The
Balance Sheet
• The balance sheet is a financial snapshot at one point in time and is usually dated for the last
day of the firm’s fiscal year
• It shows what the firm owns (assets) and how those assets were financed (liabilities and owners’
equity)
o Assets (debit accounts) are usually shown on the left side with liabilities and equity (credit accounts) on
the right side
o Items are listed vertically in order of liquidity (e.g., cash is the first asset, while fixed assets like
machinery are the last)

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Preparing Accounting Statements: The Income
Statement
• The income statement is also known as the
profit and loss statement
• Reports the income earned over a given
period of time, usually a year, quarter or
month.
• Applies the matching principle by reporting
expenses incurred in order to earn the
revenue recognized in that period
• Revenue is always reported on the top line,
with expenses below
• Expenses are often reported separately by
type: variable/direct, indirect/fixed,
interest, amortization, income taxes, etc.

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PREPARING ACCOUNTING STATEMENTS: Changing
Accounting Assumptions
• GAAP provides flexibility in the accounting treatment of economic events, such as:
o When to recognize revenue
o When to capitalize an expense (as an asset)
o What rate to use for depreciation
• The compensation that managers receive is often tied to a company’s financial
performance and managers often face considerable pressure to make the firm’s
financial performance appear as good as possible.
• As a result of this pressure, management may change accounting policies within the
limits allowed by GAAP to suit their needs and the current circumstances facing the
firm
• Any change in the application of GAAP must be disclosed in the audited financial
statements and could jeopardize the audit opinion offered by the external auditors if it
is not in compliance with GAAP.

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PREPARING ACCOUNTING STATEMENTS: Tax
Statements (1 of 2)
• In Canada, firms must report to Canada Revenue Agency (CRA) and
remit income taxes in accordance with the Income Tax Act (ITA).

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PREPARING ACCOUNTING STATEMENTS: Tax
Statements (2 of 2)
• CRA requires businesses to use capital cost allowance (CCA) rates for asset
depreciation which are specified in the ITA’s Regulations.
• Firms in Canada tend to produce two sets of financial statements: one for
shareholders prepared in accordance with GAAP, and another for the CRA prepared
according to tax rules.
• Because capital cost allowance (CCA) is an accelerated method of amortization and
assets are often replaced more frequently than they are fully depreciated:
o Actual income tax liabilities based on the ITA and CCA is usually less than what is
“estimated” when reporting to shareholders under GAAP
o This creates an “intertemporal” differences in tax liability called deferred taxes which is
capitalized on balance sheets when reporting to shareholders
o Therefore, deferred taxes does not mean the firm has an unpaid tax liability; it means there
is an intertemporal difference in tax liability

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ACCOUNTING INCOME, TAXABLE INCOME AND
ECONOMIC INCOME
• Accounting income is the net profit of the firm obtained using GAAP and accounting
depreciation
• Taxable income, or income for tax purposes is the net profit of the firm arrived at using
GAAP and CCA in accordance with the Income Tax Act
• Economic income is the amount of funds a firm could withdraw from the firm at the end
of an accounting period, and leave the firm in the same income earning position as it
started the period
• Generally: Accounting Income > Taxable Income > Economic Income
• Accounting income is usually greater than income for tax because the CCA deductions
are usually greater than accounting depreciation
• Economic income is less than income for tax because CCA and accounting depreciation
amounts are based on historical cost which understates the amount of earnings a firm
must retain since the firm will have to replace its asset base at higher replacement costs.

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PREPARING ACCOUNTING STATEMENTS: Cash Flow
Statements (1 of 2)
• Accounting profit may not reflect the firm’s actual cash flow
• The cash flow statement helps to provide a clearer picture of sources and uses of cash
• Analysts are very interested in cash flow because it indicates a firm’s solvency
• Two methods to prepare a cash flow statement:
1. Examine the changes in the balance sheet accounts and reconcile them through the cash account
2. Add non-cash items to net income

SOURCES OF CASH USES OF CASH

Asset Decreases Asset Increases
Liability Increases Liability Decreases
Common Stock Increases
Retained Earnings Increases

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PREPARING ACCOUNTING STATEMENTS: Cash Flow
Statements (2 of 2)

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3.4 CANADIAN PACIFIC ACCOUNTING STATEMENTS:
Consolidated Balance Sheet

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CANADIAN PACIFIC ACCOUNTING STATEMENTS:
Consolidated Income Statement

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CANADIAN PACIFIC ACCOUNTING STATEMENTS:
Consolidated Statement of Cash Flows

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3.5 THE CANADIAN TAX SYSTEM

• Federal and provincial governments in Canada tax individuals and

corporations based on income earned
• Corporations pay income taxes and then use after-tax income to
distribute dividends to shareholders
• Dividends received by shareholders are taxed again as one form of
personal investment income
o In recognition of this double-taxation of dividends, dividends from
Canadian corporations are given some partial relief through the
“dividend gross-up tax credit”
o Dividends received from non-Canadian companies do not qualify for
this special tax treatment
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CORPORATE INCOME TAXATION
• Corporate tax is paid at a flat or fixed rate on taxable income
• Small businesses are defined as those which earn income of $300,000 or less,
and usually pay a lower rate of tax (depending on the province)
• Companies are free to choose their own taxation (fiscal) year but, once
established, cannot alter it without justification and approval
• Taxable income generally is income earned during the fiscal year less expenses
incurred in order to earn that income
• The income statement shows that variable costs and period overhead costs can
be subtracted to determine earnings before interest and taxes (EBIT)
• For tax purposes the Income Tax Act requires that the capital cost allowance
system be used instead of accounting amortization
• Interest expenses on debt borrowed to earn income is generally deductible
from taxable income
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CAPITAL COST ALLOWANCE

• Capital cost allowance (CCA) is the method of depreciation or

amortization used by taxpayers in Canada when reporting business
income to CRA for tax purposes
• Since CCA affects a firm’s net income and its net cash flow, taxation
issues must be addressed in each financial decision a firm makes and
decision makers need to understand CCA
• CCA gives rise to a tax-shield benefit
• CCA is a non-cash deduction from income that would otherwise be
subject to income tax. Taxable income is reduced as a result of the
deduction and the result is a savings in tax payable
• Tax shield benefit = corporate tax rate × dollar amount of claimed CCA
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CCA – Nov 2018 Changes

• In Nov 2018, CRA introduced the Accelerated Investment Incentive

program.
• For asset class 53 (machinery and equipment) and asset classes
43.1 and 43.2 (specified clean energy equipment) the assets may
be written off entirely upon acquisition.
• For other asset classes, Nov 2018-27, the half-year rule will not be
applied.
• Nov 2018-23, CCA will be charged equal to net acquisition plus
50% of the cost.
• Nov 2023-27, entire year will be charged in CCA calculation.
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CCA VERSUS ACCOUNTING DEPRECIATION

• Capital Cost Allowance • Accounting Depreciation

o Similar assets are grouped into pools o Firms choose the method that best
or classes represents the economic wastage of
o Each asset class’s CCA rate is the asset
specified in the Regulations to the o Assets are depreciated individually,
ITA and approximates the economic not in a group
wastage of the asset o Estimates of useful life and salvage
o No estimate of useful life or salvage value are necessary
value is necessary
o As long as the firm remains a going
concern and assets remain in the
pool, residual undepreciated capital
cost (UCC) values remain in the pool
CCA OVER TIME

• CCA is like a declining balance method and changes each year

• The largest benefit occurs in the early years of an asset’s life
• Residual values always remain in the pool, even after the asset is
disposed
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CCA, CAPITAL GAINS, RECAPTURE AND TERMINAL
LOSS
• A taxable capital gain would occur if the firm sold a depreciable asset for
greater than its original cost
• Capital Gain = Original Cost Base – Salvage Value
• Recapture of Depreciation: if the salvage value of the asset exceeds the
undepreciated capital cost (UCC) of the asset pool, there is a recapture of
depreciation which is subject to tax
• An asset pool is closed when the last physical asset in the pool is sold and not
replaced
• Terminal Loss: if there is a positive UCC balance remaining in the pool when it
closes, that balance is called a terminal loss and is deductible from taxable
income in the year the last asset is disposed; terminal losses are non-cash
deductions just like CCA
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PERSONAL INCOME TAXATION

• Canadians are taxed on their worldwide income

• The taxation year is the calendar year: January 1st to December
31st
• The personal tax system is progressive in most provinces, where
tax rates increase as the amount of a person’s income increases
• Investment income can be earned by investors in one of three
different forms, each of which is taxed differently:
o Interest
o Dividends
o Capital Gains

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PERSONAL INCOME TAXATION OF INTEREST

• Interest income is taxed at the person’s marginal personal tax rate,

which is the same rate at which employment and business income is
taxed
• Marginal personal tax rates depend on the amount of income earned in
a progressive tax system
• All sources of interest must be claimed in each calendar year, both cash
interest payments received and interest that has accrued but not yet
been paid (e.g., Canada Savings Bonds that have not yet been
redeemed)
• The marginal tax rates on interest income are usually (depending on a
person’s circumstances) higher than those on dividends and capital
gains
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PERSONAL INCOME TAXATION OF DIVIDENDS

• Dividends from Canadian companies receive a special tax

treatment called the “gross-up tax credit”
• Cash dividends from eligible corporations are grossed up by 38%
and this total amount is included in taxable income
• Federal and provincial tax credits, which vary from province to
province, are deducted from the grossed up amount
• Federal tax credit: 15.02%
• Provincial tax credits vary in the interval 5%-14%
• The tax credits reduce the marginal tax rate applied to dividend
income
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PERSONAL INCOME TAXATION OF CAPITAL GAINS

• Only realized capital gains are taxed which means that unrealized
capital gains do not trigger tax until investments are sold.
Investors can therefore defer capital gains taxes until funds are
required.
• Only one-half (50%) of a realized capital gain is subject to tax at
the person’s marginal tax rate
• Capital losses can be used to offset taxable capital gains
• At higher marginal tax rates, investors prefer to receive investment
income in the form of capital gains and dividends because these
are often taxed at a lower marginal rate than interest income

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Copyright

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