Chapter 1 Fundamental Accounting Principles, Volume 1 PDF

Page 1 CHAPTER 1 Accounting in Business A Look at This Chapter Whether you are embarking on a new career, are managing an investment account, or have an entrepreneurial spirit like Molly Burke from our opening vignette, a clear understanding of accounting will provide you with the tools to make effective decisions. Accounting is the system of recording and interpreting financial information to make relevant decisions. In this chapter, we discuss the significant role of accounting in organizations today and describe its many users and uses. Photographer Nathan Tescon/Molly Burke Inc. LEARNING OBJECTIVES LO1 Describe the purpose and importance of accounting. LO2 Describe forms of business organization. LO3 Identify users and uses of accounting and opportunities in accounting. LO4 Identify and explain why ethics and social responsibility are crucial to accounting. LO5 Identify, explain, and apply accounting principles. LO6 Identify and explain the content and reporting aims of financial statements. LO7 Analyze business transactions by applying the accounting equation. LO8 Prepare financial statements reflecting business transactions. * Appendix 1A LO9 Describe the tools used by today’s businesses to analyze data collected from all aspects of their business. An asterisk (*) identifies appendix material. Page 2 A Canadian Social Media Success Story Molly Burke’s story is incredibly unique and profoundly impactful. From birth, Molly was night blind with the ability to see during the day. By the time she was four years old, Molly was diagnosed with retinitis pigmentosa, a genetic disorder that slowly deteriorates and causes loss of vision. By the age of 14, her vision had deteriorated to the point that she was legally blind. Throughout her life Molly has experienced many challenges, including trying to navigate her world with progressively deteriorating vision while interacting socially with peers and adapting to her learning environment. By 13, as her vision loss significantly increased, she was severely bullied by a group of girls at school who once were her friends. All these challenges led to her suffering from depression, anxiety, and suicidal thoughts at the young age of 14. It wasn’t until she found the strength to face her challenges and the courage to reach out that she came to find her purpose—bringing hope to others. Molly has been engaged with motivational speaking since the age of five, as she became involved with raising awareness for Fighting Blindness Canada. At 15, with a goal to educate, motivate, and inspire others, she won the Miss Teen Canada International pageant, as the first person with a disability to hold the coveted position. After high school Molly began her career as a motivational speaker, working with International Me to We, We Charity (Free the Children), and We Day and speaking at corporate events including KPMG, Unilever, and General Mills. She also started her own YouTube channel as another creative outlet to continue to educate on issues of disability awareness—as she did as a motivational speaker, but now about the things that she is personally passionate about. In her uplifting videos, she shares her love for fashion and makeup, her pets, dating stories, home décor, health and exercise, and life as a blind woman navigating the world around her. Molly has made herself known in facets beyond YouTube and motivational speaking through her work as a model, author, and creating her own corporate brand—Molly Burke Official. The businesses that associate with Molly include brands such as Dove, Johnson & Johnson, Samsung, Allure magazine, and Special K’s partnership with the UN’s Girl Up. Molly has acted in commercials with Dove and was one of Aerie’s REAL Role Models. She also is the author of an audiobook, It’s Not What It Looks Like, on Audible. She engages in collaborations with fellow top-level social media influencers like Charli D’Amelio and James Charles. Molly wakes up every day with the intention to educate, motivate, and inspire one person with her story. She travels the world with her guide dog Gallop, speaking on topics ranging from accessibility and diversity to bullying prevention, mental health, female empowerment, equality, and leadership. She has worked with the World Economic Forum to bring awareness to “Closing the Disability Inclusion Gap” in promoting the Valuable 500 initiative, putting disability on the business leadership agenda. She encourages others to understand that “nobody is defined by the challenges that they face but only by the strength that it has given them,” and works to make the world better and more accessible. Molly’s strength of character, inner determination, and strong support system have given her the tools to face her challenges and the courage to pursue her dreams, all while bringing positivity and hope to others. Her goal is to educate, motivate, and inspire others to find peace, happiness, and achieve their goals, even in the darkest days. Today, Molly has over 3 million followers across her various social media platforms. According to Molly, her “ultimate goal in life is to see bullying end, to see less stigma around mental health and to see people with disabilities treated as equal humans.” Throughout her life Molly has learned to embrace creativity, and indicates one of the benefits of a disability is that it “forces you to think outside the box every day.” Sources: Interview with Molly Burke, October 20, 2020; www.mollyburkeofficial.com; www.valuable500.com; “Every Way Being Blind Makes My Life Different (Ft. Molly Burke),” Allure, https://youtu.be/zE9U7zuLDFI, accessed March 30, 2021; Molly Burke Talks #DoWhatYouCant, https://youtu.be/fgkCq9-kyo4, accessed March 30, 2021; Molly Burke and Edward Ndopu: Closing the Disability Inclusion Gap, DAVOS 2020, https://youtu.be/qOKFPG98ef8, accessed March 30, 2021. CRITICAL THINKING CHALLENGE What questions might Molly Burke need to answer in order to get a loan from a bank to expand her “merch” (merchandise inventory)? Who else might require accounting information from Molly’s business? Answer The key question the bank wants answered is whether Molly Burke (MB) can repay the loan. In order to assess this, the bank would ask questions such as the following: Financial Results: How much is the business earning per year? How profitable have MB’s events been for the past year? How much are revenues and expenses? How are the results compared to the past year or couple of years? Where are results expected to be in the next few years? Cash: How much cash does MB currently have? How much is being requested for the loan? What is MB’s credit score? Debt: Are there any outstanding loans? If so, what is the balance outstanding, term, payment schedule, and interest rate? Assets: What personal or business assets does MB have? The bank may want to take some of MB’s assets as collateral. Customers: How many customers on average are served per day? How many are new or repeat customers? Employees: How many employees does MB need to hire to meet the needs of her sponsorship deliverables? Does MB pay employees a salary or a wage? How much does MB pay them? Does MB have cash in the bank to pay employees? Production Assets: Does MB own any assets that are used in the production of creative outlets? If so, does MB pay cash or is money owed on them? If MB owes money, is interest charged? Does MB lease production assets? Does MB have insurance? Creative/Production Products (Inventory): How does MB manage merchandise inventory? Does it become obsolete? If so, over what time period? Advertising: Does MB advertise? If so, how much does MB pay for advertising? Taxes: What amount of income tax does MB pay? There are many other questions that could be asked. ↑ An essential element of critical thinking is the ability to ask questions while reading (or listening or speaking). This exercise is designed to help students develop the skills related to questioning. Suggested answers are available within the answer tab (eBook) or at the end of the chapter (print). Page 3 CHAPTER PREVIEW ↑ A chapter preview introduces the importance and relevance of the material, and also links these materials to the opening article to help you understand how what you are learning in the chapter relates to the real world through practical examples. Accounting information pulsates throughout an organization, feeding decision makers with key details needed to make important decisions and navigate through today’s competitive business environment. Whether your future role is in accounting, human resources, finance, operations, marketing, or strategy, you will find the study of financial accounting integral to your ability to make relevant decisions. Understanding accounting terms such as revenue, expenses, assets, liabilities, and profitability is critical to effectively analyzing the financial performance of any business. Through your study of this book, you will learn key accounting concepts and develop an ability to interpret financial information that is essential for making sound business decisions. This first chapter accomplishes three goals in your journey toward understanding financial accounting. First, it introduces the subject of accounting and helps you to deepen your understanding of the role of accounting in business, including the importance of ethics and social responsibility in producing trustworthy financial reports. Second, it demonstrates how accounting information is created and communicated in the form of financial statements, which report on the financial performance and condition of an organization. Chapter concepts are illustrated through an in-depth demonstration of how a young entrepreneur, Hailey Walker, handles financial information as she pursues the initial start-up phase in her new food truck business, Organico. Her goal is to capitalize on the increasing consumer demand for healthier options in the fast food market by specializing in fresh, organic Mexican burritos. The illustration begins with Walker registering her business name and commencing her first month of operations on March 1, 2023. Third, this chapter introduces you to each of the learning features found in most chapters. For example, a note above explains the purpose of the chapter preview, and three additional features—learning objectives, boldfaced key terms, and real company names—are described below. Some of the features refer to Connect, located on the Web. Take the time in this chapter to explore and learn the value of these additional resources. What Is Accounting? LO1 Describe the purpose and importance of accounting. ↑ Each chapter is separated into chunks of information called learning objectives (LO). Each LO tells you what needs to be mastered in that section of reading. Accounting knowledge is a powerful tool; it provides you with essential information to make critical business decisions. How does accounting knowledge give you power? What exactly is the focus of accounting? This section answers these fundamental questions. Page 4 POWER OF ACCOUNTING Accounting is an information system that identifies, measures, records, and communicates relevant information that objectively and correctly represents an organization’s economic activities,1 as shown in Exhibit 1.1. Its objective is to help people make better decisions. It also helps people better assess opportunities, products, investments, and social and community responsibilities. In addition to reporting on the performance of a business, what the business owns, and what it owes, accounting opens our eyes to new and exciting possibilities. Put more simply, accounting involves collecting relevant information, recording it, and then reporting it to various decision makers. In the chapter-opening story, for example, Molly Burke Official collects and records accounting information so that it can be used to help her make important decisions for her business—such as negotiating prices for sponsorship and consulting opportunities, and developing an effective brand strategy. ↑ Boldfaced words or phrases represent new terminology that is explained here and defined in the glossary at the end of the chapter. Real organization names are printed in bold magenta the first time they are mentioned in each chapter. EXHIBIT 1.1 Accounting Activities (left) © Diane Diederich/istockphoto.com; (centre) © JGI/Tom Gril/Blend Images LLC; (right) © shironosov/istockphoto.com FOCUS OF ACCOUNTING Accounting for our personal finances enables us to better manage and plan for our future. Examples of common personal points of contact with financial accounting include applying for credit approvals, opening bank accounts, filling out student loan forms, and making decisions regarding whether to purchase a new or a used car. These experiences often focus on the recordkeeping (or bookkeeping) parts of accounting. Recordkeeping, or bookkeeping, is the recording of financial transactions, either manually or electronically, for the purpose of creating a bank of data that is complete, neutral, and free from error. Accounting involves the recordkeeping process but is much more. Accounting also involves designing information systems to provide useful reports that provide relevant information in monitoring and controlling an organization’s activities. In order to use the reports effectively, decision makers must be able to interpret the information. The skills needed to understand and interpret accounting information are developed through building a foundation in accounting concepts and developing an understanding of recording transactions through the recordkeeping process. The use of technology in recordkeeping reduces the time, effort, and cost of accounting while improving accuracy. As technology has changed the way we store, process, and summarize masses of data financial analysis tools have improved, resulting in improved decision making. Consulting, planning, and other financial services are now closely linked to accounting. These services require sorting through data, interpreting its meaning, identifying key factors, and analyzing its implications. Because accounting is part of so much that we do in business and our everyday lives, you can enjoy greater opportunities if you understand and are able to use accounting information effectively. Page 5 CHECKPOINT 1. What is the major objective of accounting? 2. Distinguish between accounting and recordkeeping. Do Quick Study questions: QS 1-1, QS 1-2 ↑ A series of Checkpoint questions in the chapter reinforce the immediately preceding materials. These questions give you feedback on your comprehension before you go on to new topics. Answers to these Checkpoint questions are available for you at the end of each chapter. ↑ Answers to the Quick Study (QS) questions are available on Connect. Forms of Organization LO2 Describe forms of business organization. A business is an entity represented by one or more individuals selling products or services for profit. Products sold include anything from athletic apparel (Adidas, Fabletics, Lululemon Athletica, Nike, Reebok) to electronic devices (Apple, Dell, Hewlett-Packard, Samsung) and clothing (Abercrombie & Fitch, The Gap, Zara, H&M). Service providers such as data communication providers (Bell, Rogers, Telus), food services (McDonald’s, Starbucks, Tim Hortons), and Internet services (Google, Twitter, Skype, Facebook, TikTok, Instagram) make our lives more connected. A business can be as small as an in- home tutoring business or as large as George Weston Limited, the food processing company known for its President’s Choice and No Name brands, owner of the clothing label Joe Fresh, and holder of a significant investment in the supermarket chain Loblaw Companies Limited. Nearly 100,000 new businesses are started in Canada each year, with most of them being founded by people who want freedom from ordinary jobs, a new challenge in life, or the potential of earning extra money. Most organizations engage in economic activities such as the business activities of purchasing materials and labour, and selling products and services. They can also involve activities for non-business organizations, more commonly referred to as not-for-profit organizations, such as government, schools, and health care and charities. Non-business organizations do not plan and operate for profit, but rather for other goals such as health, education, and cultural and social activities. A common feature in all organizations, both business and non-business, is the reliance on reported financial information to successfully run the organization. Page 6 BUSINESS ORGANIZATIONS When a business is initially established, the owner(s) need to select one of the four legal business structures: sole proprietorship, partnership, limited liability partnership, or corporation. Sole Proprietorship A sole proprietorship, or single proprietorship, is a business owned by one person. Initial setup of a sole proprietorship is relatively easy and inexpensive. No special legal requirements must be met in order to start this form of business, other than to file for a business licence and register the business name. While it is a separate entity2 for accounting purposes, it is not a separate legal entity from its owner. This means, for example, that a court can order an owner to sell personal belongings to pay a proprietorship’s debt. An owner is even responsible for debts that are greater than the resources of the proprietorship; this is known as unlimit ed liability. This unlimited liability is a clear disadvantage of a sole proprietorship, because tax authorities do not separate a proprietorship from its owner; the profits of the business are reported and taxed on the owner’s personal income tax return. Small retail stores and service businesses often are organized as proprietorships. Partnership A partnership3 is owned by two or more persons called partners. Similar to a proprietorship, no special legal requirements must be met in order to start a partnership, other than to register the business name and obtain a business licence. To run the business together, the partners need an oral or written agreement that usually indicates how profits and losses are to be shared, referred to as a partnership agreement. A partnership, like a proprietorship, is not legally separate from its owners; therefore, each partner’s share of profits is reported and taxed on that partner’s tax return. Partners are usually subject to unlimited liability, meaning they are personally responsible for the debts of the business. Limited Liability Partnership (LLP) A limited liability partnership (LLP) is a partnership structure where liability is limited even for the general partner. If the general partner does something wrong and is sued, their personal assets are at risk but the other limited partner’s personal assets will be protected. A limited partner’s liability is capped at the amount of capital they contribute. The LLP form of business structure is available only for law firms, accounting firms, and medical partnerships. Corporation A corporation4 is a business that is set up as a separate legal entity chartered (or incorporated) under provincial or federal laws. A corporation is responsible for its actions and any debts incurred. It can enter into its own contracts, and it can buy, own, and sell property. It can also sue and be sued. Separate legal status not only gives a corporation an unlimited life, but also entitles the corporation to conduct business with the rights, duties, and responsibilities of a person. As a result, a corporation files a tax return and pays tax on its profits. A corporation acts through its managers, who are its legal agents. Separate legal status also means that the shareholders are not personally liable for corporate acts and debts. Shareholders are legally distinct from the business and their loss is limited to whatever resources they have invested. This limited liability is a key to why corporations can raise resources from shareholders who are not active in managing the business. Ownership, or equity, of all corporations is divided into units called shares. Owners of shares are called shareholders (another term for shares is stock and for shareholders, stockholders). A shareholder can sell or transfer shares to another person without affecting the operations of a corporation. When a corporation issues (or sells) only one class of shares, we call them common shar es. A corporation that sells its shares to the public is called a publicly accountab le enterprise (PAE). The public sale of shares refers to the trading of shares in an organized stock market such as the Montreal or Toronto stock exchanges. A p rivate enterprise (PE) is a corporation that does not offer its shares for public sale. Canadian Tire Corporation is an example of a publicly accountable enterprise. Its shares are available on the Toronto Stock Exchange, and as of December 31, 2020, Canadian Tire had a total of 60.81 million shares issued to the public. This means that Canadian Tire Corporation’s ownership is divided into 60.81 million units. McCain Foods is a Canadian corporation that is a private enterprise. McCain’s shares are held by a small group of individuals and are not for sale to the public. Exhibit 1.2 lists some of the characteristics of each business form. Page 7 EXHIBIT 1.2 Attributes of Businesses Sole Partnership Corporation Limited Proprietorship Liability Company (LLC) Number of owners One owner; easy Two or more One or more One or more to set up owners, owners, called owners, called called shareholders; can members partners; get many easy to set up investors by selling stock or shares of corporate ownership* Business taxation No additional No additional Additional No additional business income business corporate income business tax income tax tax income tax Owner liability Unlimited Unlimited Limited liability. Limited liability. Owner liability. Owners, called liability. is personally Partners are shareholders (or Owners, called liable for jointly liable stockholders), are members, are proprietorship for not liable for not personally debts. partnership corporate acts and liable for LLC debts. debts. debts. Legal entity Not a separate Not a A separate entity A separate legal entity separate legal with the same entity with the entity rights and same rights responsibilities as and a person responsibilities as a person Business life Business ends Business Indefinite Indefinite with owner death ends with a or choice partner death or choice *When a corporation issues only one class of stock, it is called common stock (or capital stock). CHECKPOINT 3. Identify examples of non-business organizations. 4. What are the four common forms of business organiza tion? Do Quick Study questions: QS 1-3, QS 1-4 Page 8 Users of Accounting Information LO3 Identify users and uses of accounting and opportunities in accounting. Accounting is a service activity that serves the decision-making needs of external and internal users, as shown in Exhibit 1.3. EXHIBIT 1.3 Users of Accounting Information © Photolink/Getty Images © Yuri Arcurs/iStockphoto EXTERNAL INFORMATION USERS External users of accounting information are any party outside the company that relies on the company’s reported accounting information to make financial decisions. These users often hold a financial interest in the company but are not involved in day-to-day operations. They include existing and potential shareholders, lenders such as banks, and other creditors such as suppliers and bondholders. Each external user has special information needs that depend on the kind of decisions to be made. To make decisions, these individuals do not have access to internal records of the company but rely on information presented in financial reports, known widely as financial statements. External Reporting Financial accounting is the area of accounting aimed at providing information to external users. Its primary objective is to provide external reports called financial statements to help users analyze an organization’s operations and assess performance. Because external users have limited access to an organization’s information, their own success depends on getting external reports that communicate relevant information that is truthfully represented. Some governmental and regulatory agencies have the power to get reports in specific forms, but most external users must rely on general purpose financial statements. The term “general purpose” refers to the broad range of purposes for which external users rely on these statements. Generally accepted accounting principles (GAAP) are important in increasing the usefulness of financial statements to users. GAAP are the underlying concepts that make up acceptable accounting practices. GAAP for public companies in Canada follow International Financial Reporting Standards (IFRS). IFRS are the “accounting laws” that must be applied by accountants to public companies in Canada when recording and reporting accounting information. We discuss GAAP and IFRS along with the financial statements in more detail later. Page 9 INTERNAL INFORMATION USERS Internal users of accounting information are those individuals directly involved in making decisions in an organization’s day-to-day activities. The internal role of accounting is to provide information to help internal users improve the efficiency and effectiveness of an organization in delivering products or services. Internal Reporting Managerial accounting is the area of accounting aimed at serving the decision- making needs of internal users. Internal users working for the organization have the ability to find out the answer to an accounting question by running a customized report or requesting the information from another individual or department. An example of such a report is a monthly sales report for each Apple Store location to be used to monitor performance of the store managers in leading their teams. Another example would be a report showing a detailed listing of suppliers owed money by Apple Inc. for electronic component purchases to build iPhones, or to companies such as makers of cellphone cases sold at their physical storefronts. Internal reports aim to answer questions such as What are the manufacturing expenses per unit of product? What is the most profitable mix of goods and/or services? What level of revenues is necessary to show profit income? Which expenses increase with an increase in revenues? This book will help you to learn the skills needed to record accounting information effectively to provide answers to questions like these and others. Internal Operating Functions The responsibilities and duties of internal users extend to every function of an organization including human resources, sales, marketing, purchasing, production, distribution, and research and development. Accounting is essential to the smooth operation of each aspect of an organization. To monitor operating functions managers rely on internal controls, which are procedures set up to protect assets (like cash, equipment, and buildings); to ensure that accounting reports are free from error, neutral, and complete; to promote efficiency; and to ensure that company policies are followed. For example, certain actions require verification, such as a manager’s approval before materials enter production. Internal controls are crucial if accounting reports are to provide relevant and trustworthy information. Artificial Intelligence in Accounting Some estimate that artificial intelligence (AI) could replace 40% of today’s workforce in the next decade. Repetitive tasks such as entering invoice and transaction data will be done by AI and software. This trend toward more AI integration bodes well for those with accounting knowledge. Accountants will be needed to help develop advanced AI systems and to analyze reports and graphics created by AI systems. Because employers recognize these valuable skills, accounting is consistently ranked among the top professions in terms of both future demand and future earnings. Page 10 Data Analytics and Visualization in Accounting Data analytics and data visualization are among the top skills sought by employers. Data analytics is a process of analyzing data to identify meaningful relations and trends. Data visualization is a graphical presentation of data to help people understand its significance. In accounting, data analytics and visualization help individuals make informed business decisions. Keurig Dr Pepper uses data analytics and visualization to send accounting information to its sales route staff via an app in real time. Staff then make data-driven decisions on what sales and promotions to offer retailers. Tableau Dashboard Activities in Connect offer the opportunity to begin developing such skills. ↓ NEED-TO-KNOWs have students apply key procedures and concepts; each NTK has a video walkthrough. NEED-TO-KNOW 1-1 Users of Accounting Information LO3 Identify the following users of accounting information as either an (a) external or (b) internal user. 1. Regulator 2. CEO 3. Shareholder 4. Marketing manager 5. Executive employee 6. External auditor 7. Production manager 8. Non-executive employee 9. Bank lender Solution 1. a 2. b 3. a 4. b 5. b 6. a 7. b 8. a 9. a Do More: QS 1-1, E 1-2 Accounting Opportunities Exhibit 1.4 identifies some of the countless job opportunities in accounting by classifying accountants according to the kind of work that they perform. In general, accountants work in four broad fields: Financial Managerial Taxation Accounting related Another way to classify accountants is to identify the kinds of organizations in which they work. Most accountants are private accountants and work for a single employer, which is often a business. Public accountants are licensed and regulated by their professional accounting bodies in the provinces in which they work. For example, the Chartered Professional Accountants of Ontario provides licensing and regulation over CPAs working in Ontario. Exhibit 1.5 shows the average annual salaries for various accounting groups. EXHIBIT 1.4 Opportunities in Practice EXHIBIT 1.5 Average Annual Salaries for Accounting Positions *These values do not include benefits/bonuses. Source: Data taken from 2021 Robert Half Salary Guide for Accounting and Finance. Page 11 PERSONAL FINANCE SERIES First Steps to Financial Security: Establish a Budget and Set Aside Money for a Contingency Fund Many students want to know how they can set themselves up for a successful future. This series is designed to help you build your knowledge in how to manage your finances effectively to achieve your desired goals. You just got your first “real job,” and immediately a number of questions come to mind: What is the best way to spend my paycheque? Should I go buy a new car? Should I buy a new wardrobe? Can I afford to buy a new computer? When should I get my first apartment? No matter what your income is, having a regular series of cash flow sets you up with the ability to choose how you want to spend your money. The first step to financial security is to take control of your finances and set a monthly budget. A personal budget helps you develop a path to achieve your goals and helps you obtain an understanding of your overall expected expenses and planned savings for unexpected items. Setting a clear budget not only will help you avoid buying items you do not have the money in the bank to pay for, but also helps prevent you from getting behind in your bills. In your budget, you can create categories for the main items you would like to spend your money on for the upcoming month in areas such as entertainment, education, connectivity, transportation, and food. It is okay if you need to update your budget over the month, but as you use up your estimate in each category you will need to adjust other categories if you want to spend more money. For example, if you are invited out for dinner and have already used up your entertainment budget, you could choose to spend the $50 on dinner, but would need to take from one of your other categories, such as your clothing budget. If you know you enjoy shopping over the holidays or on Black Friday or Boxing Day, you can have a plan to anticipate this spending in advance and fill your category over the upcoming months to prepare for future spending. For example, if it is June 1 and you anticipate spending $1,200 on miscellaneous electronics, clothing, and gift items next November 30, you have 6 months to save. You will need to set aside $200 per month starting in the month of June. By the end of November, you will have $1,200 of guilt-free spending to enjoy. The following year, you will have 12 months of foresight. If you anticipate a similar shopping event, you will need to set aside only $100 per month for your shopping spree, starting in December. Budgets should be thought of as a spending plan, so that you can effectively reduce costs on things that you don’t value and spend your money in meaningful ways. Money set aside as savings is in effect a plan to build the resources to spend your money in a meaningful way in the future—that might be to pay for the car you are excited to purchase one day, to buy an apartment, or to spend the money years in the future for your retirement. Next chapter: Look for the Personal Finance Series in Cha pter 2 covering how to plan ahead for unexpected expenses. Source: Adapted from Economic Times, India, https://economictimes.indiatimes.com/analysis/how-big- should-be-your-contingency-fund/articleshow/10384247.cms?from=mdr Tools: Budget planner (free): https://itools-ioutils.fcac-acfc.gc.ca/BP-PB/budget-planner Budgeting tool (free for students): www.youneedabudget.com Podcast: You Need A Budget (YNAB), Episode 338, “Budgeting Is Spending,” August 2018 (4 mins). FINANCIAL ACCOUNTING Financial accounting serves the needs of external users by providing standardized financial reports referred to as financial statements. Public companies are required to issue annual financial reports that are audited by a professional accountant. An audit is an independent review of an organization’s accounting systems and records; it is performed to add credibility to the financial statements. External au ditors perform the audit at the request of the board of directors to protect investor interests. Page 12 Page 13 MANAGERIAL ACCOUNTING Managerial accounting serves the needs of internal users by providing special- purpose reports. These special-purpose reports are the result of general accounting, cost accounting, budgeting, internal auditing, and management consulting. Genera The task of recording transactions, processing the recorded data, and preparing l accou reports for members of the management team such as the controller (the chief nting accounting officer of an organization). Cost ac The process of accumulating the information that managers need about the various c countin osts within the organization. g Budgeti The process of developing formal plans for an organization’s future activities. ng Interna Function performed by auditors employed within the organization for the purpose of l auditi evaluating the efficiency and effectiveness of internal accounting controls and ng systems. Manag Service provided by external accountants who suggest improvements to a company’s ement procedures; suggestions may concern new accounting and internal control systems, consult new computer systems, budgeting, and employee benefit plans. ing TAXATION Income tax raised by federal and provincial governments is based on the profit (income) earned by taxpayers. These taxpayers include both individuals and corporate businesses. Sole proprietorships and partnerships are not subject to income tax, but owners of these two non-corporate business forms must pay tax on profit earned from these business forms. The amount of tax is based on what the laws define to be profit for tax purposes. In the field of taxation, tax accountants help taxpayers comply with these laws by preparing their tax returns and providing assistance with tax planning for the future. The government—specifically, the Can ada Revenue Agency (CRA)—employs tax accountants for collection and enforcement. PROFESSIONAL CERTIFICATION Accounting is a profession, like law and medicine, because accountants have special access to confidential matters and the responsibility to adhere to the rules of the profession. The professional status of an accountant is often indicated by one or more professional certifications. In Canada, Chartered Professional Accountants of Canada (CPA Canada) is the national organization that has been established to train and monitor its highly qualified professionals to navigate through today’s complex and dynamic business climate while demonstrating a commitment to its core values. The CPA certification program is designed to provide students with a pathway to gain the necessary skills and experience that lead to earning the CPA credential.5 CPA Canada also provides an alternative credential: the Advanced Certificate in Accounting and Finance (ACAF) program. This nationally recognized certificate is geared toward individuals pursuing roles in accounting and finance functions who are interested in obtaining a credential and job-ready skills, but not as a qualified CPA. For detailed information regarding professional accounting education programs, refer to the following website: www.cpac anada.ca The preceding discussions illustrate how critical the accounting function is Page 14 for all organizations. You can be certain that wherever your future career path leads you, an understanding of financial accounting will be critical because it is integrated deeply into the language of business. A study of this text will help you to develop the foundational skills required to succeed in using this new language and to consider how it relates to your future career. CHECKPOINT 5. What is the difference between private and public acco untants? 6. What are the four broad fields of accounting? 7. What is the purpose of an audit? 8. Distinguish between managerial and financial accounti ng. 9. What is the difference between external and internal users of accounting information? 10. Why are internal controls important? Do Quick Study question: QS 1-5 Ethics and Social Responsibility LO4 Identify and explain why ethics and social responsibility are crucial to accounting. Ethics and ethical behaviour are critical to the effectiveness of the accounting profession and to those who use accounting information. If trust is missing in the accounting profession, shareholders lose confidence in the financial markets and will refrain from investing in businesses. This will make it very difficult for businesses to grow, survive, and be successful in Canada. An important objective of accounting is to provide useful information for decision making. For information to be useful it must be trusted; this demands ethics in accounting. Closely related to ethics is social responsibility. Both are discussed in this section. UNDERSTANDING ETHICS Ethics are beliefs based on our value system that enable us to differentiate right from wrong. Business ethics involves producing safe, quality products and treating customers responsibly, understanding the impact of one’s actions to the environment, society, and the employees of the company. An ethical dilemma occurs when an individual comes across a situation and needs to make a decision about a right or wrong course of action. Factors impacting the individual making the decision include society’s legal framework, the individual’s personal value and belief system, and their ability to see the impact of a decision on all individuals that are affected by the decision. Companies can encourage employees to uphold corporate values by ensuring employees are properly trained and that their compensation systems are aligned with these values. Examples of ethical issues in the world of business include: Proper labelling of products for consumers to make informed decisions (such as “organic” or “genetically modified,” and accurate nutrition and ingredient labelling). Recording sales made to customers in the appropriate year. GAAP require companies to follow principles in determining when to recognize revenue as earned from the customer. Publicly funded charities utilizing their resources for the end benefit of their stated purpose. The charity directors would need to develop a policy against utilization of charity funds for personal uses such as vacations, personal gifts, etc. Companies specifically designing products to break down some time after the elapsed warranty period to require customers to replace the product. Universities redirecting monies donated for scholarships and bursaries for capital expansion or employee compensation. Identifying the optimal ethical decision can be very difficult. Considering how your Page 15 decisions impact others is a key aspect of choosing the best path when confronted with a difficult decision. The preferred ethical path is to decide on a course of action that maximizes the benefit to the largest number of stakeholders and one that enables you to sleep at night. Organizational Ethics Organizational ethics are influenced through management example and leadership and are reinforced through the design of compensation systems. Companies that are concerned about their public image in the area of sustainability report their annual performance in a sustainability report. This report is geared to communicate company initiatives in the area of social, environmental, and corporate governance programs to external and internal users. A growing body of research indicates that there is a strong link between companies that adopt sustainable business practices and their financial performance.6 Companies like Mountain Equipment Co-op, Telus, Canadian Tire, Cascades, Bank of Montreal, and Intel were recognized as part of the Corporate Knights Top 50 Socially Responsible Companies for 2020.7 Ethical practices build trust, which promotes loyalty and long-term relationships with customers, suppliers, employees, and investors. Good ethics adds to an organization’s reputation and its success. ETHICAL IMPACT Resolving Ethical Dilemmas The Chartered Professional Accountants of Ontario’s Rules of Professional Conduct—Approach to Ethical Conflict Resolution state that as part of the resolution process members should consider: Relevant facts; Ethical issues involved; Fundamental principles and rules applicable to the matter in question; Established internal procedures; and Alternative courses of action. After considering the above issues, an appropriate course of action needs to be considered that is consistent with the key principles and rules identified as being relevant. The accountant should also assess the consequences of each possible course of action. If the accountant is having difficulty determining the right course of action, the member should consult with other appropriate persons within the firm or employing organization for help. Where a matter involves a conflict with, or within, an organization, the accountant should also consider consulting with those responsible for the governance of the organization, such as the board of directors or the audit committee. Source: Adapted from Chartered Professional Accountants of Ontario, https://media.cpaontario.ca/cpa- members/pdfs/20928_Revision%2020160226.pdf, accessed September 24, 2020. Accounting Ethics A high commitment to ethics is crucial in the field of accounting due to the confidential nature of information accountants are exposed to and the massive financial and social impact if ethics are neglected. If accounting information is fraudulently presented, shareholders, employees, and many other parties can experience significant consequences. Misleading information can result in many people losing their life’s savings when they make investment decisions based on falsified information. Professional accountants have ethical obligations in at least four general areas: they Page 16 are expected to maintain a high level of professional competence, to treat sensitive information as confidential, to exercise personal integrity, and to be objective in matters of financial disclosure. These expectations are outlined in a formal code of ethics that is established and monitored by the professional accounting bodies of the provincial chartered professional accountants. The CPA Code of Professional Conduct requires members to comply with the Code of Ethics of Chartered Professional Accountants, which outlines that accountants have a responsibility to society; describes their obligations to clients, employers, and colleagues; and obliges the following of sound and fair accounting and business practices. This code can help guide accountants when confronted with ethical dilemmas, including concerns that they must not be associated with deceptive information. Ethics codes are also useful when one is dealing with confidential information. For example, auditors have access to confidential salaries and an organization’s strategies. Organizations can be harmed if auditors pass this information to others. To prevent this, Canadian professional accounting bodies require all accountants to maintain confidentiality of information about their client or employer. Ethics and Academic Integrity Have you ever been asked by a peer to text them a picture of your homework or give them your answers for an assignment, quiz, or exam? If so, how did you react? One of the biggest impacts you can have on your personal growth and development of personal integrity to prepare you for ethical decision making in your chosen career is by upholding academic integrity as a student. Ensure you understand your academic institution’s policies around academic dishonesty (also referred to as academic misconduct). Many students have been reported for academic dishonesty without directly intending to “cheat.” As a result, it is very important to educate yourself around the types of activities that would result in consequences. For example, did you know that resubmitting an assignment, project, or report in a subsequent class is an example of academic dishonesty? Also, “googling” information and using it in your assignments or reports without referencing the Internet source is considered by many institutions to be an act of academic dishonesty. Utilizing unauthorized resources on an exam, such as a programmable calculator or other device or resource not permitted by your instructor, is another example of academic misconduct. Ensure you understand the consequences imposed by your institution for engaging in academic dishonesty. For example, many Canadian institutions give students who engage in academic dishonesty a zero grade on the specific assignment or test. A second occurrence would result in a grade of zero in the course, sometimes also noting the academic dishonesty directly on the transcript. A third occurrence could mean that you are blocked from attending that post-secondary institution. In any case, it would be much better to avoid damaging your reputation by unknowingly engaging in activities that are violating your instructor’s policies around academic honesty. Refer to the Important Tip box for more information on how to avoid damaging your personal reputation or integrity in this way. Important Tip: Investigate Your Instructor’s Policies Around Academic Honesty Preserve your reputation and your academic standing by educating yourself regarding what each instructor’s perceptions and rules are around permitted activities and excluded activities surrounding academic integrity. A conversation with your instructor regarding their viewpoint on this matter and how it relates to the work that needs to be performed in their class as well as a discussion around reasons why students have been reported for academic dishonesty in their class can help you to develop your own moral compass around academic integrity. Preventing academic dishonesty: Do not procrastinate. Stay on top of your weekly readings and homework assignments to ensure you aren’t feeling pressure to take shortcuts. Check before sharing your work with others. Educate yourself around appropriate collaboration with peers and your instructor’s view of academic misconduct. Ensure you understand when teamwork is supported and when it is determined to be dishonest. Take the time to get to know your instructor. Studies show that students who have a relationship with their instructor are less likely to engage in academic misconduct. (They can also provide an excellent reference for you when you go to find a job!) Cite Internet resources or other work utilized. Avoid plagiarism by referencing any work you take from others, including any Internet-derived information you have obtained to complete projects, assignments, or other student work. If you google it, cite it. Reach out to get help if needed. If you experience personal circumstances that make submitting your assignments on time or attending your tests or exams extremely difficult, reach out to your instructor to come up with a mutually agreed upon solution. Many Canadian post-secondary institutions have support services for issues relating to mental health. For more information on academic integrity, check out “Betting on Integrity” posted by Academic Integrity Watch on YouTube. SOCIAL RESPONSIBILITY Social responsibility is a concern for the impact of our actions on society as a whole. It requires that an organization identifies issues, analyzes options, and makes socially responsible decisions. Socially conscious employees, customers, investors, and others see to it that Page 17 organizations follow claims of social awareness with action, by placing significant pressure on organizations to contribute positively to society. Organizations such as WestJet and Loblaw Companies take social responsibility seriously. WestJet invests in the community through WestJet Cares for Kids, a program that supports national charities including Boys & Girls Clubs of Canada, Big Brothers Big Sisters of Canada, Hope Air, Make-A-Wish Canada, Missing Children Society of Canada, Ronald McDonald House Charities Canada, and the David Foster Foundation. Appendix III at the end of the text includes three sets of real-life financial statements to provide you with a frame of reference. CHECKPOINT 11. What are the guidelines to use in making ethical and socially responsible decisions? 12. Why are ethics and social responsibility valuable to organizations? 13. Why is ethics crucial to accounting? Do Quick Study question: QS 1-6 Generally Accepted Accounting Principles (GAAP) LO5 Identify, explain, and apply accounting principles. As has already been stated, the goal of accounting is to provide useful information for decision making. For information to be useful, it must be relevant and trustworthy. The accounting profession has created a framework and set of principles to ensure accounting is valuable and can be relied on when making important decisions. The underlying concepts that make up acceptable accounting practices are referred to as generally accepted accounting principles (GAA P). Page 18 GAAP FOR PUBLIC VS. PRIVATE ENTERPRISES Canada currently has two main sets of accounting standards. Publicly accountable enterprises (PAEs), including companies that have shares trading on Canadian stock exchanges, are required to meet International Financial Reporting Sta ndards (IFRS). Additionally, the Accounting Standards Board (AcSB), the body that originally governed accounting standards in Canada, has issued a set of “made in Canada” Accounting Standards for Private Enterprises (ASPE). Publicly Accountable Private Enterprises (PAEs) Enterprises (PEs) GAAP to be used IFRS ASPE or IFRS Why IFRS? Although professional accountants around the world all follow GAAP, how GAAP are interpreted and applied in the recording and reporting of accounting information differs from country to country. These differences can prevent investors, creditors, and other users of global accounting information from making the most informed decisions possible. To improve the comparability of accounting information, the International Accounting Standards Board (IA SB) was established to try to achieve global agreement on the use of a common set of accounting standards, namely IFRS. Why ASPE? Private enterprises are privately owned and so have some different reporting needs than public enterprises. For example, a small sole proprietorship might incur significant costs if it had to comply with the complexities of the related IFRS. The AcSB developed ASPE to meet the need for simplification in areas where the adoption of IFRS might have caused significant cost/benefit concerns for private enterprises. Private enterprises can choose whether to follow ASPE or IFRS. Although these two sets of standards—ASPE and IFRS—are developed by different standard setters, the underlying accounting principles and framework upon which the standards have been developed have many similarities. The differences, within the scope of an introductory financial accounting textbook, are identified and briefly discussed in the “IFRS and ASPE—The Differences” section at the end of each chapter. This textbook focuses on GAAP as they relate to IFRS, and we begin emphasizing these in the early chapters of this book. The other categories of financial reporting frameworks that are not discussed in detail in this course are the Accounting Standards for Not-for-Profit Organizations, Accounting Standards for Pension Plans, and Public Sector Accounting Standards (PSAS). Not-for-profit organizations provide a framework for financial reporting for organizations that do not operate for profit, but instead focus on other goals such as education, health, and support for individuals in need. The CNIB Foundation, Doctors Without Borders, and the Nature Conservancy of Canada are examples of Canadian not-for-profit organizations. PSAS provide a financial reporting framework for government organizations such as local school boards, the City of Winnipeg, and the Province of Saskatchewan. Conceptual Framework The primary purpose of GAAP is to ensure the usefulness of financial information for external users. The conceptual framework outlines the objectives and concepts that form the building blocks of the accounting principles. The main objective of financial reporting is to provide useful information to external users including existing and potential investor groups, banks, and other lenders to make decisions about providing the entity with resources. For financial information to be useful, it must possess the fundamental qualitative characteristics of relevance and faithful representation.8 Page 19 Relevance Information that has relevance helps users predict future performance or confirm previous predictions or understandings.9 Faithful Representation Information that has faithful representation is complete, neutral, and free from error.10 Information is neutral when prudence (caution) is exercised to ensure assets, liabilities, income, or expenses are not overstated or understated. Usefulness is enhanced when the financial information is comparable, verifiable, timely, and understandable. Important Characteristics of Reported Financial Information Comparability: If companies use a similar framework for accounting, users are able to compare the performance of two different companies or compare the company’s performance in different fiscal years, enhancing their ability to make effective decisions.11 Verifiability: Different knowledgeable individuals would reach consensus that the numbers represented in the financial statements are reasonable.12 When financial statement information is presented in a way that the underlying information is representative of the underlying transactions, users can rely on the information to make decisions. Timeliness: Information is available to decision makers in time to influence their decisions.13 Financial information that is presented in a timely manner, such as when audited financial statements are published within a month or two of a company’s year-end, enables investors and other users to form conclusions on management’s effectiveness in managing resources. Understandability: Information is presented clearly and concisely.14 By presenting financial transactions in an easy-to-understand format, users can form more effective conclusions on how the resources are being utilized in the company. In the next section of the chapter, we highlight some of the fundamental accounting principles that all companies must follow. Fundamental Building Blocks of Accounting The following discussion and Exhibit 1.6 summarize the core accounting principles that form the framework of GAAP.15 Note that the primary objective of GAAP is to provide financial information that is useful for external users. Professional judgment is often required to achieve the right balance in satisfying the various elements of the framework with the focus on meeting the needs of external users. EXHIBIT 1.6 Summary Model of GAAP Framework Note: Trade-offs between elements require professional judgment to achieve appropriate balance. Page 20 Reporting Entity Concept The reporting entity concept requires that each separate economic entity or business of the owner must keep accounting records apart from those of the owner and any other company owned by the owner. This concept requires every business to be accounted for separately from its owner or owners. Financial statements can be for a single business, a portion of an entity’s business, or more than one business. To maximize the usefulness of information presented, users want information about the performance of a specific entity. A reporting entity may not be a separate legal entity but is established for financial reporting purposes. Examples of reporting entities: KPMG (partnership) Lush Cosmetics Ltd. (corporation) Rogers Wireless Inc. (corporation) Okanagan Indian Band (public sector) Reporting Period Financial statements are prepared for a specific period of time. This concept is known as the reporting period concept. Financial statements are often prepared monthly for internal purposes and are reported externally quarterly and/or annually. Financial statements provide comparative information for at least one preceding reporting period. Cost Constraint The cost constraint indicates that the benefits of providing information need to justify the costs incurred in reporting financial statement information to external users. Page 21 Materiality Information that is significant to decision makers should be included in the financial statements. This concept is referred to as the materiality principle. Going Concern Assumption According to the going concern assumption, financial statement users can safely assume that the statements reflect a business that is going to continue its operations at least 12 months into the future unless clearly notified. Therefore, assets are maintained in the accounting records at original cost and not reduced to a liquidation value as if the business were being bought or sold. Companies are required to inform users about material uncertainties that cast significant doubt on their ability to continue on in the foreseeable future.16 Example: It is assumed from a review of Organico’s financial statements that the business is continuing its operations, because there is no information presented in the audited statements notifying the users that the company is experiencing financial hardships. Currency Transactions are to be expressed using units of money in the currency of the country in which the company primarily operates17 as the common denominator. It is assumed that the monetary unit is stable; therefore, a transaction is left at its originally recorded cost and is not later adjusted for changes in currency value or inflation. The greater the changes in currency value and inflation, the more difficult it is to use and interpret financial statements across time. Example: Assume that in August 2023 Organico, a Canadian company, purchased equipment from a supplier in the United States at a total cost of $1,000 (US), or $950 (Cdn) ($1,000/1.0526 exchange rate). If the exchange rate changes several months later to 1.0256, Organico does not restate the value of the equipment to $975 ($1,000/1.0256 current exchange rate). The equipment remains in the accounting records at $950 (Cdn). Recognition and Measurement Business activities can be described in terms of transactions and events. A busi ness transaction is an exchange of economic consideration between two parties that causes a change in assets, liabilities, or equity. An economic consideration is something of value; examples include products, services, money, and rights to collect money. These transactions cause changes in the organization’s resources and need to be accounted for. Recognition involves determining when it is appropriate to capture this information in the financial statements. One key principle that requires analysis in terms of when a transaction should be recognized is the revenue recognition principle. Revenue transactions can be complex and require some investigation into the characteristics of the transaction to determine when is the appropriate time to record the revenue as earned. For example, does a builder that has been engaged by TD Canada Trust to build a new branch recognize some revenue over the course of the project, or when the building has been fully completed and final inspections have been passed? What about warranty obligations that carry forward for many years? Profit-driven organizations can have the bias or preference to recognize Page 22 revenue early in order to report a higher level of profit. Generally accepted accounting principles require that revenue be recorded at the time that it is earned by satisfying the performance obligation of the contract. This is generally triggered when the service is performed or product has been delivered, regardless of whether cash or another asset has been exchanged.18 The amount of revenue to be recorded is the cash received plus the cash equivalent value (market value) of any other assets received. Example: Assume that on April 3, Organico delivers lunch for a sales meeting at Telus in the amount of $600. Telus does not pay the $600 invoice until May 15. Organico records revenue in the amount of $600 when the work was performed on April 3, at the point in time when the food was delivered. It also reports an asset of $600, representing the balance receivable from Telus. Alternatively, if Organico received $1,000 on April 15 in advance for work to be done next month (on May 10), revenue is not recorded until the future contract’s performance obligations are executed—on May 10. The amount collected represents a future obligation of the company—unearned revenue. Expenses are recognized when costs are incurred and are matched (or are recognized) in the same period as the revenue is recognized. For example, rent expense for the month of May is recognized in the month it is incurred—May. The cost of the food delivery in the Telus example above will be recognized on April 3, when the work is done (food is delivered) and the revenue is recognized. This concept is referred to as the matching principle. Within the accounting standards there are four key methods used to determine the dollar value at which to capture/record a transaction in the financial accounting records:19 1. Historical cost. Historical cost is the most commonly adopted method to record accounting transactions. It requires that all transactions be recorded based on the actual cash amount received or paid. In the absence of cash, the cash equivalent amount of the exchange is recorded.20 Example: If Organico purchased used equipment for $5,000 cash, it is recorded in the accounting records at $5,000. It makes no difference if Hailey Walker thinks that the value of the equipment is $7,000. 2. Current value measurement basis: Current cost. Current cost indicates the amount of cash required to acquire that asset or received to take on an equivalent liability today. For example, investments in actively traded corporate stock are reported at their fair value at the year-end date. Fair value. The asset or liability is reported at the amount of cash that would be received by selling the asset or paying off the liability in the normal course of business. For example, inventory is reported at the lower of historical cost and realizable value. Value in use (assets)/fulfillment value (liabilities). Assets are reported at the present value of future expected cash flows, after discounting to reflect the time value of money in terms of expected interest/inflation. For example, long-term debt instruments (corporate bonds) sold are reported at the present value of future cash payments, as described in Chapter 14. Unless otherwise indicated, assume the measurement method used is historical cost, which is the amount paid/payable or the amount collected/collectible. In future chapters you will be informed of the specific measurement method to be used for specific assets or liabilities. Page 23 CHECKPOINT 14. Why is the reporting entity concept important? 15. Describe the historical cost measurement method and explain why it might be considered verifiable. 16. A customer pays cash today for a product that is to be delivered to them next month. When should revenue be recognized? Do Quick Study questions: QS 1-7, QS 1- 8, QS 1-9 Communicating Through Financial Statements LO6 Identify and explain the content and reporting aims of financial statements. Financial statements are an organization’s primary means of financial communication and are the end result of a process, or cycle, that begins with a business transaction like a sale. These transactions are recorded, classified, sorted, and summarized in order to produce the statements. PREVIEWING FINANCIAL STATEMENTS We will begin our study of the four major financial statements—the income statement, statement of changes in equity, balance sheet, and statement of cash flows—with a brief description of each. Exhibit 1.7 shows how these statements are linked. Examples of financial statements are illustrated in the following pages using Organico. EXHIBIT 1.7 Links Among the Financial Statements Note: Flexibility is permitted in the naming of financial statements. For example, statement of financial position is another name for the balance sheet. In Appendix III at the end of the textbook, notice that Spin Master Corp. uses the term statement of financial position, while Indigo and Recipe Unlimited Corporation use the heading balance sheet. Statement of profit and loss (P&L), statement of earnings, and other names are used instead of income statement. For consistency, the financial statements will be named throughout this textbook as introduced in Exhibit 1.7. A balance sheet reports on an organization’s financial position at a point Page 24 in time. The income statement, statement of changes in equity, and statement of cash flows report on performance over a period of time. Selection of a reporting period is up to preparers and users (including regulatory agencies). A one-year, or annual, reporting period is common, as are semi-annual, quarterly, and monthly periods. The one-year reporting period is also known as the accounting or fiscal year. Businesses whose reporting period follows the calenda r year begin on January 1 and end on December 31. Many companies choose a fiscal year based on their natural business year that ends when sales and inventories are low. For example, Lululemon Athletica’s fiscal year-end is the Sunday closest to January 31, after the holiday season, reporting operating results as at February 2, 2020, February 3, 2019, and January 28, 2018, respectively.21 Income Statement The purpose of an income statement (statement of profit or loss) is to measure and summarize the results of a business’s operating activities over a period of time. Revenues – Expenses = Profit or Loss For example: $100 Revenues – $75 Expenses = $25 Profit OR $300 Revenues – $360 Expenses = $60 Loss Revenues are the value of assets exchanged for products and services provided to customers as part of a business’s main operations. Assets are economic resources controlled by a business and include cash, equipment, buildings, and land. They reflect a right of ownership that has the potential to produce economic benefits such as income. Later in the chapter, we will define assets more precisely. The income statement for Organico’s first month of operations is shown in Exhibit 1.8. It shows that Organico earned total revenues of $4,100 during March: $3,800 from food services revenue plus $300 from teaching revenue. Expenses reflect the costs of providing products or services. They can be direct costs incurred, such as the cost of wages, utilities, insurance, or the cost of items sold, or can reflect the using up of assets, as in the case of depreciation expense on a building. The income statement in Exhibit 1.8 shows that Organico used up some of its assets in paying for rented space. The $1,000 expense for rental space is reported in the income statement as rent expense. Organico also paid for an employee’s salary at a cost of $700. This is reported on the income statement as salaries expense. The income statement heading in Exhibit 1.8 identifies the business, the type of statement, and the time period covered. Knowledge of the time period is important for us in judging whether the $2,400 profit earned in March is satisfactory. Profit, or income, means that revenues are more than expenses. A loss means that expenses are more than revenues. An income statement lists the types and amounts of both revenues and expenses to help users understand and predict company performance. This detailed information is more useful for making decisions than a simple profit or loss number would be. Statement of Changes in Equity Equity is equal to total assets minus total liabilities; it represents how much of the assets belong to the owner. Equity increases with owner investments and profit and decreases with owner withdrawals and losses. Owner investments occur when the owner transfers personal assets such as cash into the business. Since owner investments do not result from the sale of a product or service, they are not revenue and not reported on the income statement. Owner withdrawals, or wit hdrawals, occur when the owner takes cash or other assets from the business. Withdrawals represent a distribution of profit to the owner. Since withdrawals do not help to create revenue, they are not expenses and therefore are not reported on the income statement. The purpose of the statement of changes in equity is to measure and Page 25 report on changes in the equity position of a business over the reporting Page 26 period. This statement starts with beginning equity and adjusts it for transactions that (1) increase it (investments by the owner and profit), and (2) decrease it (owner withdrawals and losses). The statement of changes in equity for Organico’s first month of operations is shown in Exhibit 1.9. This statement describes transactions that changed equity during the month. It shows $10,000 of equity created by Hailey Walker’s initial investment. It also shows $2,400 of profit earned during the month. The statement also reports the owner’s $600 withdrawal. Organico’s equity balance at the end of the month is $11,800. Balance Sheet The purpose of the balance sheet, or statement of financial position, is to report the resources owned and the claims on resources of a business at a point in time. This statement is usually prepared at the end of a month, quarter, or year. It describes financial position by listing the types and dollar amounts of assets, liabilities, and equity. Assets are the properties or economic resources controlled by a business as a result of past events. A common characteristic of assets is their ability to provide future benefits to the company.22 Cash is an asset that businesses can easily exchange for goods and services. Accounts receivable is an asset created by selling products or services to customers on credit, meaning in advance of collecting cash from the customer. It reflects amounts owed to a business by its credit customers. Customers that owe money for services performed are called debtors. Other common assets include merchandise inventory held for sale, supplies, equipment, buildings, and land. Discussed in Chapter 4 are other assets having intangible rights, such as those granted by a patent or copyright. Liabilities are debts or obligations of a business to transfer cash or another economic resource as a result of past events. These existing obligations represent a dollar value of claims of others against the assets of the business. A common characteristic of liabilities is they represent a future obligation to settle with no practical ability to avoid, reducing future assets or requiring future services or products.23 Typical liabilities include accounts payable and notes payable. An ac count payable is a liability created by buying products or services on credit. It reflects amounts owed to others. A note payable is a liability expressed by a written promise to make a future payment at a specific time. Other common liabilities are salaries and wages owed to employees, interest payable, and money collected from customers in advance of providing a service called unearned revenues (further described in Chapter 2). Individuals and organizations that own the right to receive payments from a business are called its creditors. One entity’s payable is another entity’s receivable. If a business fails to pay its obligations, the law gives creditors a right to force sale of its assets to obtain the money to meet their claims. When assets are sold under these conditions, creditors are paid first but only up to the amount of their claims. Any remaining money goes to the owner(s) of the business. Creditors often compare the amounts of liabilities and assets on a balance sheet to help them decide whether to lend money to a business. A loan is less risky if liabilities are small in comparison to assets, because there are more resources than claims on resources. A loan is more risky if liabilities are large compared to assets. Equity is the owner’s claim on the assets of a business. It represents the Page 27 assets that remain after deducting liabilities,24 also called net assets. We explained that income is the difference between revenues and expenses of a business over a period of time. Income on the income statement results in an increase in equity on the balance sheet due to profitable operating activities over a period of time. An operating loss on the income statement results in a decrease in equity on the balance sheet in an accounting period. In this way, the income statement links to the balance sheet at the end of a reporting period. Changes in equity are reported in the statement of changes in equity, and give us the ending balance of equity that is reported in the balance sheet. Exhibit 1.10 shows the balance sheet as of March 31, 2023. The balance sheet heading lists the business name, the statement, and the specific date on which assets and liabilities are identified and measured. The amounts in the balance sheet are measured as of the close of business on that specific date. The balance sheet for Organico shows that it has three different assets at the close of business on March 31, 2023. The assets are cash, supplies, and equipment, for a total dollar amount of $18,000. The balance sheet also shows total liabilities of $6,200. Equity is $11,800. Equity is the difference between assets and liabilities. The statement is named a balance sheet because (1) the total amounts on both sides of the statement are equal; and (2) the reporting of assets, liabilities, and equity is in balance. Statement of Cash Flows The statement of cash flows describes the sources and uses of cash for a reporting period. It also reports the amount of cash at both the beginning and the end of a period. The statement of cash flows is organized by a company’s major activities: operating, investing, and financing. Since a company must carefully manage cash if it is to survive and prosper, cash flow information is important. As an example, the statement of cash flows for Organico is shown in Exhibit 1.1 1 (notice that Organico shows both operating and financing activities but it had no investing activities during March). To fully appreciate this financial statement, a solid understanding of some basic accounting concepts is required. Therefore, a detailed discussion has been left to Chapter 16. Exhibit 1.12 provides a brief summary of the elements of the financial statements.25 EXHIBIT 1.12 Elements of Financial Statements Summary Element of F/S Definition Characteristics Example Assets Economic The resource: By purchasing a food truck, resources 1) Will result in a future Organico acquires an asset controlled by a financial benefit that will provide a future business that 2) Is owned by the business benefit. It will enable Organico have the potential 3) Transaction/exchange to to make and distribute its to produce acquire the item has burritos to customers economic occurred benefits Element of F/S Definition Characteristics Example Liabilities Debts or Present obligation to Organico purchases $1,100 of obligations of a transfer an economic biodegradable food packaging business resource resulting from a supplies from CanFood Supply past event that the entity Co. and agrees to pay cash for has no practical ability to the items in 30 days avoid Equity/Net The owner’s Represents the residual Hailey Walker has $11,800 of Assets claim on the interest of the owner(s) in equity/capital at the end of the assets of the the assets of the company first month of operations ( E business after deducting liabilities xhibit 1.9) Profit The difference Increase in assets or Organico earns $2,400 in its between revenues decreases in liabilities, first month of operations and expenses of a resulting in increases in ( Exhibit 1.8) business during a equity other than those specific period of relating to contributions time from owners Expenses Costs incurred or Represents decreases in Organico pays for fuel to the using up of assets or increases in operate its food truck assets as a result liabilities that result in of the operations decreases in equity other of the business than distributions to owners Element of F/S Definition Characteristics Example Revenue The value of Must be: Organico sells a burrito to a assets received or 1) Earned, meaning the customer receivable as a asset/service has been result of selling transferred/provided to the goods or services customer to customers 2) Expect to collect from the customer 3) Able to quantify or measure the transaction in terms of value expected from the sale/service based on the terms of the contract with the customer Learning Summary: Changes to Equity Increases in equity are caused by: Decreases in equity are caused by: Owner investments Owner withdrawals Profit (excess revenue over expenses) Losses (expenses exceed revenue) Ending Owner’s Equity = Beginning Owner’s Equity + Owner Investments + Profit – Withdrawals by Owner Financial Statements and Forms of Organization Earlier in the chapter, four different forms of business organization were described: sole proprietorships, partnerships, limited liability partnerships, and corporations. Exhibit 1.13 summarizes key differences among these three forms of business ownership. While many differences exist, financial statements for these three types of organizations are very similar. EXHIBIT 1.13 Financial Statement Differences Based on Type of Business Organization Type of Business Organization Difference Sole Proprietorship Partnership Corporation LLP Equity on the Sole owner Partners Shareholders Partners balance sheet belongs to: Distributions to Withdrawals Withdrawals Dividends Withdrawals owners are called: When Not an expense Not an expense Expense Not an expense managers are also owners, their salaries are: The emphasis in the early chapters of this book is on sole proprietorships. This allows us to focus on important measurement and reporting issues in accounting without getting caught up in the complexities of additional forms of organization. We do discuss other forms of organization, however, and provide examples when appropriate. Chapters 11 and 12 return to this topic and provide additional detail about the financial statements of partnerships and corporations. Page 28 ETHICAL IMPACT $18.7 Million Maple Syrup Theft On July 30, 2012, Micheal Gavreau arrived at a warehouse to audit $30 million worth of inventory at the Global Strategic Maple Syrup Reserve. To his surprise, several of the barrels were discovered to be empty; others had their contents replaced with water. It was the “largest theft investigated by the Sûreté du Québec in its history.” The leader of the heist was found guilty of fraud, theft, and trafficking stolen goods and was sentenced to eight years in prison and fined $9.4 million. This situation occurred because of inadequate internal controls. In Chapter 7 we will introduce you to the concept of internal controls and the critical role they play in maintaining corporate assets. What would you do if you noticed unusual activities or discrepancies at your audit client or place of work, such as boxes that looked like they had been tampered with? Would you turn a blind eye or would you take the time to investigate? Video Links: Follow this link to view a video summary of the full story of “The Sweetest Heist”: htt ps://youtu.be/adCQ9cwYA8o. See also Dirty Money season 1 episode 5 on Netflix. CHECKPOINT 17. What are the four major financial statements? 18. Describe revenues and expenses. 19. Explain assets, liabilities, and equity. 20. What are three differences in financial statements for different forms of organization? Do Quick Study question: QS 1-10 Page 29 The Accounting Equation LO7 Analyze business transactions by applying the accounting equation. Notice in Exhibit 1.10 that there are two main sections of the balance sheet: assets on one side and liabilities and equity on the other side. Observe that the total assets of $18,000 equal the total liabilities and equity of $18,000. This equality is known as the accounting equation. This equation is based on relationships fundamental to accounting. When an organization invests in assets, it is the result of an equal amount of financing. This relationship is expressed in the following equation: Investing = Financing Since invested amounts are referred to as assets, and financing is made up of owner and non- owner financing, we can also express this equality as: Assets = Non-Owner Financing + Owner Financing Non-owners are creditors. Creditors and owners hold claims or rights in the assets. Page 30 Creditors’ claims are called liabilities and the owner’s claim is called equity. The equation can be rewritten as shown in Exhibit 1.14. EXHIBIT 1.14 The Accounting Equation The accounting equation describes the relationship between a company’s assets, liabilities, and equity. To demonstrate, assume you want to buy a car that costs $25,000. The bank lends you $15,000 and you pay $10,000 out of your personal savings account. The accounting equation can be rearranged by moving liabilities to the left side of the equation: Assets − Liabilities = Equity Net assets Assets less liabilities equals net assets, another name for equity. Equity has four parts as shown in the expanded accounting equation. Equity Assets = Liabilities + Owner, Capital − Owner, W ithdrawals + Revenues − Expenses We see that equity increases from owner investments and from revenues. It decreases from owner withdrawals and from expenses. These four parts of equity follow. + Owner, Owner investments are inflows of cash and other net assets from owner contributions, which Capital increase equity. – Owner, Owner withdrawals are outflows of cash and other assets to owners for personal use, which Withdrawals reduce equity. + Revenues Revenues increase equity (via net income) from sales of products and services to customers; examples are sales of products, consulting services provided, facilities rented to others, and commissions from services. – Expenses Expenses decrease equity (via net income) from costs of providing products and services to customers; examples are costs of employee time, use of supplies, advertising, utilities, and insurance fees. NEED-TO-KNOW 1-2 The Accounting Equation LO7 Part 1: Use the accounting equation to compute the missing financial statement amounts. Company Assets Liabilities Equity Bose $150 $ 30 $ (a) Vogue $ (b) $100 $300 Solution a. $120 b. $400 Part 2: Use the expanded accounting equation to compute the missing financial statement amounts. Owner, Owner, Company Assets Liabilities Capital Withdrawals Revenues Expenses Tesla $200 $ 80 $100 $ 5 $ (a) $40 YouTube $400 $160 $220 $ (b) $120 $90 Solution a. $65 b. $10 Do More: QS 1-11, QS 1-12, QS 1-13, QS 1-14, E 1-7, E 1-8, E 1-9, E 1-20 CAUTION: The illustration of transaction analysis on the following pages is a learning tool to demonstrate the effects of transactions on the accounting equation. How transactions are recorded in the real world is the topic of Chapter 2. Page 31 TRANSACTION ANALYSIS As previously mentioned, not all business activities are transactions. It is important to first differentiate between business events and business transactions. Business events do not involve an exchange of economic consideration and as such are not captured in accounting records. A business transaction is an exchange of economic consideration between two parties that causes a change in assets, liabilities, or equity. Once it is determined a business transaction has occurred, recognition and measurement principles previously discussed can guide us to determine when it is appropriate to record the transaction in the accounting records and at what dollar value. Source documents identify and describe transactions entering the accounting process. They are the source of accounting information, and can be in either paper or electronic form. Source documents, especially if obtained from outside the organization, provide objective evidence about transactions and their amounts, making information more reliable and useful. Examples of source documents are sales invoices, cheques, purchase orders, charges to customers, bills from suppliers, employee earnings records, and bank statements. Every transaction recorded must leave the accounting equation in balance. Total assets always equal the sum of total liabilities and total equity. We show how this equality is maintained by looking at the activities of Organico in its first month of operations. 1. Investment by Owner. On March 1, 2023, Hailey Walker registered her business Page 32 name and began setting up her new food truck business Organico as a sole proprietorship. Walker is the owner and manager of the business. The marketing plan for Organico is to focus primarily on providing fresh, organic Mexican fast food with a focus on quality and taste. Walker invests $10,000 cash in the new company, which she deposits in a bank account opened under the name Organico. By moving her personal money into the business an exchange of resources has taken place, so this is classified as a transaction. Transactions affect the accounting equation. As shown, this transaction affects both Organico’s cash (an asset) and equity (called Hailey Walker, Capital), each for $10,000. Assets = Liabilities + Equity Explanation Cash = Hailey Walker, Capital (1) +$10,000 = +$10,000 Investment by Owner This specific increase in equity is identified as an investment by the owner, differentiating it from other transactions affecting equity. 2. Purchase Supplies for Cash. Organico uses $2,500 of its cash to purchase organic food supplies. This is a transaction because it involves an exchange of cash, an asset, for another kind of asset, supplies. The transaction produces no expense because no value is lost. The decrease in cash is exactly equal to the increase in supplies. The equation remains in balance. 3. Purchase Equipment and Supplies on Credit. Hailey Walker finds a used food truck from a supplier that specializes in restaurant equipment supplies, CanFood Supply Co. Walker is able to negotiate a deal with the same supplier on biodegradable food packaging supplies; these purchases total $7,100. As we see from the accounting equation in (2) above, however, Organico has only $7,500 in cash. Concerned that these purchases would use nearly all of Organico’s cash, Walker arranges to purchase the items on credit from CanFood Supply Co. This is a transaction because an exchange has occurred: Organico has acquired items in exchange for a promise to pay for them later. Supplies cost $1,100, and the equipment costs $6,000. The total liability to CanFood Supply is $7,100. Organico will pay for the supplies in 30 days, but has arranged to pay for the equipment by signing an agreement called a note. The effects of this transaction on the accounting equation are: Page 33 This purchase increases assets by $7,100, while liabilities (called accounts payable and notes payable) increase by the same amount. Both of these payables are promises by Organico to repay its debt, where the note payable reflects a more formal written agreement. We will discuss these liabilities in detail in later chapters. 4. Services Rendered for Cash. A primary objective of a business is to increase its owner’s wealth. This goal is met when a business produces a profit, also called income. Profit is reflected in the accounting equation as an increase in equity. Organico earns revenue by selling fresh, organic Mexican burritos and providing cooking demonstrations. On March 10, Organico provides catering services for a corporate sales training event for Lululemon Athletica Inc. and sells $2,200 worth of burritos for cash. This is a transaction since an exchange of resources has taken place. When revenue is earned in

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