CSC_Chapter11_Corporations and their Financial Statements_F2021.pptx

CHAPTER 11 Corporations and their Financial Statements Important Notes: • The slides used in this course are based on previous slides and content provided by the Canadian Securities Institute (CSI). They have been amended by Fanshawe College for the benefit of students. • Students must not rely on...

CHAPTER 11 Corporations and their Financial Statements Important Notes: • The slides used in this course are based on previous slides and content provided by the Canadian Securities Institute (CSI). They have been amended by Fanshawe College for the benefit of students. • Students must not rely on the slides in entirety and are encouraged to read the textbook chapters in full and utilize the online learning resources made available through CSI. Topics 1. 2. 3. 4. Types of Business Structures Financial Statements of a Corporation The Annual Report Public Company Disclosures and Investor Rights 5. Takeover Bids and Insider Trading 3 Chapter Highlights • There are three main types of business structure: sole proprietorship, partnership, and a corporation. • Financial statements provide a wealth of information about a company’s operations, profitability, and its going concern status. • They are used as a scorecard of the performance of current operations. • They also provide insight into future profitability. • On January 1, 2011 Canada moved from Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS) 4 Types of Business Structures 5 Types of Business Structures Let’s look at the characteristics of each of the following types of business structures: 1. Sole Proprietorship 2. Partnerships 3. Corporations 6 Types of Business Structures Sole Proprietorship (or Single Proprietorship) A business owned by one person who operates it for his or her own profit. Advantages Disadvantages  Own boss  Unlimited liability  All profits go to the owner  Easy to establish  Limited management ability  Limitations on size  Certain tax advantages  Tax disadvantages 7 Partnerships A partnership is a business that consists of two or more owners doing business together for a profit. General Partnership: • Owners involved in the day-to-day operations of the business. • Risk shared equally and each of the partners have unlimited liability. Limited Partnership: • Owners cannot participate in the daily operations of the business • Liability is limited to the amount of the limited partners investment. 8 Partnerships Advantages: • Easier to set up than a corporation • Can usually raise larger amounts of capital (than a sole proprietorship) • More management skills Disadvantages: • Conflicts • Unlimited liability • Limited life • Limited growth 9 Corporations A corporation is a legal entity that can sue, be sued, make and be party to contracts, and acquire property. Companies can be incorporated federally or provincially. Public corporation: A corporation that has one or more classes of shares that are publicly traded on a stock exchange or OTC. Private corporation: A closely held company. Limited number of shareholders (no more than 50). Charter prohibits inviting the public to subscribe for their securities. 10 Corporations Advantages of Corporations: • Limited liability • Continuity of existence • Transfer of ownership • Ability to finance • Growth • Professional management 11 Corporations Disadvantages of Corporations: • Loss of flexibility • Taxation – possibility of double taxation • Expense – annual costs • Capital withdrawal – can be complicated 12 Voting Rights • Common shareholders have certain rights based on their equity investment in the company. Voting Trusts • When a corporation is being restructured due to financial difficulties • Shareholders may be asked to give their voting rights to a trustee to prevent shareholder interference Managers Appoint Directors Elect Shareholders 13 Voting by Proxy • The proxy statement must accompany the notice of a shareholders’ meeting, along with an information circular informing the shareholder of issues for consideration at the annual meeting. • Such issues include: • details about proposed directors • directors’ and officers’ remuneration • interest of directors and officers in material transactions • the appointment of auditors • other matters to be acted upon at the meeting • Although shareholders are generally encouraged to attend the annual shareholders meeting and vote in person, most retail investors cast their votes by proxy. The proxy is typically a member of the company’s management team who is given authority through power of attorney to vote according to the shareholder’s intentions. • If a shareholder does not vote or leaves the items on the proxy statement unmarked, the ballot is automatically cast with management’s viewpoint. 14 AGM Reality • In many public corporations, the management group itself does not own a large percentage of the issued shares and may depend on the support of the shareholders at large. • At the annual shareholders’ meetings, enough shareholders normally sign proxy forms appointing management nominees as their proxy, so that management is able to carry any resolution it wishes. 15 Corporate Structure 16 Financial Statements of a Corporation 17 Who uses financial statements? • Management • Investors • Advisors • Analysts • Bankers (lenders) • Competitors • Regulators 18 Importance of Financial Statements • Indicator of the financial health of a company and thus the potential performance of the company’s securities. • Knowledge of a company’s present financial position and its past earnings record is needed when selecting securities. • Combine this information with an understanding of the industry, the economy in general, and the specific plans and prospects for the company in question to make a sound selection from investment alternatives. 19 International Financial Reporting Standards (IFRS) • On January 1, 2011 moved from GAAP to IFRS for publicly accountable enterprises. • IFRS is principle-based • The goal is to have good reporting objectives • GAAP was more rigid and rule based • IFRS requires more extensive and detailed disclosure • Private companies have the option to adopt IFRS 20 Four Financial Statements 1. The Statement of Financial Position (Balance Sheet) 2. The Statement of Comprehensive Income (Income Statement/Earnings Statement) 3. The Consolidated Statement of Changes in Equity (Statement of Retained Earnings) 4. The Consolidated Statement of Cash Flows (Cash Flow Statement) 21 Statement of Financial Position • Shows the financial picture of a company as at a single point in time. • Represents a snapshot of the company at one particular point in time, of “what the company has, and how they got it”. • Shows what the company ‘owns’ in the form of assets, and what it ‘owes’ in the form of liabilities. 22 Statement of Financial Position Assets = Equity + Liabilities Assets consist of what the company owns and what is owed to it. Equity represents the shareholder’s interest in the company. Also referred to as book value of company. Liabilities are what the company owes. 23 Statement of Financial Position ABC Company Statement of Financial Position as at December 31, 20XX Total Assets Total Equity Total Liabilities Total Equity and Liabilities 24 Assets Non-Current Assets Property, Plant and Equipment Goodwill Investments in Associates Current Assets Inventories Prepaid Expenses Trade Receivables Cash and Cash Equivalents 25 Assets Property, Plant & Equipment – capital assets • Capital assets consisting of land, buildings, equipment, tools, etc. used in the daily operations of the business • Generally not for resale • Carried at cost less amortization (except land) 26 Depreciation, Amortization & Depletion • Purpose: to allocate assets’ cost over its useful life to better match revenues and expenses • Depreciation - a normal cost of ‘doing business’ to record the ordinary wearing out of the firm’s capital assets • Amortization – the gradual writing off of intangible assets such as patents and trademarks. • Depletion is similar to amortization and is usually used by mining, oil, natural gas, timber companies and other extractive industries. • Annual allowances for depreciation, amortization and depletion appear as non-cash expenses in the statement of comprehensive income. 27 Depreciation Example A $100,000 piece of equipment is purchased. The firm believes that the equipment will have a useful life of 10 years and a residual value of $0. Straight Line: (Cost – Residual Value) / Useful Life Declining Balance: Assume a rate of 20% per year. 28 Depreciation Example Straight Line: $100,000/10 = $10,000 claimed as depreciation expense in each year. Declining Balance: Yr. #1 20% x $100,000 = $20,000 Yr. #2 20% x ($100,000 – $20,000) = $16,000 Yr. #3 20% x $64,000= $12,800 Yr. #4 20% x $51,200= $10,240 Etc. 29 Capitalization • Recording an expenditure as an asset rather than an expense so that the expense can be spread over more than one accounting period. • The asset is then amortized over a number of accounting periods. • Typically used for capital assets that generate returns over more than one period. • Also used for expenditures that arise from costs associated with assets that cannot yet be put to use or generate revenues. 30 Goodwill and other Intangible Assets • Goodwill is often defined as the probability that a regular customer will continue to return to do business. • How is goodwill created? • Goodwill appears on the purchasing company’s statement of financial position as the excess of the amount paid for the shares over their net asset value • Intangible assets lack physical substance. • These include: patents, copyrights, trademarks, franchises. 31 Investments in Associates • The degree of ownership a company has in another company • Significant influence is presumed to exist when a company owns 20% or more of the voting rights of the other company 32 Treatment of a Long-Term Investment The Issue: • Different degrees of ownership allow different levels of influence or control by the owner. • Different influence or control requires different accounting treatment. Levels Accounting Method Little Influence (<20%) Cost Significant Influence (20% – 50%) Equity Control (>50%) Consolidated 33 Cost Method (<20%) Consolidated Statement of Financial Position • Shown at cost as an investment. Statement of Comprehensive Income • Cash dividends reported as revenue from investments on earnings statement. 34 Equity Method (20% – 50%) • Concern that the owner can influence dividend policy Consolidated Statement of Financial Position • Shown at cost as “Investment in Associates” Statement of Comprehensive Income • Equity income is expressed as the proportional share of the profits (or loss) of the owned company….”share of profit of associates” • Reported as revenue on the earnings statement • But, not considered dividends thus is a non-cash source of funds 35 Equity Method (20% – 50%) Statement of Comprehensive Income- example: • SLE Inc. owns 30% of DKE Co. • DKE earned $475,000 (after tax) in its last fiscal year • SLE will report $142,500 on its earnings statement as equity income…..”share of profit as associates” • This amount will be removed when conducting a cash flow analysis 36 Consolidated Method (>50%) Consolidated Statement of Financial Position: • All assets and liabilities of subsidiary are combined with the parent’s assets. • Proportion of the subsidiary not owned by the parent shown as “non-controlling interest” under equity section. Example: SLE owns 75% of DKE • • SLE is the majority shareholder The 25% of the company that it does not own is reported as a non-controlling interest as it represents the interest outsiders have in the subsidiary company 37 Consolidated Method (>50%) Consolidated Statement of Comprehensive Income: • All sales & expenses of the parent and subsidiary are combined • The parent claims 100% of the subsidiary’s net income, and accounts for the portion it doesn’t have a right to as comprehensive income attributable to “non-controlling interests” • Thus before showing net profit, must deduct the proportion of earnings of minority owners • Minority interest or non-controlling interest in subsidiary companies • Is a non-cash transaction • The deduction made on the earnings statement represents the amount not owned by the parent company 38 Current Assets • Cash or other assets that will be realized, consumed, or sold, in the normal course of business (normally within one year) • • • • Inventories Prepaid expenses Trade Receivables Cash and cash equivalents • Key measure of liquidity to assess ability to meet day-to-day expenses 39 Inventories • The goods and supplies the company keeps in stock. • Valued at original cost or net realizable value – whichever is lower. If original cost is used, there are two commonly used methods: • Weighted average of all items in inventory • FIFO (first-in-first-out) – items acquired earliest are assumed to be used or sold first • Note: LIFO (last-in-first-out) – Not used in IFRS 40 Inventories (cont’d) Discussion: • If prices are changing, each of these methods produces a different inventory value and a different profit. • When prices are rising, which method produces the higher inventory value on the statement of financial position? • What if prices are falling? • What is the link between the Statement of Comprehensive Income and inventory? 41 Inventory - Example A computer company manufactured 1,000 hard drives in January at a cost of $125 each. In February, an additional 1,000 hard drives were manufactured at $150 each. Today, March 1st, the company sells 1,000 hard drives. 1. Calculate the remaining inventory using FIFO and Weighted Average cost. 2. How is the balanced sheet impacted and what about Cost of Goods sold and profit? 42 Inventory - Example A computer company manufactured 1,000 hard drives in January at a cost of $125 each. In February, an additional 1,000 hard drives were manufactured at $150 each. Today, March 1st, the company sells 1,000 hard drives. Total Cost = $125,000 + $150,000 = $275,000 Total Units = 2,000 Average Cost = $275,000 / 2,000 = $137.50 Remaining Inventory FIFO = 1,000 x $150 = $150,000 Avg Cost = 1,000 x $137.50 = $137,500 Cost of Goods Sold FIFO = 1,000 x $125 = $125,000 Avg Cost = 1,000 x $137.50 = $137,500 Therefore, FIFO results in highest inventory figure and highest profit figure. 43 Prepaid Expenses and Trade Receivables • Prepaid expenses: payment made by the company for services to be received in the near future. • Trade receivables (Accounts receivable): money owing to the company for goods or services it has sold 44 Equity Includes, but is not limited to: • Share capital • Share capital is the money paid in by shareholders. • Retained earnings • represent the profits earned over time that have not been paid out as dividends • Non-controlling interest • appears as a category when a company owns more than 50% of a subsidiary company and consolidates its financial statements. 45 Liabilities Non-Current Liabilities • Long-Term Debt • Deferred tax liabilities Current Liabilities • Current portion of long-term debt • Current taxes payable • Trade payables • Short-term borrowings 46 Deferred Tax Liabilities • Represents income tax payable in future periods. • Commonly results from temporary differences between the book value of assets and liabilities as reported on the statement of financial position and the amount used for income tax purposes. • Company will take the difference between the two amounts and multiply it by a future tax rate to arrive at the amount of future tax. 47 Statement of Comprehensive Income • Shows revenue and related expenses for a period ending at a specific point in time. • Shows adequacy of earnings to assure successful operation and provide income for holders of its securities. • Earning power and cash flow are of primary interest. 48 Statement of Comprehensive Income ABC Company Statement of Comprehensive Income for the Year Ended Dec. 31, 20XX Revenue Less: Cost of sales Gross Profit Plus: Other income Less: Distribution costs Less: Administration expenses Less: Other expenses Less: Finance costs Plus: Share of profit of associates Less: Income tax expense Profit 49 Statement of Comprehensive Income ABC Company Income Statement for the Year Ended Dec. 31, 20XX Revenue 100 Cost of sales (65) Gross profit 35 Other income 6 General expenses Distribution costs (10) Administrative expenses (2) Other expenses (3) Finance costs (2) Share of profit of associates 4 Income tax expense(12) Profit 16 Other comprehensive income 0 Total comprehensive income 16 50 Statement of Comprehensive Income – Key Items Revenue – Income from selling its main products or services Cost of Sales – expenses which go directly into the cost of manufacturing a product – the cost of goods purchased for resale Other Income – not directly related to a company’s normal operating activities (dividends and interest received from investments) 51 Statement of Comprehensive Income – Key Items General Expenses Distribution Costs – salaries and/ commissions to sales personnel and advertising Administrative Expenses – office salaries, accounting staff salaries and office supplies Other Expenses – expenses not directly related to the company’s normal operating activities 52 Statement of Comprehensive Income – Key Items Finance Costs – interest payments to debt holders Share of profit of associates – proportionate share of profit when company has significant influence without control Income tax expense – both current and deferred taxes 53 Statement of Changes in Equity Shows extent to which profits are distributed to shareholders or retained in the company. Links the Statement of Financial Position and Statement of Comprehensive Income 54 Statement of Cash Flows • Shows how cash was generated and spent during the year. • Identifies sources and uses of funds in operating, investing and financing activities. • Used to evaluate the company’s ability to generate cash for reinvestment, to repay debts, and pay dividends. 55 Statement of Cash Flows Operating Activities: • Begins with the company’s profit and adjusts for items such as depreciation, amortization and share of profit of associates that do not involve an outlay or receipt of cash. Financing Activities: • Include the proceeds from issuing shares • Funds received under long-term debt issues • Repayment of long-term debt and payment of dividends 56 Statement of Cash Flows Investing Activities: • Consist of outlays of cash to acquire capital assets • Receipts of cash on the disposal of capital assets • Dividends received from associates 57 The Annual Report 58 What’s in an Annual Report? • Is a publication that provides an overview of the firm’s finances and a review of its activities over the course of the previous year. • Notes to the Financial Statements • Includes, accounting policies used, more detailed descriptions of fixed assets, share capital, long-term debt and commitments and contingencies. • Potential investors should also look to the notes to ascertain whether the company uses derivatives for hedging or other purposes 59 What’s in an Annual Report? • Auditor’s Report • The auditor is appointed at the company’s AGM by resolution of the shareholders. • The auditor must express an opinion in writing as to the fairness of the company’s financial statements. • Contents of the Auditors Report • First paragraph – identified the statements that are covered • 2nd paragraph – outlines financial responsibility of management • 3rd paragraph – how the audit was conducted • 4th paragraph – gives auditor’s opinion in accordance with IFRS 60 Company Disclosures and Investor Rights 61 Continuous Disclosure Once a reporting issuer has distributed securities, the company must comply with the timely and continuous public disclosure requirements of the acts. These include: • Filing with the administrators annual and interim financial statements meeting prescribed standards of disclosure, and any material change reports • Sending to the shareholders: quarterly interim financial statements, comparative audited annual financial statements and notices of annual meetings 62 Investor Rights There are three statutory rights available to the purchaser of securities issued in Canada under prospectus requirements. 1. Right of Withdrawal 2. Right of Rescission 3. Right of Action for Damages 63 Investor Rights Right of Withdrawal The relevant securities legislation usually provides purchasers during a distribution by way of a prospectus with the right to withdraw from an agreement to purchase securities within two business days after receipt or deemed receipt of a prospectus and any amendment, by giving notice to the vendor or its agent. 64 Investor Rights Right of Rescission Most provinces give purchasers during a distribution by way of a prospectus the right to rescind or cancel a contract for the purchase of securities, if the prospectus or amended prospectus offering the security contains a material misrepresentation. 65 Investor Rights Right of Action for Damages The acts of most provinces provide that the issuer, the directors of an issuer, the seller of a security, the underwriter who signs a certificate for a prospectus, and any other person who signs a prospectus, may be liable for damages if the prospectus contains a material misrepresentation. 66 Takeover Bids and Insider Trading 67 Takeover Bids • An offer to the shareholders of a company to purchase the shares of the company that, with the offeror’s already owned securities, will in total exceed 20% of the outstanding voting securities of the company. 68 Insider Trading Insiders are generally defined to include: • A director or senior officer of the company, or a subsidiary • A person or company, who owns or controls, more than 10% of the voting shares of the company (excluding an underwriter) • A director or senior officer of a company which is itself an insider of the company due to ownership, control or direction over more than 10% of the voting shares of the company involved 69 Insiders Requirements • The insider must report to the administrators details of any change from the previous report (trading activity) within ten days after the trade takes place. • All reports filed with the administrator are open for public inspection. • Failing to file an insider report or giving false or misleading information are offences under the acts and are usually punishable by a fine. • Can lookup insiders on the following site: www.sedi.ca 70 A few summary points • A corporation’s owners are not personally liable for debts, losses, or obligations arising from its business activities. A corporation is owned by its shareholders but is taxed as a separate legal entity. • A corporation’s financial statements show what the company owns, how it was financed, and how much money it earned or lost over a given period. • After distributing securities to the public, a reporting issuer must comply with the timely and continuous public disclosure of information. • Investors in the securities of a public company have the right of withdrawal, the right of rescission, and the right to take legal action for damages. • A takeover bid is an offer to purchase the shares of the company that will exceed 20% of the outstanding voting securities of the company. • Insider trading is illegal! 71 Questions