Chapter 1 Notes PDF
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McMaster University
2015
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These are study notes for a chapter on financial accounting. The notes cover learning objectives, accounting systems, and types of business organizations.
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Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce LEARNING OBJECTIVES After studying Chapter 1, you should be able to: 1. Explain why accounting is the language of business 2. Explain accounting’s conceptual framework and underlying assumptions 3. Describe the purpose of e...
Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce LEARNING OBJECTIVES After studying Chapter 1, you should be able to: 1. Explain why accounting is the language of business 2. Explain accounting’s conceptual framework and underlying assumptions 3. Describe the purpose of each financial statement and explain the elements of each one 4. Explain the relationships among the financial statements 5. Make ethical business decisions Copyright © 2015 Pearson Canada Inc. 1-1 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce OBJECTIVE 1: Explain why accounting is the language of business A. Accounting is an information system that measures business activities, processes data into reports, and reports results to decision makers. Exhibit 1-1 illustrates the flow of information in an accounting system. Financial statements report this information to users. B. Accounting information is used by 1. Managers to set goals, evaluate those goals, and take corrective action. 2. Investors to decide whether to invest in a business or evaluate an investment. 3. Creditors to evaluate a borrower’s ability to make required payments. 4. Government and regulatory bodies such as Canada Revenue Agency (CRA) to ensure organizations pay the correct amount of taxes. 5. Individuals to make investment decisions and/or manage a bank account. 6. Not-for-profit organizations, which use accounting information in virtually the same way as profit organizations. C. Accounting information can be classified into two categories: 1. Financial accounting provides information for managers inside the business and for decision makers outside the organization, such as investor and creditors. 2. Managerial accounting generates inside information for internal use by management. D. Types of business organizations (summarized in Exhibit 1-2): 1. Proprietorship—an unincorporated business with a single owner. The owner has unlimited liability which means that the owner assumes personal responsibility for the debts of the business. 2. Partnership—an unincorporated business with two or more owners. Each partner has unlimited liability. 3. Corporation—an incorporated business owned by shareholders whose ownership is evidenced by the number of shares held. Shareholders elect the members of the board of directors, which sets policy for the corporation and appoints officers. A shareholder has limited liability. A corporation is distinct from its owners and has many of the rights entitled to a person. Copyright © 2015 Pearson Canada Inc. 1-2 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce OBJECTIVE 2: Explain accounting’s conceptual framework and underlying assumptions A. Generally Accepted Accounting principles (or GAAP) are the professional guidelines that govern how accountants record, measure, and report financial information. 1. The Canadian Institute of Chartered Accountants (CICA) establishes GAAP. 2. There are multiple sets of GAAP and each is applicable according to the type of entity or organization. a. Publicly accountable enterprises (PAEs) must apply International Financial Reporting Standards (IFRS) which are standards set by the International Accounting Standards Board (IASB) to enhance the comparability of financial information reported by public enterprises around the world. IFRS was effective January 1, 2011 for Canadian public companies. b. Private enterprises apply the Accounting Standards for Private Enterprises (ASPE). However, private enterprises have the option of using IFRS or ASPE. c. Other sets of GAAP are applicable to not-for-profit organizations, pension plans and government entities. 3. A summary of IFRS-ASPE differences is presented at the end of the chapter. B. The overall objective of financial reporting is to provide useful information to users to make investing and lending decisions. The characteristics of useful information include: relevance, faithful representation, comparability, verifiability, timeliness and understandability. (Exhibit 1-3 provides an overview of accounting’s conceptual framework.) 1. The relevance characteristic must be considered to ensure the financial statements provide information to the user that is useful. To be relevant, financial information must provide predictive and/or confirmatory value and must be material in nature or magnitude that omitting or misstating it could affect the decisions of an informed user. 2. The faithful representation (or reliability) characteristic states that accounting records should be based on accurate data. The actual cost of assets or services is usually more reliable than market value. NOTE: Consider the conflict between information that is timely (based on estimates) and reliable that may require additional time to ensure accuracy that may render the statements irrelevant. C. There are four accounting assumptions underlying the conceptual framework. 1. The going-concern assumption assumes that the entity will remain in operation for the foreseeable future. The market values of assets may vary from year to year, and for this reason cost is deemed to be preferable to market value for measurement purposes. 2. The separate-entity assumption states that each entity is an economic unit and is kept separate from other entities including the activities of its owners. Assume that you own three businesses and maintain one chequebook for all three. How can this situation prevent you from maximizing your profits? (If one or two of the businesses are unprofitable, then you would make more money without them. However, you would have no way of knowing.) The entity concept would require a separate set of records for each business. 3. The historical-cost assumption states that assets should be recorded at actual cost. Copyright © 2015 Pearson Canada Inc. 1-3 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce You purchased some land on January 1 of the current year. You had to borrow $100,000 for 2 years at 10% interest at the local bank that appraised the land for $105,000. You will eventually pay $100,000 plus $20,000 for the interest. On December 31 of the current year, you receive an offer for the land for $110,000, but you do not want to sell the land. At what value should the land be reported on the balance sheet? The original cost (excluding interest) of $100,000. 4. The stable-monetary-unit assumption allows accountants to ignore the effect of inflation in the accounting records thus reporting under the assumption that the value of the currency is stable. Copyright © 2015 Pearson Canada Inc. 1-4 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce OBJECTIVE 3: Describe the purpose of each financial statement and explain the elements of each one A. The financial statements provide a company’s financial results for users to make decisions. The income statement for TELUS Corporation is presented. B. The financial statements provide answers to four basic questions. The financial statements that would be used to answer these questions are summarized in Exhibit 1-4. 1. How well did the company perform during the year? (The answer is found on the income statement) 2. Why did the company’s retained earnings change during the year? (The answer is found on the statement of retained earnings.) 3. What is the company’s financial position at the end of the year? (The answer is found on the balance sheet.) 4. How much cash did the company generate and spend during the year? (The answer is found on the statement of cash flows.) C. The Income Statement (or statement of profit or loss) reports the revenues, expenses, and net income or net loss of a company for a specified period of time. (The Consolidated Statements of Income for TELUS Corporation is illustrated in Exhibit 1-5.) 1. TELUS Corporation has chosen a fiscal year ending at the same time as the calendar year. However, a company can choose a fiscal year that is not the same as a calendar year. Most of Canada’s big banks have a fiscal year-end of October 31. 2. TELUS Corporation reports operating results for two fiscal years for comparability purposes enabling users to detect any trends. 3. The income statement has two main elements: income and expenses. a. Income includes revenue earned through the sale of goods and services and gains. b. Gains reflect an increase in the economic benefits to a company usually due to a transaction outside of the company’s ordinary business activities. For example, the sale of a long-lived asset which exceeds the carrying amount on a company’s books. c. Expenses consist of costs incurred to purchase goods and services to run a business and losses. d. Losses are the opposite of gains and reflect a decrease in the economic benefits to a company usually due to a transaction outside of the company’s ordinary business activities. For example, the sale of a long-lived asset which does not exceed the carrying amount on a company’s books. 4. The major expense for TELUS Corporation is called Cost of Goods Sold, which represents the cost of the goods TELUS Corporation sold to its customers. 5. The Income Statement reports net income or net loss which is equal to Total Revenues and Gains less Total Expenses and Losses or the amount of income or loss that is left after total expenses have been deducted from total income. 6. Net income is sometimes known as net earnings or net profit. Copyright © 2015 Pearson Canada Inc. 1-5 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce D. The Statement of Retained Earnings reports the changes in a company’s retained earnings during a specified period and reflects the accumulated net income of the company since it started business. (The Consolidated Statements of Retained Earnings for TELUS Corporation is illustrated in Exhibit 1-6.) 1. The Net Income reported on the income statement is added to the opening balance of retained earnings. 2. After a company earns net income, the board of directors must decide whether to retain the income for use in the business or to pay dividends. Dividends reduce retained earnings. TELUS Corporation declared dividends of $715 million in 2011. E. The Balance Sheet (or statement of financial position under IFRS) reports a company’s financial position at a moment in time. (The Consolidated Balance Sheets of TELUS Corporation is illustrated in Exhibit 1-7.) 1. The balance sheet is dated as of the last day of the period. The amount of assets reported is the amount of assets TELUS Corporation owned as of the last day of the accounting period. The other financial statements cover a period of time. 2. The balance sheet reports three main categories: Assets, Liabilities, and Shareholders’ Equity (TELUS Corporation’s term for owners’ equity). The relationship between these categories is known as the accounting equation where assets always equal the sum of liabilities and owners’ equity: A=L+OE. Exhibit 1-8 illustrates the accounting equation using the 2011 figures from the Balance Sheet of TELUS Corporation. Beginning assets and shareholders’ equity are $120,000 and $30,000, respectively. Liabilities increased $15,000 during the year, and the ending assets are $145,000. What was the ending shareholders’ equity? Assets = Liabilities + Shareholders’ Equity Beginning of year $120,000 = X+ $30,000 X= $90,000 End of year $145,000 = (90,000+15000) + X X=$40,000 3. Assets are economic resources owned by a business that are expected to be of benefit in the future. Assets are divided into two categories: current and non-current (long-term) assets. a. Current assets are those assets that the company expects to convert to cash, sell, or consume during the next 12 months or within the business’s normal operating cycle if longer than a year. i. The operating cycle is the time span during which (a) cash is used to acquire goods and services, and (b) these goods and services are sold to customers, from whom the business collects cash. ii. Examples of current assets are: Cash. Receivables--the amount that a company expects to collect from its customers who bought merchandise on credit. Inventory--the merchandise TELUS Corporation sells to its customers. Prepaid expenses--the amount of advertising, rent, insurance, and/or supplies that TELUS Corporation has already paid for but has not yet used. b. Non-current assets (or long-term assets) consist mainly of property, plant, and equipment. These assets are partially used, or amortized. TELUS Corporation also Copyright © 2015 Pearson Canada Inc. 1-6 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce reports Goodwill and Intangible Assets. Intangible Assets are assets with no physical form such as patents and trademarks. Other Assets is a category for assets not reported elsewhere on the balance sheet. How a business comes up with the funds to acquire additional assets? A company can borrow (liabilities), or use invested funds (owners’ equity), or hopefully, earn it (also owners’ equity). 4. Liabilities are debts the entity owes as a result of a past event, and which it expects to pay off in the future using some of its assets. Liabilities are also divided into current and non- current/long-term categories. a. Current liabilities are debts that are payable within one year or within the entity’s normal operating cycle if longer than a year. i. Examples of current liabilities are: Accounts payable represents amounts owed for goods and services that have been purchased but not yet paid for. The word payable indicates a liability. Notes payable—amounts borrowed with a promise to pay back within the year Income taxes payable is the amount owed to the government for income taxes. b. Non-current liabilities (or long-term liabilities) are due in periods beyond the next twelve months. 5. Owners’ Equity is the owners’ remaining interest in the assets of the company after deducting all its liabilities. a. Owners’ equity or shareholders’ equity in the case of a corporation like TELUS Corporation has four common components: i. Share capital refers to the amounts contributed by shareholders in exchange for shares. ii. Contributed surplus which consists of amounts contributed by shareholders in excess of share capital. iii. Retained earnings which comes from the statement of retained earnings represents the amount of net income that has been reinvested in the business. Revenues are amounts earned by delivering goods or services. Revenues increase net income and therefore also increase retained earnings. Expenses are the costs of operating a business. Expenses decrease net income and therefore also decrease retained earnings. If expenses exceed revenues, the result is a net loss. Dividends are distributions of assets (usually cash) to the shareholders. The amount of dividends declared is determined after net income is computed. Dividends decrease retained earnings because they represent the amount of the net income that is not reinvested in the business. iv. Accumulated other comprehensive income which is an accumulation of past earnings not included in retained earnings and is required under IFRS. Copyright © 2015 Pearson Canada Inc. 1-7 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce g e b. The owners’ equity of n proprietorships and of e partnerships makes no r distinction between a what is invested and t what is earned. The e equity of each owner is accounted for under the s single heading, Capital. a l F. The Statement of Cash Flows e reports the sources and uses of s cash from the three major. activities of a business-- b. Investing Activities relate to the purchase operating, investing, and and sale of long-term assets that a financing. (The Consolidated company uses to conduct is operations. Statements of Cash Flows for TELUS Corporation pays cash to TELUS Corporation is purchase assets and receives cash when illustrated in Exhibit 1-9.) assets are sold. 1. The three major activities c. Financing Activities relate to the way a include: company acquires the funds used for a. Operating Activities investing and operating activities. A relate to the business can finance its activities by transactions and other borrowing from a bank or other lender, events that determine issuing shares to its owners, and paying net income/ (loss). dividends. i. Cash receipts from a Operating activities are the most important because company’s sales without them there is no need for the other two. of its primary Investing activities are of secondary importance goods and because a company’s current and future operating services. ii. Cash effectiveness is determined by wise investment payments to decisions. suppliers and employees for the G. Notes to the financial statements are provided as goods and an integral part of the financial statements and services should be read carefully as part of a review of the t financial statements. h e y p r o v i d e t o Copyright © 2015 Pearson Canada Inc. 1-8 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce OBJECTIVE 4: Explain the decision making process. relationships among the financial statements A. Exhibit 1-10 summarizes the relationships among the financial statements 1. The income statement is the only financial statement that lists revenues and expenses. a. Net income (or net loss), the difference between revenues and expenses, is reported on the income statement. b. This amount is then used on the statement of retained earnings. 2. The statement of retained earnings reports the following: a. The beginning balance of retained earnings; b. The addition of net income or the subtraction of net loss to that beginning balance; c. The subtraction of dividends; and d. The ending balance of retained earnings. e. The ending balance is used on the balance sheet. 3. The balance sheet is the only financial statement that reports all assets, liabilities, and owners’ equity. The balance sheet must show that the assets equal the sum of liabilities and owners’ equity. 4. The statement of cash flow reports cash flows from three types of business activities-- operating, investing, and financing. a. A net cash flow is reported for each activity. b. The ending cash balance is reported. This amount should also be reported on balance sheet. B. The Decision Guidelines summarize how people use financial statements in their Copyright © 2015 Pearson Canada Inc. 1-9 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce CHAPTER 1 Circle the letter of the best response. 1. Which of the following statements is false? A. Accounting is the information system that measures business activities, processes that information into reports, and communicates the results to decision makers. B. Financial statements report financial information about a business entity to decision makers. C. Owners of a corporation are not personally liable for the debts of the corporation. D. The purpose of financial accounting is to provide information to people inside the entity, such as the owners and managers. 2. Mary owns and operates a fabric shop. Mary needs to borrow money to expand; therefore, she prepared financial statements to present to her banker. Mary recorded the assets of her store at the cost she paid for them 2 years ago rather than when she transferred them to her business this year. Mary has violated which of the following principles or concepts? A. Reliability principle B. Entity Assumption C. Going-concern principle D. Stable-monetary-unit concept 3. Which of the following is false? A. Owners’ Equity - Assets = Liabilities B. Assets = Owners’ Equity + Liabilities C. Owners’ Equity = Assets - Liabilities D. Liabilities = Assets - Owners’ Equity 4. SMT Inc. experienced an increase in total assets of $2,000 during the current year. During the same year, total liabilities decreased $6,000. If dividends for the year were $10,000 and the owners made no additional investment, how much was net income? A. $14,000 B. $6,000 C. $18,000 D. $2,000 5. Which of the following statements is true? A. The cash flow statement reports all changes in assets, liabilities, and shareholders’ equity of the business during the period. B. Revenues and expenses are reported only on the balance sheet. C. The income statement reports cash flows from three types of business activities--cash receipts, cash payments, and investing. D. On the statement of retained earnings, any dividends for the period are subtracted from the beginning balance of retained earnings. Copyright © 2015 Pearson Canada Inc. 1 - 10 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce Table 1-1 The following information is taken from the accounting records after current period operations and presented in random order. Accounts payable $ 9 Service revenue 38 Cash 25 Equipment 110 Common shares 200 Retained earnings (ending balance) ?? Dividends 15 Accounts receivable 4 Land 100 Office supplies 5 Utilities expense 2 Salary expense 18 Cash receipts: Cash payments: Collections from customers 30 Acquisition of land 50 Sale of equipment 15 Issuance of shares to owners 90 Dividends 15 To suppliers 5 6. Total assets are: A. $150. B. $181. C. $244. D. $158. 7. Net income is: A. $18. B. $36. C. $120. D. $20. 8. Cash flow from financing activities is: A. $(85). B. $(55). C. $75. D. $(15). 9. The ending balance in Retained Earnings is: A. $35. B. $55. C. Copyright © 2015 Pearson Canada Inc. 1 - 11 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce $75. D. $15. 10. On which financial statement can the Beginning balance in retained earnings be found? A. Balance sheet B. Income statement C. Statement of retained earnings D. Both A and C Copyright © 2015 Pearson Canada Inc. 1 - 12 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce ANSWER KEY 1. D 2. B 3. A 4. C 5. D 6. C 7. A 8. C 9. A Explanation: The answer to Q9 is $35, which is the amount needed to get the balance sheet to balance (Total Assets = $244; Total Liabilities and Shareholder's Equity, excluding Retained Earnings = $209). 10. C Copyright © 2015 Pearson Canada Inc. 1 - 13