FINANCIAL ACCOUNTING: A CRITICAL APPROACH

Chapter 2 Financial Statements: A Window on an Entity

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Learning Objectives

LO 1 Identify components of financial statements, understand the info each statement provides, and prepare simple examples

LO 2 Describe the accounting equation

LO 3 Explain the nature of assets, liabilities, owners equity, revenues, and expenses

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Learning Objectives

LO 4 Differentiate between accrual-basis and cash-basis accounting, and prepare simple income statements using each method

LO 5 Use financial statement information to assess the liquidity, risk, and profitability of an entity

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Financial Statements

Balance Sheet Income Statement and Statement of

Comprehensive Income Statement of Changes in Equity or Statement of Retained Earnings Statement of Cash Flows Notes to the Financial Statements

LO 1

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The Balance Sheet

A summary of an entitys financial position at a point in time

Elements: Assets (A), Liabilities (L), Owners Equity (OE)

Information about an entitys financial position can help stakeholders: evaluate its financial health assess its risk predict its future cash flows

LO 1

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Accounting Equation

The accounting equation is the conceptual foundation of accounting Assets (A) Liabilities (L) Owners Equity (OE)

(A = L + OE)

LO 2

7

Exercise 2-1 page 63

a. $614,000 b. $425,000 c. $189,000 d. $236,000

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 1 $425,000 ? $189,000

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Exercise 2-1 page 63

a. $614,000 b. $425,000 c. $189,000 d. $236,000 (425,000 189,000)

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 1 $425,000 ? $189,000

9

Exercise 2-1 page 63

a. $110,000 b. $1,350,000 c. $730,000 d. $620,000

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 2 ? $730,000 $620,000

10

Exercise 2-1 page 63

a. $110,000 b. $1,350,000 c. $730,000 d. $620,000 (730,000 + 620,000)

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 2 ? $730,000 $620,000

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Exercise 2-1 page 63

a. $150,000 b. $50,000 c. $250,000 d. $200,000

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 3 $200,000 50,000 ?

12

Exercise 2-1 page 63

a. $150,000 b. $50,000 c. $250,000 d. $200,000 (200,000 50,000)

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 3 $200,000 50,000 ?

13

Exercise 2-1 page 63

a. $420,000 b. $770,000 c. $70,000 d. $350,000

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 4 $420,000 ? $350,000

14

Exercise 2-1 page 63

a. $420,000 b. $770,000 c. $70,000 d. $350,000 (420,000 350,000)

For each of the following independent situations, fill in the missing amount. Assets = Liabilities + Owners Equity Situation 4 $420,000 ? $350,000

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Assets

According to IFRS, an asset must have the following characteristics: Provide a future benefit to the

entity it must be probable that the entity

will enjoy the benefit Assets are economic resources

available to entity

LO 3

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Assets

Current assets Used up within one year (operating cycle)

Non-current assets Benefits extend beyond one year

LO 3

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Asset Criteria

Result from transaction with another entity Cost can be determined Must provide future benefit Benefit must be reasonably measurable

What are some current assets? Long-term assets?

LO 3

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Question

a. Employees who work for the company b. Research into new products for the

company c. A building owned by the company but

rented out d. Advertising spent on attracting

customers to the company

Which of the following would be considered an asset for accounting purposes?

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Question

a. Employees who work for the company b. Research into new products for the

company c. A building owned by the company but

rented out d. Advertising spent on attracting

customers to the company

Which of the following would be considered an asset for accounting purposes?

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Liabilities

Liabilities are an entitys obligation to pay money or provide goods or services to suppliers, lenders, customers, and government

According to IFRS, a liability must be the result of a past transaction or economic

event require some kind of economic sacrifice to settle

LO 3

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Liabilities

Obligations incurred by entity Not necessarily a legal obligation Current liabilities

Paid or satisfied within one year Non-current liabilities

Paid or satisfied beyond one year

What are some current liabilities? Long-term liabilities?

LO 3

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Question

a. $100,000 non-current liability b. $100,000 current liability c. $90,000 non-current liability d. $10,000 current liability and $90,000

non-current liability

Bass Ltd. borrowed $100,000 from the bank. They will repay $10,000 a year for the next ten years plus 5% interest. How would the loan be initially recorded on Basss balance sheet?

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Answer

a. $100,000 non-current liability b. $100,000 current liability c. $90,000 non-current liability d. $10,000 current liability and $90,000

non-current liability

Bass Ltd. borrowed $100,000 from the bank. They will repay $10,000 a year for the next ten years plus 5% interest. How would the loan be initially recorded on Basss balance sheet?

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Owners Equity

Owners equity: the amount owners have invested in an

entity represents the amount of the assets

financed by the owners Terms

Shareholders equity (corporation) Partners equity (partnership) Proprietors equity (proprietorship)

LO 3

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The Income Statement

Results for an accounting period Unlike balance sheet

Revenues minus expenses Net income (Bottom line)

What are some examples of revenue? What are some examples of expenses?

LO 1

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The Income Statement

Measures an entitys economic activity over a period of time, such as a year

Uses for an income statement are: evaluating the performance of an entity and its

management predicting future earnings and cash flows estimating the value of an entity determining the amount of tax that must be paid

LO 1

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The Income Statement

The income statement can have significant economic consequences for entities and their stakeholders including: stock prices often change when a company

announces its net income managers bonuses are often based on net income net income is used to determine income taxes the selling price of a business can be based on net

income

LO 1

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Format of Income Statement

Revenue xxx - Cost of Goods Sold (xxx) = Gross Margin xxx - Operating Expenses (xxx) = NI Before Income Taxes xxx - Income Taxes (xxx) = Net Income xxx

LO 1

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Question

a. $240,000 b. $400,000 c. $1,800,000 d. $3, 200,000

Lennox. Ltd. reported sales of $5,000,000, cost of goods sold of $3,200,000, operating expenses of $1,400,000 and income tax expense of $160,000 for the year. What was their net income for the year?

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Answer

a. $240,000 b. $400,000 c. $1,800,000 d. $3, 200,000 (5,000,000 3,200,000 1,400,000 160,000)

Lennox. Ltd. reported sales of $5,000,000, cost of goods sold of $3,200,000, operating expenses of $1,400,000 and income tax expense of $160,000 for the year. What was their net income for the year?

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Exercise 2-19 page 67

Complete together with the class Prepare an income statement. What is the net income? What is Sussexs gross margin for 2013? What is Sussexs gross margin percentage for 2013?

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Exercise 2-10 page 65

Complete together with the class

Prepare a balance sheet

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The Statement of Comprehensive Income

Current GAAP attempts to capture all transactions and economic events that involve non-owners and that affect equity

Net income + Other comprehensive income (OCI) = Comprehensive income

LO 1

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The Statement of Comprehensive Income

Comprehensive income also affects the equity section of the balance sheet

In the equity section of the balance sheet, there is an account called Accumulated Other Comprehensive Income (AOCI)

LO 1

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Statement of Shareholders Equity

Companies that follow IFRS must provide a statement of shareholders equity

Presents the changes in each account in the equity section of the balance sheet during a period

LO 1

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Statement of Retained Earnings

Canadian GAAP for private companies only requires a statement of retained earnings

Summarizes changes during the period Opening retained earnings + net income for period - dividends declared = ending retained earnings

LO 1

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Statement of Cash Flows

Cash from/used in operations

Cash from/used in financing activities

From long-term liabilities and directly from investors

Cash from/used in investing activities

Used to buy capital assets

LO 1

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The Relationship Among Financial Statements

The individual financial statements are closely related

Many transactions and economic events involve both the Income Statement and the Balance Sheet, and any transaction that involves cash is included in the Statement of cash flows

LO 1

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Notes to Financial Statements

The notes to the financial statements Expand and explain the information in the

statements Explain the accounting policies Provide additional information that may help

stakeholders assess an entity

LO 1

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Format of Financial Statements

Format of general purpose financial statements No single way to format financial statements

An example of the balance sheet format suggested by IFRS is seen in Exhibit 2.5

Notice that in contrast to the Leons balance sheet Non-current assets are at the top of the asset side and

current assets at the bottom On the liabilities and equity side, equity is at the top, followed

by non-current liabilities, and then current liabilities

LO 1

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Cash Basis

Revenue recorded when receive cash

Expenses recorded when pay cash

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Accrual Basis

Revenue Economic benefit earned from providing goods

or services Represents an increase in owners equity Expenses Economic sacrifices or costs made to earn

revenues Using up an asset or incurring a liability

LO 3

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Analysis

Liquidity - the availability of cash or the ability to convert assets to cash to meet obligations important to creditors who are expecting to be paid

Liquidity measure: Working capital

Current assets minus current liabilities

LO 5

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Analysis

Debt-to-equity ratio: Liabilities

Shareholders equity

A measure of how an entity is financed - the higher the ratio, the more debt an entity is using relative to equity

LO 5

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Analysis

Using the income statement to assess performance

Gross margin = sales cost of sales

Gross margin % = Gross margin Sales

LO 5

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Materiality

Materiality is the significance of financial information to stakeholders Info. is material if its omission or misstatement

affects the judgment of the users of the financial statements

Financial statements should be free of material misstatements or errors, & all material info should be reported in the financial statements or notes because its absence may affect decision making

LO 1

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Accounting Equation (Revisited)

The income statement is part of the owners equity section of the balance sheet

A = L + (OE beginning + Revenue Expenses of the period-Dividends)

OR A = L + (OE beginning + Net Income-Dividends)

LO 2