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© 2003 McGraw-Hill Ryerson Limited
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Review of AccountingReview of Accounting
McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited
Prepared by:Terry FegartySeneca College
Revised by: PChua
© 2003 McGraw-Hill Ryerson Limited
Chapter 2 - Outline
What is Accounting? The Income Statement (I/S) The Balance Sheet (B/S) The Statement of Retained Earnings The Statement of Cash Flows (CFs) Limitations of Financial Statements Comparison of Accounting and Cash Flows Income Tax Considerations Summary and Conclusions
PPT 2-2
© 2003 McGraw-Hill Ryerson Limited
What is Accounting? Accounting is important to adequately understand the concepts of finance. Accounting provides financial information about a business. Accounting provides information as to where a firm has and where it is at the
present time. These information provide an estimate of the future direction of the firm.
Financial statements help us understand these. 4 principal financial statements:
Income Statement Balance Sheet Statement of Retained Earnings Statement of Cash Flows
FS are of interest to stakeholders in business: shareholders managers creditors suppliers and customers government
PPT 2-3
© 2003 McGraw-Hill Ryerson Limited
The Income Statement
An Income Statement provides a measure of the
profitability of a firm over a time period.
Revenues from customers for services or merchandise
Expenses from vendors for merchandise, services or supplies
RevenuesLess: ExpensesEquals: Net Income/Net Loss
PPT 2-4
© 2003 McGraw-Hill Ryerson Limited
Preparing Income Statement is Done in Stair-step Fashion- Allows us to examine the profit or loss after each type of
expense is deducted.
Sales – Cost of Goods SoldStep 1 = Gross Profit – Operating ExpensesStep 2 = Operating Profit – Interest ExpenseStep 3 = Earnings Before Taxes – Income TaxesStep 4 = Earnings Aftertaxes
PPT 2-5
© 2003 McGraw-Hill Ryerson Limited
About Amortization Expense
The purpose of Amortization is to allocate the cost of an equipment over its life, so that at the end of its life, the cost becomes zero or close to zero.
In essence, we are matching the annual cost of using/owning an equipment over its useful life.
Systematic expensing of a portion of the cost of a fixed asset against sales.
This charging of Amortization is purely an accounting entry procedure and does not directly involve the movement of funds.
© 2003 McGraw-Hill Ryerson Limited
KRAMER CORPORATIONIncome Statement
For the Year Ended December 31, 2002
1. Sales . . . . . . . . . . . . . . . . . $2,000,000 2. Cost of goods sold . . . . . . . . . . . 1,500,000 3. Gross profits . . . . . . . . . . . . . 500,000 4. Selling and administrative expense . . . . 220,000 5. Amortization expense . . . . . . . . . . 50,000 6. Operating profit (EBIT)* . . . . . . . . 230,000 7. Interest expense . . . . . . . . . . . . 20,000 8. Earnings before taxes (EBT) . . . . . . . 210,000 9. Taxes . . . . . . . . . . . . . . . . . 99,50010. Earnings aftertaxes (EAT) . . . . . . . . 110,50011. Preferred stock dividends . . . . . . . . 10,50012. Earnings available to common shareholders. $ 100,00013. Shares outstanding . . . . . . . . . . . 100,00014. Earnings per share . . . . . . . . . . . $1.00
15. Common stock dividends . . . . . . . . . 50,000*Earnings before interest and taxes.
PPT 2-6
Table 2-1
© 2003 McGraw-Hill Ryerson Limited
The Income Statement
The Income Statement uses accrual basis of recording transactions, i.e., revenues and expenses are recorded at the time of transaction.
Finance uses cash flow basis, i.e., it records revenues and expenses only when there is cash inflow and outflow involved.
This attention to cash flow will enable the manager to determine the real cash situation of the firm and therefore its short-term survival.
© 2003 McGraw-Hill Ryerson Limited
PPT 2-25Table 2-11aComparison of accounting and cash flows
Accounting Flows Cash Flows
Earnings before amortization and taxes (EBAT) . . $1,000$1,000
Amortization . . . . . . . . . . . 100 100
Earnings before taxes (EBT) . . . . . . . 900 900
Taxes . . . . . . . . . . . . . 400 400
Earnings aftertaxes (EAT) . . . . . . . $ 500500
Amortization charged without cash outlay . . . +100
Cash flow . . . . . . . . . . . . $ 600
© 2003 McGraw-Hill Ryerson Limited
Statement of Retained Earnings
Details changes in Retained Earnings from the beginning to the end of the fiscal year.
Retained Earning Balance (start of year)
Plus: Net Income After Taxes
Less: Cash Dividends Paid
Retained Earning Balance (end of year)
© 2003 McGraw-Hill Ryerson Limited
Statement of Retained Earnings
Retained Earnings, balance, January 1, 2002………..........................$250,000
Add: Net income After Taxes, 2002 ………………………………...110,500
Deduct: Preferred Stock Dividends declared in 2002……………….10,500
Common Stock Dividends declared in 2002 ……………… 50,000
Retained Earnings, balance, December 31, 2002 ……………………..300,000
KRAMER CORPORATION Statement of Retained Earnings For the Year Ended December 31, 2002
© 2003 McGraw-Hill Ryerson Limited
The Balance Sheet
A Balance Sheet (B/S) shows what a firm owns and how it is financed at a point in
time (ex.; December 31)
Remember the ALOE!
Assets = Liabilities + Owners’ Equity
PPT 2-9
© 2003 McGraw-Hill Ryerson Limited
Classifications on the Balance Sheet
Assets*:what a business owns
Current AssetsEx: Accounts receivable, InventoryWill be sold or used up within 1 year
Capital AssetsEx: Building
*Asset accounts are listed in order of liquidity
Liabilities: what a business owes
Current LiabilitiesEx: Accounts payableDue within 1 year
Long-term LiabilitiesDue some time after 1 year
Equity: what the owner(s) have invested in the business
Shareholders’ EquityCapital stockRetained earnings
PPT 2-10
© 2003 McGraw-Hill Ryerson Limited
KRAMER CORPORATIONBalance Sheet (Statement of Financial Position)
December 31, 2002Assets
Current assets:Cash . . . . . . . . . . . $ 40,000Marketable securities . . . . . 10,000Accounts receivable . . . . . . $ 220,000
Less: Allowance for bad debts . 20,000 200,000Inventory . . . . . . . . . 180,000Prepaid expenses . . . . . . . 20,000
Total current assets . . . . . 450,000Other assets:
Investments . . . . . . . . . 50,000Capital assets:
Plant and equipment, original cost. . $ 1,100,000Less: Accumulated amortization 600,000
Net plant and equipment . . . . 500,000Total assets . . . . . . . . . $1,000,000
PPT 2-11
Table 2-4a
© 2003 McGraw-Hill Ryerson Limited
Liabilities and Shareholders’ Equity
Current liabilities:Accounts payable . . . . . . . . . . $ 80,000Notes payable (bank indebtedness) . . . . . 100,000Accrued expenses . . . . . . . . . . 30,000
Total current liabilities . . . . . . . 210,000
Long-term liabilities:Bonds payable, 2012 . . . . . . . . . 90,000
Total liabilities . . . . . . . . . 300,000
Shareholders’ equity:Preferred stock, 500 shares . . . . . . . 50,000Common stock, 100,000 shares . . . . . . 350,000Retained earnings . . . . . . . . . . . 300,000
Total shareholders’ equity . . . . . . 700,000Total liabilities and shareholders’ equity . . . . $1,000,000
PPT 2-12
Table 2-4b
© 2003 McGraw-Hill Ryerson Limited
Limitations of Financial Statements Based on past transactions rather than future forecasts
May not recognize important economic changes as they occur, such as increase in property values Inflation-adjusted values
Variety of accounting policies and methods are used inventory valuation
PPT 2-14
© 2003 McGraw-Hill Ryerson Limited
The Statement of Cash Flows
Provides summary of all inflows and outflows of cash over the same period as the Balance Sheet.
Translates income statement and balance sheet data into cash flow information.
Provides insights into the firm’s operating, investment, and financing cash flows.CF from operating activities PLUS
CF from investing activities PLUS CF from financing activities PLUS EQUALS = Net increase (decrease) in cash and marketable securities
Reconciles changes in cash and marketable securities.
© 2003 McGraw-Hill Ryerson Limited
Figure 2-1Illustration of concepts behind the statement of cash flowsCash inflows Cash outflows
NIAT Net LossAmortization Increase in CA Decrease in CA Decrease in CLIncrease in CL
Sale of plant Purchase of plantand equipment and equipment
Liquidation of Long-term investmentlong-terminvestment
Sale of bonds, Retirement or
common stock, repurchase ofpreferred stock, bonds, common stock,and other preferred stock, andsecurities other securities
Payment of cash dividends
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Add items 1, 2, and 3 together to arrive at net increase(decrease) in cash & marketable securities
PPT 2-17
© 2003 McGraw-Hill Ryerson Limited
KRAMER CORPORATIONComparative Balance Sheets
AssetsCurrent assets:
Cash . . . . . . . . . . $ 40,000 30,000Marketable securities . . . . . 10,00010,000Accounts receivable (net) . . . 200,000170,000Inventory . . . . . . . 180,000160,000Prepaid expenses . . . . . . 20,000 30,000
Total current assets . . . . 450,000 400,000Investments (long term) . . . . . 50,000 20,000Plant and equipment . . . . . 1,100,000 1,000,000
Less: Accumulated amortization . 600,000 550,000Net plant and equipment . . . . 500,000 450,000Total assets . . . . . . . . $ 1,000,000 $ 870,000
Dec. 31 Dec. 31 2002 2001
PPT 2-19
Table 2-6a
© 2003 McGraw-Hill Ryerson Limited
Comparative Balance SheetsLiabilities and Shareholders’ Equity
Current liabilities:Accounts payable . . . . . . . . $ 80,000 $ 45,000Notes payable . . . . . . . 100,000 100,000Accrued expenses . . . . . . . . 30,000 35,000
Total current liabilities . . . 210,000 180,000Long-term liabilities:
Bonds payable, 2012 . . . . . . . 90,00040,000Total liabilities . . . . . 300,000 220,000
Shareholders’ equity:Preferred stock, . . . . . . . . 50,000 50,000Common stock, . . . . . . . . . 350,000 350,000Retained earnings . . . . . . . . 300,000 250,000
Total shareholders’ equity . 700,000 650,000Total liabilities and shareholders’ equity $ 1,000,000 $ 870,000
Dec. 31 Dec. 31 2002 2001
PPT 2-20
Table 2-6b
© 2003 McGraw-Hill Ryerson Limited
KRAMER CORPORATIONStatement of Cash Flows
For the Year Ended December 31, 2002Operating ActivitiesNet income (earnings after taxes) . . . . . . . . $ 110,500
Add items not requiring an outlay of cash:
Amortization . . . . . . . . . . $ 50,000
Cash flow from operations 160,500
Changes in non-cash 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 non-cash working capital . . . . . (10,000)
Cash provided by (used in) operating activities . . . $ 150,500
PPT 2-22
Table 2-10a
© 2003 McGraw-Hill Ryerson Limited
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 . . . . . . . . . . . 50,000Preferred stock dividends paid . . . . . . . . . (10,500)Common stock dividends paid . . . . . . . . . (50,000)Cash used in financing activities . . . . . . . . . (10,500)
Net increase (decrease) in cash and cash equivalents during the year . . . . . . . . . . . . 10,000*Cash, beginning of year . . . . . . . . . . 30,000*Cash, end of year . . . . . . . . . . . . $ 40,000*This would include cash equivalents, if there were any
PPT 2-23
Table 2-10b
© 2003 McGraw-Hill Ryerson Limited
Income Tax Considerations
Income taxes affect financial decisions
Corporate taxes vary by province, by type of business and by size of business (For Current Tax Facts and Figures, visit http://www.pwcglobal.com/extweb/pwcpublications.nsf/DocID/610D4D11DFD01AB98525694200659640)
Cash flows aftertax are most relevant for decision-making
Aftertax investment income paid to shareholders or other individuals varies depending upon the form of the income (eg. Dividend income, interest income, capital gains.
Expenses deductible from taxable income provide a tax shield (tax savings)
PPT 2-26
© 2003 McGraw-Hill Ryerson Limited
Tax Shield on Tax-Deductible Expense
Scenario A Scenario B
Earnings Before Interest and Taxes …………. $400,000 $400,000
Interest ………………………………………… 100,000 0
----------- -----------
Earnings Before Taxes ……………………….. 300,000 400,000
Taxes (40%) …………………………………... 120,000 160,000
----------- -----------
Earnings After Taxes ………………………… $180,000 $240,000
Difference in Earnings After Taxes - $60,000
© 2003 McGraw-Hill Ryerson Limited
Tax Shield on Amortization (Capital Cost Allowance)
Corporation A
Corporation B
Earnings before amortization and taxes .
$400,000
$400,000
Amortization (capital cost allowance) . . . . . .
100,000
0
Earnings before taxes . 300,000 400,000
Taxes (40%) . . . . . 120,000 160,000
Earnings aftertaxes . . 180,000
240,000
+ amortization charged without cash outlay . . .
100,000
0
Cash flow . . . . . . .
280,000 240,000
Difference - $40,000
PPT 2-28
© 2003 McGraw-Hill Ryerson Limited
Taxation of Business Income
Corporations can earn the following types of income: Active Business Income Passive Income Capital Gains
Types of Corporations for tax purposes: Non-Manufacturing Manufacturing or Processing Canadian-controlled private corporation (CCPC)
© 2003 McGraw-Hill Ryerson Limited
Summary and Conclusions
The 4 basic financial statements are the income statement, the balance sheet, statement of Retained Earnings, and the statement of cash flows
There are inherent limitations in the income statement and balance sheet as to reporting current values and economic events
Cash flows aftertax are essential information for business decision-making
PPT 2-29
