© 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 2.1

Finance for Non-Financial ManagersFifth Edition

Slides prepared by

Pierre G. BergeronUniversity of Ottawa


Accounting and Financial Statements

Chapter Objectives

1. Explain the activities related to bookkeeping.

2. Describe the accounting function and give an outline of the four financial statements.

3. Explain the contents and the structure of the income statement, the statement of retained earnings and the balance sheet.

4. Explain the meaning of analysis in financial management.

5. Discuss the importance of decision-making making in financial management.

6. Explain the contents and structure of the financial statements prepared for not-for-profit organizations.

Chapter ReferenceChapter 2: Accounting and Financial Statements


Financial Management Includes

Bookkeeping

Accounting

Analysis

Decision-Making


1. BookkeepingAs a rule, when all accounts are closed at the end of an

accounting period, the asset and expense accounts have debit balances and the liability, equity and revenue

accounts have credit balances.

Debit Balance Sheet Accounts Credit

Assets

Transfer (net income / profit) is made at the end of the accounting period

Liabilities

Equity

Debit Income Statement Accounts Credit

Expenses Revenue


The Accounting Equation

Balance Sheet

Statement of retained earnings

Income Statement

Credit Decreases Increases Increases Increases Decreases

Debit Increases Decreases Decreases Decreases Increases

A = L + E R - E

Ends with the Trial Balance

Debits = Credits Earnings

Net income


The Accounting Cycle

Business Business Activity is Entry is recorded in transferred to

Transaction Document

takes place is prepared

1. Cash account 3. House

2. VISA 4. Car

Balance Sheet

1. Salary 3. Rent

2. Food 4. Clothing

Income Statement

Journals Ledgers


The Trial Balance (Wiley Inc. Dec. 31, 2006) Debit Credit

Cash $25,000

Sales revenue $500,000

Prepaid expenses 20,000

Interest on debt 10,000

Cost of sales 300,000

Bank loan 50,000

Retained earnings (beginning of year) 135,000

Accounts receivable 100,000

Accrued expenses 15,000

Selling expenses 50,000

Income taxes 25,000

Current income taxes payable 2,000

Future income taxes payable (Deferred taxes) 3,000

Mortgage 200,000

Inventories 200,000

Accounts payable 100,000

Current portion of long-term debt 20,000

Administrative expenses 50,000

Capital assets (at cost) 500,000

Amortization 25,000

Accumulated amortization 100,000

Dividends 20,000

Capital Stock 200,000

BS

IS

BS

BS

BS

BS

BS

BS

BS

BS

BS

BS

BS

SRE

BS

SRE

IS

IS

IS

IS

IS

IS

BS

$ 1,325,000 $ 1,325,000Total


Accrued ExpensesAccrued Expenses

Represent a bill which the company stills owes during the current operating year (i.e., wages, rent, bonus, federal, provincial, or municipal taxes).

Dec. 24

An employee works for a week without being paid

for $800

Dec. 31 Jan.7

So, the company owes $800 (liability) to the employee when the

books are closed


Prepaid ExpensesPrepaid Expenses

Payments made on accounts for which services have not yet been provided (i.e., rent, insurance, office supplies, property taxes).

June 30

Pay $4,000 for insurance this year and show $2,000 as an expense,

December 31 June 30

But, will also show in the closing balance sheet an amount of $2,000

(asset) as a prepaid expense.


2. Financial Statements

To determine the value or wealth of a business, look at the BALANCE SHEET (also known as the statement of

financial position) since it gives a reading of its financial position at a given point in time; it’s like a snapshot or an

X-Ray.

To determine the flow or wealth of a business, look at the INCOME STATEMENT (also known as the earnings

statement, the statement of operations and the profit and loss statement) since it shows the infusion of revenue and

expenses between two accounting periods.

To determine the accumulated wealth of a business, look at the STATEMENT OF RETAINED EARNINGS

since it shows the amount paid to the shareholders and the amount retained in the business.


Financial Statements - Structure and Contents

Sales revenue

Cost of sales

Gross profit

Operating expenses

Net income

Retained earnings (beginning)

Earnings for the year

Less: dividends

Retained earnings (ending)

Assets

• Current

• Capital

Liabilities

• Current

• Long-term

Equity

• Sources of funds (Where they come from)

• Uses of funds (Where they went)

Income Statement Statement of Retained Earnings

Balance Sheet Cash Flow Statement

$100,000

$230,000

$25,000 $100,000 $25,000 $150,000 Inc. C.L. L.T.D.

$ 20,000

$ 80,000

$20,000 $230,000 $25,000 Div. C.A. C.A.

$100,000

$80,000

$150,000

$25,000


Income Statement (Operating Performance)

Sales revenue

Cost of sales

Gross profit

Operating expenses

• Selling expenses

• Administrative expenses

Total operating expenses

Operating income (EBIT)

Interest income (charges)

Income before taxes

Income taxes

Net income

1

2

3

Operating section

Non-operatingsection

Owner’s section


Wiley’s Financial StatementsWiley Inc.

Income Statement for the Period Ending December 31, 2006

Sales revenue $ 500,000

Cost of sales 300,000

200,000

Selling expenses $ 50,000

Administrative expenses 50,000

25,000

Total expenses 125,000

75,000

Interest on debt 10,000

Income before taxes 65,000

Income taxes 25,000

$ 40,000

Wiley Inc.Statement of Retained Earnings as at December 31, 2006

Retained earnings (beginning of year) $ 135,000

Earnings for the current year $ 40,000

Dividends 20,000 20,000

Retained earnings (end of year) $ 155,000

1 Gross profit

Amortization

Cash flow

$ 25,000

$ 65,000

$ 40,000

2Operating income (E B I T)

3Net income

EBITDA

$75,000

25,000

$100,000


Balance Sheet (Financial Structure)

Current Assets Current Liabilities

Capital Assets Long-Term Debts

Equity

Working capital

• Capital budgeting • Financial leverage

• Cost of financing

• Cost of capital


Wiley’s Financial Statements

1

2

3

4

5

Wiley’s Inc.Balance Sheet as at December 31, 2006

Current assets

Cash $25,000

Accounts receivable 100,000

Inventories 200,000

Prepaid expenses 20,000

Total current assets $345,000

Capital assets (at cost) 500,000

100,000 400,000

Total assets $745,000

Current liabilities

Bank loan 50,000

Accounts payable 100,000

Accrued expenses 15,000

Current income taxes payable 2,000

Current portion of long-term debt 20,000

Total current liabilities $187,000

Mortgage 200,000

Future income taxes payable 3,000

Total long-term debts $203,000

Capital stock 200,000

155,000

Shareholders’ equity 355,000

Total liabilities and shareholders’ equity $745,000

Accumulated amortization

Retained earnings


Taxation, Amortization, and Capital Cost Allowance

1. Corporate tax rate (varies from province to province)

2. Taxation for small businesses (if taxable income is less than they benefit from a small business deduction)

3. Business expenses and deductions

• Operating expenses (i.e., cost of sales, operating

expenses)

• Financing charges (interest on debt)

• Business losses (carried over in future years)

• Capital cost allowance (Canada

Revenue Agency)

$200,000 25%

Amortization


AmortizationAmortization (capital assets)

A $100,000 asset with a 5-year life span.Revenue $ 200,000

Expenses

Amortization

Other expenses 160,000

Total expenses 180,000

Income before taxes 20,000

Income taxes 10,000

Net income 10,000

• Goodwill• Patents• Franchise• Trademarks• Legal and architectural fees• Research and development

Amortization (intangible assets)

These costs can also be capitalized and

amortized over a period of time (years)

just like amortization for capital assets.

• It is an accounting entry.

• It represents the loss in value of an asset

due to wear and tear.

• The cost of the asset is spread against

revenue; it is more realistic.

• It is sometimes referred to as “reserve

for amortization” (accumulated).

Add back amortization 20,000

Cash flow $ 30,000

20,000


CCA and Amortization

1 $100,000 @ 50% $25,000* $ 20,000

2 75,000 @ 50% $37,500 20,000

3 37,500 @ 50% $18,750 20,000

4 18,750 @ 50% $ 9,375 20,000

5 9,375 @ 50% $ 4,687 20,000

CCA @ 50% Amortization

Declining

* Income tax regulations allow only half of the CCA rate during the first year.

Straight line


Income Statement and P&L Statement

Year 1

*The company paid $2,500 less in taxes due to higher CCA rate. Therefore, the company owes this amount to the government in the form of future income taxes payable (it’s like an interest free loan).

Accountant’s worksheet

$300,000

150,000

150,000

50,000

75,000

75,000

40,000

$35,000

Sales revenue

Cost of sales

Gross profit

Operating expenses

CCA/Amortization

Total expenses

Income before taxes

Taxes - Current (50%)

Future

Income/Profit after taxes

$300,000

150,000

150,000

50,000

70,000

80,000

40,000

$40,000

25,000

37,500

2,500

20,000

40,000

$300,000

150,000

150,000

50,000

70,000

80,000

40,000

$40,000

Income statement

P & L statement

20,000

37,500

2,500


Future Income Taxes Payable (Deferred Taxes)

1 $25,000 $ 20,000 $ 5,000 $ 2,500 $ 2,500

2 $37,500 $ 20,000 $17,500 $ 8,750 $ 11,250

3 $18,750 $ 20,000 - $ 1,250 - $ 625 $ 10,625

4 $ 9,375 $ 20,000 - $ 10,625 - $ 5,312 $ 5,313

5 $ 4,687 $ 20,000 - $ 15,313 - $ 7,656 -----

YearsCCA @

50%

Amortization @ 20%

Difference between CCA & amortization

Difference in annual future

income taxes @ 50%

Difference in cumulative

future income taxes


The Auditor’s Report

Canadian corporate law requires that every limited company appoint an auditor to represent shareholders and report to them annually on the company’s financial statements, expressing an opinion in writing as to their:

• fairness, and

• consistency.

In Canada, the auditor’s report conventionally has two paragraphs:

1. Scope of the examination (accounting procedures in use and tests

of the accounting records);

2. Auditor’s opinion on the statements indicating that the financial

statements present fairly the financial position of the company in

accordance with Generally Accepted Accounting Principles (GAAP)

applied on a basis consistent with that of the preceding year.


Accounting for Inflation and Changing Values

A. Need

Question the validity of traditional accounting practices.

Do financial statements prepared according to traditional accounting principles present fairly the financial position of a company in periods of inflation?

B. Suggested Solutions

1. Price level accounting

Restating all figures in financial statements in terms of current purchasing power.

2. Current value accounting

What it would currently cost to acquire an asset with the same capability or capacity as the one presently owned.

C. Current Canadian Practice

In 1982, the recommendations call for Canadian enterprises whose securities are traded in a public market to disclose in their annual reports supplementary information on the effect of changing prices.


4. Financial Analysis

• Horizontal analysis

• Vertical analysis

• Statement of sources and uses of

funds

• Ratio analysis

• Break-even analysis

• Leverage analysis

• Risk analysis


5. Decision-Making

• Financing decisions

• Working capital decisions

• Capital budgeting decisions

• Growth decisions

• Capital structure decisions

• Lease or buy decisions

• Pricing decisions

• Operating budgeting decisions

• Valuation decisions


6. Not-For-Profit Organizations

Statement of financial position

Assets minus liabilities equals net assets.

Statement of operations

Revenues

Less expenses

Equals excess of revenues over expenses.

Documents

© 2008 by Nelson, a division of Thomson Canada LimitedTransparency 2.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron