CSC Chapter 1 Volume 11 PDF

SECTION 4 THE CORPORATION 11 Corporations and Their Financial Statements 12 Financing and Listing Securities © CANADIAN SECURITIES INSTITUTE  Corporations a...

SECTION 4 THE CORPORATION 11 Corporations and Their Financial Statements 12 Financing and Listing Securities © CANADIAN SECURITIES INSTITUTE  Corporations and Their Financial Statements 11 CHAPTER OVERVIEW In this chapter, you will learn about the three types of business structures, with a particular focus on the corporate structure. You will then learn about the various types of financial statements that corporations use to track their financial position and performance. In the context of public corporations, you will learn the rules of disclosure and the statutory rights of investors. Finally, you will learn the regulations around takeover bids and insider trading. LEARNING OBJECTIVES CONTENT AREAS 1 | Define the three types of business structures. Corporations and their Structure 2 | Describe the advantages, disadvantages, process, and structure of corporations. 3 | Describe the structure and purpose of the Financial Statements of a Corporation various financial statements. 4 | Summarize the two key components of a The Annual Report company’s annual report. 5 | Describe the rules for public company Public Company Disclosures and Investor disclosure and the statutory rights of Rights investors. 6 | Explain the general regulatory and disclosure Takeover Bids and Insider Trading requirements for takeover bids and insider trading. © CANADIAN SECURITIES INSTITUTE 11 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. amortization goodwill public corporation asset gross profit reporting issuer beneficial owner information circular retained earnings book value insider trading share capital capitalization intangible asset share of profit of associates continuous public International Financial sole proprietorship disclosure Reporting Standards statement of cash flows control position inventory statement of changes in corporation investments in associates equity cost method liabilities statement of comprehensive income cost of sales material change statement of financial current assets nominee position current liabilities non-controlling interest straight-line method declining-balance method non-current assets takeover bid deferred tax liabilities non-current liabilities trade payables depletion partnership trade receivables depreciation prepaid expenses trustee equity private corporation voting trust first-in-first-out proxy weighted-average method © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 3 INTRODUCTION The investment potential of a corporation’s securities depends on the company’s future performance, which can be difficult to forecast precisely. However, past performance often provides a clue. Therefore, an investor with some knowledge of a company’s present financial position and past financial record is more likely to make a wise investment decision. (Of course, the investor must also understand the industry in which the company operates, the economy in general, and the specific plans and prospects of the company in question to make a sound selection from investment alternatives.) Whether you are an investor, advisor, or analyst, you must approach a corporation’s financial statements as an investigator. Becoming familiar with the information presented in the financial statements is a first step toward making informed investment decisions. Those statements are one of the best ways that a company can communicate the successes and challenges it has experienced to the investing public. In this chapter, we discuss the different types of financial statements that corporations use and the various components that make up each type. We also examine several aspects of corporations in general, including the corporate structure itself and the various rules and regulations under which corporations operate. CORPORATIONS AND THEIR STRUCTURE 1 | Define the three types of business structures. 2 | Describe the advantages, disadvantages, process, and structure of corporations. A corporation is a distinct legal entity separate from the people who own its shares. An incorporated business pays taxes and can sue or be sued in a court of law. Property acquired by the corporation does not belong to the shareholders of the corporation, but to the corporation itself. The shareholders have no liability for the debts of the corporation, and there can be no additional levy on shareholders if the debts of a bankrupt corporation exceed the value of its realizable assets. Although corporations are the focus of this chapter, you should also be familiar with the other business structures, including sole proprietorships and partnerships: In a sole proprietorship, one person runs the business and is taxed on earnings at his or her personal income tax rate. The owner profits if the venture is successful, but is also personally liable for all debts, losses, and obligations arising from business activities. In other words, there is no distinction between personal assets and assets held in the business. In a partnership, two or more persons run the business, the structure of which is legislated under the Partnership Act. Partnerships can be general or limited. With a general partnership, both (or all) general partners run the day-to-day operations and are personally liable for all debts and obligations incurred in the course of business. With a limited partnership, general partners run the business while limited partners cannot participate in daily business activities. The limited partners’ liability is limited to the amount of their investments. Unlike sole proprietorships and partnerships, corporations are able to raise funds by issuing equity or debt, and are thus more suitable for large business ventures. © CANADIAN SECURITIES INSTITUTE 11 4 CANADIAN SECURITIES COURSE      VOLUME 1 ADVANTAGES AND DISADVANTAGES OF INCORPORATION The advantages and disadvantages of incorporation are summarized below. ADVANTAGES OF INCORPORATION Limited shareholder The shareholders of a corporation risk only the amount of money they have invested in liability the corporation’s common shares. For example, a shareholder who has invested $1,000 in a corporation’s common shares is not liable for additional contributions, even if the corporation were to go bankrupt and have obligations to creditors that exceed the value of its realizable assets. Continuity of existence A corporation’s continued existence is not affected by the death of any or all of its shareholders. Its existence is terminated only by imposed acts such as bankruptcy of the corporation itself. A corporation is unlike a sole proprietorship, which ends when the proprietor dies. It also differs from a partnership, which terminates upon the death or withdrawal of one partner, unless an agreement to the contrary exists. Transfer of ownership Shareholders of a public corporation can usually transfer their shares to other investors with relative ease. This liquidity is an attractive feature of share ownership. And, although the ownership of shares may change, the assets of the corporation continue to be owned by the corporate entity itself. Ability to finance Raising capital by issuing different classes of shares and debt instruments is much easier for corporations than for sole proprietorships or partnerships. Limited liability means that investors can contribute capital with a chance of return and without risk beyond the amount of the investment. Growth Corporations are structured to easily handle the large amounts of capital needed to operate large and growing businesses. Professional The shareholders are the ultimate owners of the corporation, but they play a very small management part in its management. Through their voting rights, they elect a board of directors to manage corporate affairs. If the directors do not manage the corporation to their satisfaction, the shareholders may elect different directors. DISADVANTAGES OF INCORPORATION Inflexibility A corporation is subject to many rules imposed by various statutes. Changes in the charter and by-laws of the corporation can be complicated and sometimes require formal approval of the government of the incorporating jurisdiction, as well as of the directors and shareholders. Taxation The possibility of double taxation arises when the after-tax profits of a corporation are distributed in the form of dividends to shareholders, who themselves pay tax on their dividend income. Expense After the initial cost of incorporation, annual costs apply that are additional to those incurred in proprietorships or partnerships. Some of those costs include annual returns, audits, preparation of federal and provincial corporate tax returns, the holding of shareholders’ meetings, and, for many corporations, securities laws. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 5 Capital withdrawal Corporations must carefully follow statutory procedures for the purchase and redemption of shares by the corporation, when permitted by the applicable statute. However, relatively minor investors in a public corporation can withdraw their capital simply by selling their shares on the market. PRIVATE AND PUBLIC CORPORATIONS Corporations can be either private or public: Private corporations have charters that restrict the right of shareholders to transfer shares, limit the number of shareholders to no more than 50, and prohibit members from inviting the public to subscribe for their securities. Public corporations are companies whose shares are listed on a stock exchange or traded over the counter. CORPORATE BY-LAWS A corporation, whether private or public, is regulated by the federal or provincial act under which its charter is issued, by the charter itself, and by various by-laws. A general by-law is prepared at the time of incorporation and contains rules that govern the conduct of the corporation. The by-laws are passed by the board of directors and approved by the shareholders. Provisions in the by-laws usually deal with the following types of issues: Shareholders’ and directors’ meetings Qualification, election, and removal of directors Appointment, duties, and remuneration of officers Declaration and payment of dividends Date of fiscal year end Signing authority for documents VOTING RIGHTS The common shareholders of a publicly traded company have certain rights based on their equity investment in the company. A very important right is the opportunity to vote on certain company matters at annual meetings and at special or general meetings. Shareholders can vote in the election of the board of directors, who guide and control the business operations of the corporation through its officers. Shareholders can also vote on corporate matters such as the sale, merger, or liquidation of the business, as well as decision regarding a stock split or the amendment of the corporation’s charter. Shareholders may also have the right to vote on executive compensation packages. SHAREHOLDERS’ MEETINGS The list of eligible shareholders is prepared, and is effective, as of a certain date prior to a regular or annual shareholder meeting. Shareholders are then notified of the meeting within a specified time period. At the annual meeting, they elect the directors, appoint independent auditors (or accountants), receive the financial statements and the auditor’s (or accountant’s) report for the preceding year, and consider other matters regarding the company’s affairs. To vote at the annual meeting, shareholders must have shares registered in their own name, or else they must be in possession of a completed proxy form. © CANADIAN SECURITIES INSTITUTE 11 6 CANADIAN SECURITIES COURSE      VOLUME 1 VOTING BY PROXY Corporations see the annual shareholders’ meeting as an opportunity to report on their activities to their shareholders. Before the meetings, shareholders receive a proxy statement that outlines what is to be voted on at the meeting. Every shareholder who is registered on a company’s books as owning shares is entitled to vote at the company’s annual general 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. The shareholder indicates those intentions on a proxy statement (or proxy form). 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, and particulars of other matters to be acted upon at the meeting. The proxy statement must be completed in writing and signed by the shareholder granting the proxy. If a shareholder does not vote or leaves the items on the proxy statement unmarked, the ballot is automatically cast with management’s viewpoint. Therefore, it is important for shareholders to read the resolutions carefully and make their intentions clear. 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. However, in some circumstances, a contest might arise for control of the corporation. In such cases, both the management group and the challengers actively seek proxy support from the shareholders at large before the meeting. Although such conflicts are rare, they can lead to the removal of the existing management, if enough shareholders lend support to the challengers. DIVE DEEPER You can view a sample proxy statement by visiting the website of the System for Electronic Document Analysis and Retrieval. There, you can access a database that contains public companies’ proxy statements, which have been filed with the securities regulators. DID YOU KNOW? Shares are most often registered in the name of a bank, investment dealer, or the CDS Clearing and Depository Services rather than in the name of the true beneficial owner of the shares. In such cases, the institution in whose name the securities are registered is the nominee. Nominees must make sure that all beneficial holders are notified of meetings, and that they receive voting instruction forms and other shareholder information. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 7 VOTING TRUSTS A corporation that is undergoing a restructuring because of financial difficulties may be placed under the control of a few individuals through a voting trust. The voting trust is usually put into effect for specific periods, or until certain results have been achieved. This measure is used because financiers may be willing to inject new capital only if they can be assured of control to protect their investment until the corporation recovers. To transfer voting control, shareholders are asked to deposit their shares with a trustee—usually a trust company— under the terms of a voting trust agreement. The trustee issues a voting trust certificate, which returns to the shareholder the same rights possessed by the original shares. Voting privileges, however, remain with the trustee. THE CORPORATE STRUCTURE A typical corporate structure at the executive level is illustrated in the Figure 11.1. Figure 11.1 | Simplified Organizational Chart of a Hypothetical Corporation Shareholders Board of Directors * Chairman of the Board President Executive Vice President Vice-President Vice-President Vice-President Vice-President Secretary and Vice-President Vice-President Human Finance Marketing General Research Public Affairs Resources Counsel * Many boards of directors elect executive, finance, and audit committees. © CANADIAN SECURITIES INSTITUTE 11 8 CANADIAN SECURITIES COURSE      VOLUME 1 The various members at the top of the corporate structure have the following responsibilities: Directors Directors must be of the age of majority and of sound mind. A director must not be an undischarged bankrupt person. They set company policies by passing resolutions. They normally appoint and supervise officers and signing authorities for banking, budget approval, financing, and plans for expansion. They are normally responsible for the decision to issue shares and declare dividends and other dispositions of profits. They are personally liable for illegal acts of the corporation done with their knowledge and consent. They are personally responsible for employee wages, declared dividends, and government remittances. They must act honestly, in good faith, and in the best interests of the corporation. Chairman The chairman of the board is elected by the board of directors. of the board Persons in this position may have all or any of the duties of the president or any other officer of the corporation. They may be the chief executive officer. They preside over meetings of the board and generally exert great influence on the management of the affairs of the corporation. Their job may be combined with that of president. President The president is appointed by and responsible to the board of directors. Persons in this position exercise authority through the other officers and through the heads of departments or divisions. If the job of president is not combined with that of the chairman, the president may act as chairman in the latter’s absence. Vice-Presidents Vice-presidents are appointed by, and responsible to, the president. They lead specific areas of the corporation’s operations, such as sales or finance. Officers Officers are appointed by the board of directors. They are corporate employees responsible for the day-to-day operation of the business. FINANCIAL STATEMENTS OF A CORPORATION 3 | Describe the structure and purpose of the various financial statements. The structure of a corporation helps us understand how the company functions in its day-to-day activity in the marketplace. However, the company’s financial statements shows us the company’s performance and how it changes over time. Before investing in any company’s stocks or bonds, you should be able to interpret its financial statements correctly, analyze them effectively, and compare them with those of other companies. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 9 Canada has adopted the International Financial Reporting Standards (IFRS), a globally accepted high-quality accounting standard used by public companies in more than 100 countries. The international standards are principles-based, with a focus on detailed disclosure, whereas GAAP accounting is a mix of rule- and principles-based accounting. With rule-based accounting, specific procedures are rigidly observed. Financial statements prepared in this way are less ambiguous, but the process is more complex. It is also difficult to create rules that fit every situation. Principles-based accounting has more general guidelines and broader objectives. For example, IFRS requires corporations to provide extensive and detailed disclosure to explain why particular accounting treatments are used, and enough data to allow an investor to make an objective analysis. As a result, financial statements are more transparent and easier to compare to those of other Canadian publicly traded companies that use the international standards. Financial statements act as an assessment of the company’s financial health and as an overview of its operations: they show what the company owns and how it was financed, as well as how much money it earned or lost over a given period (typically, one year). We will now discuss the structure, components, and purposes of the various corporate financial statements, and explain how they relate to each other. STATEMENT OF FINANCIAL POSITION The statement of financial position shows a company’s financial position on a specific date. In annual reports, that date is the last day of the company’s fiscal year. Many companies have a fiscal year end that corresponds with the calendar year end (December 31), but this is not a requirement. Banks and trust companies traditionally end their fiscal year on October 31. DID YOU KNOW? For banks and trust companies, October is the last month of each fiscal year; November is the first month of their next fiscal year. The statement of financial position shows three items: Assets consist of what the company owns and what is owed to it. Equity represents the shareholders’ interest in the company. Liabilities are what the company owes. Equity is also referred to as the book value of the company. It represents the excess of the company’s assets over its liabilities. Accordingly, the company’s total assets are equal to the sum of equity plus the company’s liabilities. The company’s financial position can be expressed as an equation in two ways, as shown below: Total Assets = Total Equity + Total Liabilities or Total Assets - Total Liabilities = Total Equity A statement of financial position is prepared and presented in more or less the same way for all Canadian publicly traded companies. Appendix A, at the end of this chapter, displays the financial statements of the fictional company Trans-Canada Retail Stores Ltd. as an example. The relationship between items on that company’s statement of financial position is shown in Table 11.1. © CANADIAN SECURITIES INSTITUTE 11 10 CANADIAN SECURITIES COURSE      VOLUME 1 Table 11.1 | Simplified Statement of Financial Position Assets $19,454,000 Total Assets $19,454,000 Equity $13,306,000 Total Equity $13,306,000 Liabilities $6,148,000 Total Liabilities $6,148,000 Total Equity and Liabilities $19,454,000 Using the two formulas for the statement of financial position, as noted above, we can express the financial position of Trans-Canada Retail Stores Ltd. as follows: 19,454,000 = 13,306,000 + 6,148,000 or 19,454,000 - 6,148,000 = 13,306,000 DID YOU KNOW? Equity represents the total value of a company’s assets that shareholders would theoretically receive if the company were liquidated. However, this item does not necessarily indicate the amount that shareholders would actually receive for their ownership interest, in the event of sale. The market value of the shareholders’ interest could be worth more or less than the book value, largely depending on the company’s earning power and prospects. We will now explain each category of the statement of financial position for the company Trans-Canada Retail Stores Ltd., in the order that it appears in Appendix A. CLASSIFICATION OF ASSETS Assets are classified on a statement of financial position as current and non-current. ITEMS 1–3: NON-CURRENT ASSETS Non-current assets include property, plant, and equipment (PP&E); goodwill and other intangible assets; and investments in associates. They are shown as items 1 to 3 on the Trans-Canada Retail Statement of Financial Position. PROPERTY, PLANT AND EQUIPMENT The category of PP&E consists of land, buildings, machinery, tools and equipment of all kinds, trucks, furnishings, and other items used in the day-to-day operations of a business. A company’s PP&E is valuable because it is used directly in producing the goods and services the company eventually sells. Unlike current assets, which are consumed or converted by successive steps into cash, the items that make up a company’s PP&E are not intended to be sold. Property (except land), plant, and equipment wear out over time or otherwise lose their usefulness. Between the time that a given asset is acquired and the time when it is no longer economically useful, it decreases in value. This loss over a period of years is known as depreciation. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 11 Timber companies and other industries involved in resource extraction use the term depletion, which is similar to the term depreciation used by mining, oil, natural gas. The assets of resource extraction industries consist largely of natural wealth such as minerals in the ground or standing timber. As these assets are developed and sold, the company loses part of its assets with each sale. Such assets are known as wasting assets, and depletion is the annual decrease in value the company records. In contrast, amortization is the term used to describe the gradual writing off of intangible assets such as patents or trademarks. DID YOU KNOW? Calculating Depreciation Items in the PP&E category are initially shown on the statement of financial position at original cost, including certain costs of acquisition (such as installation costs). Except for land, PP&E items are depreciated each year (i.e., reduced in value to reflect wear and tear), and the total accumulated depreciation is deducted from the original cost. To spread the cost of PP&E items over their years of useful service, companies record depreciation expenses in each year’s statement of comprehensive income. PP&E items are used in the process of producing goods or services. Therefore, their depreciation is a cost of doing business, similar to wages and other expenses. The amount recorded as depreciation each year is based on the original cost of each asset, its expected useful life, and any residual value. Two commonly used methods of calculating depreciation are the straight-line method and the declining-balance method: The straight line method applies an equal amount to each period. This is the method used most frequently in Canada by public companies. The declining-balance method applies a fixed percentage, rather than a fixed dollar amount, to the outstanding balance to determine the expense to be charged in each period. This amount is then deducted from the capital asset balance to determine the amount against which the percentage will be applied in the subsequent period (thus the term declining balance). The declining-balance method typically uses some multiple of the straight line rate. The equation used for the straight line method is shown in Figure 11.2. Figure 11.2 | Calculating Annual Depreciation Expense Straight Line Method Original Value - Residual Value Annual Depreciation Expense = Expected Life Where: Original Value = Cost of purchase Residual Value = Value at end of useful life Expected Life = Expected number of years of useful life © CANADIAN SECURITIES INSTITUTE 11 12 CANADIAN SECURITIES COURSE      VOLUME 1 The two methods of calculating depreciation are compared in the example below. EXAMPLE Straight-Line Method: A piece of equipment bought by XYZ Co. Ltd. at $100,000 is expected to have a useful life of eight years and a residual value of $10,000 at the end of the asset’s useful life. Using the straight-line method, the annual depreciation for this asset is calculated as follows: 100,000 - 10,000 = $11,250 8 The depreciation rate is therefore 12.5% (calculated as 100% ÷ 8) per year for each of the eight years of expected usefulness. Declining-Balance Method: Let’s assume that XYZ instead chooses to use a depreciation rate of 25% (double the straight-line rate) under the declining-balance method on each year’s remaining balance. The calculation is as follows: In year 1, $100,000 depreciates at 25%, which equals $25,000. In year 2, $75,000 (calculated as $100,000 − $25,000) depreciates at 25%, which equals $18,750. The annual calculations for each of the two methods are compared and illustrated in Table 11.2. Remember that the cost of the asset is $100,000, the residual value is $10,000, and its useful life is eight years. The carrying amount shown in the table is the amount recorded each year on the statement of financial position. Table 11.2 | Straight-Line Method versus Declining-Balance Method for Depreciation STRAIGHT-LINE METHOD DECLINING-BALANCE METHOD Fiscal Year-End Depreciation Charge Carrying Amount Depreciation Charge Carrying Amount Year 1 $11,250 $88,750 $25,000 $75,000 Year 2 11,250 77,500 18,750 56,250 Year 3 11,250 66,250 14,063 42,188 Year 4 11,250 55,000 10,547 31,641 Year 5 11,250 43,750 7,910 23,730 Year 6 11,250 32,500 5,933 17,798 Year 7 11,250 21,250 4,449 13,348 Year 8 11,250 10,000 3,337 10,011 Depreciation is intended to allocate the cost (minus residual value) of the company’s PP&E over the useful lives of the assets. It provides a realistic matching of earnings to expenses in a fiscal period to determine a company’s net or comprehensive income on an annual basis. The depreciation method, estimated life, and valuations must be reviewed each year according to the IFRS accounting system. Note that annual allowances for depreciation, depletion, and amortization appear as non-cash expenses in the statement of comprehensive income. Therefore, it is quite possible for a company to add considerable amounts to its cash resources for the year—and yet show little or no profit—if substantial depreciation, depletion, or amortization charges were made. These effects are reflected in the statement of cash flows, where the cash from operations is reported. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 13 An accounting activity called capitalization records an expenditure as an asset, rather than an expense. The purpose of this activity, related to depreciation, is to spread the amount over more than one accounting period. When a company capitalizes an asset, profit in the year of acquisition is affected to a much lesser degree. EXAMPLE Ajax Inc. purchases a piece of machinery for $10 million. Instead of recording the purchase as an expense on the statement of comprehensive income, the company records it as an asset on the statement of financial position. As an asset, its value then depreciates over a number of years. If the company had recorded the $10 million cost on its statement of comprehensive income as an expense in the year it was incurred, the purchase would have had a substantial impact on a company’s profit for that year. Under IFRS, fewer acquisition-related costs are allowed to be capitalized; instead, they must be expensed in the year of acquisition. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill is often defined as the probability that a regular customer of a company will continue to do business with that company because of its location or its reputation for fair dealing and good products. People in the habit of doing business with a firm are likely to continue that habit even when the firm changes hands. For that reason, a buyer of a business is often willing to pay for the good name of that business, or for its continued good management, in addition to the value of its assets. 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 are non-monetary assets that do not have physical substance. They can be sold, licensed, or transferred, but they usually decline greatly in value when a company is liquidated. Some common examples are patents, copyrights, franchises, and trademarks. In general, the value given to intangible assets on the statement of financial position should be viewed with caution. Their value is connected more to their contribution to earning power than to their saleability as assets. For example, a trademark may have worth to a business in terms of brand recognition, yet its dollar value would be difficult to assess if it were to be sold on its own. INVESTMENT IN ASSOCIATES Investment in associates refers to the degree of ownership that a company has in another company. As a general rule, significant influence is presumed to exist when a company owns at least 20% – but less than half – of the voting rights of the other company. ITEMS 5–8: CURRENT ASSETS Current assets are assets that will be realized, consumed, or sold in the normal course of business, typically within one year. They include inventory, prepaid expenses, and trade receivables, as well as cash and cash equivalents. Current assets are the most important group of assets because they largely determine a firm’s ability to pay its day- to-day operating expenses. Current assets are shown as Items 5 to 8 on the Trans-Canada Retail Statement of Financial Position (Appendix A). INVENTORY Inventory consists of the goods and supplies that a company keeps in stock. For example, a furniture manufacturer that sells chairs to Trans-Canada Retail would have inventories of raw materials (the fabric and wood used to build the chairs), work-in-progress (the assembled chair frames), and finished goods (the completed chairs ready for shipping). © CANADIAN SECURITIES INSTITUTE 11 14 CANADIAN SECURITIES COURSE      VOLUME 1 Inventories are changed into cash through successive steps as raw materials are processed into finished goods. Finished goods sold on credit rather than for cash give rise to trade receivables, which are eventually paid off in cash. This process goes on day after day, providing the funds to enable the company to pay for wages, raw materials, taxes, and other expenses. Ultimately, inventories provide the profits out of which dividends may be paid to shareholders. Inventories are valued at original cost or net realizable value, whichever is lower. You can think of net realizable value as the expected sale price less the costs associated with selling the asset. The following two methods are commonly used to determine the value of inventories at original cost: The weighted-average method uses the average of the total cost of the goods purchased over the period on a per unit basis. The first-in-first-out (FIFO) method implies that items acquired earliest are assumed to be used or sold first. EXAMPLE A computer company manufactured 1,000 hard drives last month, at a cost of $125 each, and an additional 1,000 units this month, at a cost of $150 each. (The higher costs relate to rising raw materials prices.) The company sells 1,000 hard drives today. Under the FIFO method, the inventory is valued as follows: The cost of the goods sold is $125 per hard drive, because that was the cost of each of the first hard drives into inventory. The remaining hard drives are valued at the more recent and higher cost of $150 each, which works out to an inventory value of $150,000, calculated as 1,000 hard drives × $150 = $150,000. Under the weighted-average method, the inventory is valued as follows: The total cost of the hard drives is $275,000, calculated as (1,000 × $125) + (1,000 × $150) = $125,000 + $150,000 = $275,000. The average cost of the inventory is $137.50, calculated as $275,000 ÷ 2,000 units = $137.50. The cost of the goods sold is $137.50 per hard drive. The inventory value reported on the statement of financial position is $137,500, calculated as $137.50 × 1,000 = $137,500. As shown in the above example, if prices are changing, each of these methods produces a different inventory value on the statement of financial position. Consequently, the two methods show a different profit, based on the costs of the goods sold. As you will learn when we discuss the statement of comprehensive income later in this chapter, a lower cost of goods sold results in higher profits for the company. PREPAID EXPENSES Prepaid expenses are payments made by the company for services to be received in the near future. Prepaid expenses are the equivalent of cash because they eliminate the need to pay cash for goods or services in the immediate future. (Nevertheless, IFRS treats these expenses as an entry separate from cash and cash equivalents.) Rents, insurance premiums, and taxes, when paid in advance, are examples of prepaid expenses. TRADE RECEIVABLES The trade receivables category represents money owing to a company for goods or services it has sold. Because some customers fail to pay their bills, an item called allowance for doubtful accounts is often subtracted from receivables. This allowance is management’s estimate of the amount that will not be collected. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 15 The net amount of trade receivables is shown on the statement of financial position as trade receivables minus the allowance for doubtful accounts. CASH AND CASH EQUIVALENTS The cash and cash equivalents category represents cash on hand, funds in the company’s bank accounts, or funds held in short-term investments. These items hold minimal risk of a change in value and are readily convertible into cash. CLASSIFICATION OF EQUITY We now turn our attention to the various categories of equity shown in the statement of financial position. The items in this section represent shareholders’ equity, which is the amount that shareholders have at risk in the business. This category includes share capital, retained earnings, and non-controlling interest, which are shown on the statement of financial position as Items 11 to 13. ITEM 11: SHARE CAPITAL Share capital is the money paid in by shareholders. This is the amount received by the company for its shares at the time that they were issued. Therefore, the share capital shown on the statement of financial position is not related in any way to the current market price of the outstanding shares. Share capital does not change from year to year unless the company issues new shares or buys back outstanding shares. ITEM 12: RETAINED EARNINGS Retained earnings represent the profits earned over time that have not been paid out as dividends—in other words, the portion of annual earnings retained by the company after payment of all expenses and the distribution of all dividends. The earnings retained each year are reinvested in the business. The reinvestment of accumulated earnings may be held in cash or reinvested in inventories, property, or any other of the company’s assets. If a company suffers a loss in any year, the loss is deducted from the retained earnings. In this event, each shareholder’s ownership interest in the company is reduced because the retained earnings amount has been reduced. If more losses than earnings accumulate, the result is a deficit. ITEM 13: NON-CONTROLLING INTEREST Non-controlling interest appears as a category when a company owns more than 50% of a subsidiary company and consolidates its financial statements. In other words, the company combines all the assets, liabilities, and operating accounts of the parent company with those of its subsidiary or subsidiaries into a single joint statement. Even when the parent company owns less than 100% of a subsidiary’s stock, all of the subsidiary’s assets and liabilities are combined in the consolidated financial statements. However, the part of the subsidiary that is not owned by the parent company is shown in the statement of financial position as non-controlling interest. This item is the interest or ownership that outsiders have in the subsidiary company. Under IFRS, non-controlling interest is presented separately from the parent company’s shareholders’ equity. CLASSIFICATION OF LIABILITIES As with assets, liabilities are classified on the statement of financial position as current and non-current. ITEMS 15 AND 16: NON-CURRENT LIABILITIES Non-current liabilities include long-term debt and deferred tax liabilities. These items are shown as Items 15 and 16 on the Trans-Canada Retail Statement of Financial Position (Appendix A). LONG-TERM DEBT The long-term debt of a company is debt that is due in annual instalments over a period of years, or else in a lump sum in a future year. The most common of these debts are mortgages, bonds, and debentures. Frequently, capital © CANADIAN SECURITIES INSTITUTE 11 16 CANADIAN SECURITIES COURSE      VOLUME 1 assets classified as PP&E are pledged as security for such borrowings. Any portion of long-term debt that is due within the current year is shown as a current item. It is customary to describe long-term debt items in the notes to the financial statements. Notes must be detailed enough to tell the reader what kind of security is provided on the loan, what interest rate is carried, when the debt becomes repayable, and what sinking fund provision, if any, is made for repayment. DEFERRED TAX LIABILITIES The deferred tax liabilities category represents income tax payable in future periods. These liabilities commonly result from temporary differences between the book value of assets and liabilities as reported on the statement of financial position and the amount attributed to that asset or liability for income tax purposes. The difference between these two amounts is multiplied by a future tax rate to arrive at the tax amount owing for the period. ITEMS 18–21: CURRENT LIABILITIES For the most part, current liabilities are debts incurred by a company in the ordinary course of its business that must be paid within the company’s normal operating cycle (typically, one year). The Trans-Canada Retail Statement of Financial Position shows four common types of current liabilities (items 18 to 21): Current portion of long-term debt due in one year Taxes payable to the government in the near term Trade payables (unpaid bills for items such as raw materials and supplies) Short-term borrowings from financial institutions DID YOU KNOW? When calculating a company’s debt ratios (see Chapter 14 for more information on ratios), it is important to distinguish between debts, such as short-term borrowings and bonds, and other types of liabilities, such as trade payables and taxes owed. Only debts incurred by borrowing are included in ratios involving debt. STATEMENT OF COMPREHENSIVE INCOME The statement of comprehensive income shows how much money a company earned during the year compared to how much money it spent. The difference between the two amounts is the company’s profit or loss for the year, out of which dividends may be paid to the shareholders. The statement of comprehensive income reveals the following information about a company: Where earnings come from Where earnings go The adequacy of earnings, both to assure the successful operation of the company and to provide income for the holders of its securities DID YOU KNOW? When analyzing the financial condition of a company, its earning power and cash flow are of primary interest. The proof of a company’s financial strength and security lies in its ability to generate earnings and, through those earnings, cash flow. Evidence of the adequacy of these items is provided by both the statement of comprehensive income and the statement of cash flows. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 17 STRUCTURE OF THE STATEMENT OF COMPREHENSIVE INCOME The first section of the statement of comprehensive income typically has three parts: revenue, cost of sales, and gross profit. Simply put, gross profit is the amount remaining after the cost of sales is subtracted from revenue. After gross profit is determined, other income is added and general expenses are subtracted to arrive at total comprehensive income. The various categories of the Trans-Canada Retail Statement of Comprehensive Income are explained in detail below. ITEMS 24–26: REVENUE, COST OF SALES, AND GROSS PROFIT REVENUE Revenue is a key figure in the statement of comprehensive income. It consists of income made from the sale of products or services. For example, if the company is a public utility, it derives income from the sale of gas or electricity. Revenue is the figure needed to calculate various ratios, such as net and gross profit margins, that are used to determine the soundness of a company’s financial position. These ratios are used by credit managers, bankers, and security analysts in making a detailed investigation of a company’s financial affairs. COST OF SALES Expenses that arise in producing the income received from the sale of the company’s products or services are deducted from revenue. The first such deduction, in the case of a manufacturing or merchandising business, is termed cost of sales. This item includes costs of labour, raw materials, fuel and power, supplies and services, and other kinds of expenses that go directly into the cost of manufacturing, or in the case of a merchandising company, expenses that go directly into the cost of goods purchased for resale. Although all statements of comprehensive income provide the same financial information, a company can use one of the following two formats, depending on how expenses are disclosed: By nature of their use (e.g., depreciation, raw materials, and employee benefits) By function (e.g., cost of sales, administrative, and distribution) Note: The Trans-Canada Retail Statement of Comprehensive Income discloses expenses by function. GROSS PROFIT After deducting the cost of sales from the amount of revenue we have the company’s gross profit figure for the period. This figure is significant because it measures the margin of profit or spread between the cost of goods produced for sale and revenue. When the percentage of gross profit to revenue is calculated and compared with those of other companies engaged in the same line of business, it provides an indication of whether the company’s merchandising operations are more or less successful in producing profits than its competitors. Between different companies in the same business, differences in the margin of gross profit generally reflect differences in managerial ability. ITEM 27: OTHER INCOME Generally, a company has two main sources of income, revenue and other income. Revenue is derived from the sale of products or services, whereas other income is not directly related to a company’s normal operating activities. This category includes dividends and interest from investments, rents, and sometimes profits from the sale of PP&E. Good accounting practice requires that revenue and other income be shown separately in the statement of comprehensive income, especially if the other income is substantial. It is important to separate the two categories; otherwise, it would be impossible to gain a true picture of the company’s real earning power based on its main © CANADIAN SECURITIES INSTITUTE 11 18 CANADIAN SECURITIES COURSE      VOLUME 1 operations. For example, a company might realize a substantial profit from the sale of securities or some other asset in one year. However, a profit of this kind is not likely to be repeated the next year. To combine it with revenue would give a false impression of the company’s earning power. Therefore, other income is added after gross profit is calculated. ITEMS 28 TO 31: GENERAL EXPENSES After other income is added to gross profit, the following general expenses are deducted: Distribution costs, including such expenses as advertising costs and salaries and commissions to sales personnel Administrative expenses, including office salaries, accounting staff salaries, and office supplies Other expenses not directly related to the company’s normal operating activities, including expenses associated with the sale of PP&E Finance costs in the form of interest payments on debtholders’ securities or loans to the company The distribution of income to creditors is usually made in the form of fixed interest charges to banks and other debtholders who have lent money to the company. These interest charges are paid out of income before taxes and are fixed in the sense that the amount of interest that has to be paid on borrowed money is definite. For example, if the company has $1,000,000 worth of bonds outstanding in the hands of investors, and these bonds bear interest at the rate of 9% per annum, the interest to be paid each year is a fixed amount of $90,000. Interest charges are also fixed, which means that they must be paid before any income is distributed to shareholders. A default in payment would give creditors the right to place the company in receivership and put the company at risk of bankruptcy. ITEM 32: SHARE OF PROFIT OF ASSOCIATES Share of profit of associates occurs when one company’s investment in another company creates significant influence without gaining control, and when each company has its own financial statements. The equity accounting method is used to capture the income received from the investment. Traditionally, a company has significant influence (but falls short of control) when it owns at least 20%—but less than half—of voting shares. EXAMPLE Trans-Canada Retail Stores Ltd. owns 25% of Alberta Retail Stores Ltd. Alberta Retail Stores earned $20,000 (after tax) in a particular fiscal year. In its statement of comprehensive income, Trans-Canada Retail Stores reports $5,000 of this amount (25% × $20,000) as share of profit of associates. The cost method of accounting is primarily used for ownership holdings that do not result in significant influence (traditionally ownership of less than 20%) and where investments in other companies are reported in the form of investments on the financial statements. Certain profit calculations must be adjusted for share of profit of associates because the company reports this income but does not actually receive it in cash. Therefore, share of profit of associates is a non-cash source of funds—just as depreciation, amortization, and depletion are non-cash uses of funds. Company profit must be reduced by the amount of share of profit of associates when calculating ratios, when a true picture of the company’s cash profit is required (see also item 32 on the consolidated statement of cash flows). If an entity under a company’s significant influence experiences a loss, the company reports its share of the loss on its statement of comprehensive income. This entry is called share of loss of associates, and reduces profit on the statement. As with share of profit of associates, a share of loss of associates is a non-cash item. The amount of the share of loss of associates must therefore be added back to the company’s profit when calculating ratios to show a true picture of the company’s cash profit. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 19 ITEM 33: INCOME TAX EXPENSE Income tax expense includes both current tax and deferred tax for the time period. The notes to the company’s financial statements provide additional information on this topic. ITEM 34: PROFIT The next step in the statement of comprehensive income is the calculation of profit (or loss). This is the amount of profit from the year’s operations that may be available for distribution to shareholders. Note: The section called other comprehensive income on the Trans-Canada Retail Statement of Comprehensive Income has no entries. However, on another company’s statement, this section might include the following items: Actuarial gains and losses on defined benefit plans Gains and losses from currency translations relating to the financial statements of a foreign operation The total comprehensive income (Item 35) consists of the profit (or loss) plus the other comprehensive income. At this point, total comprehensive income is transferred to the statement of changes in equity. STATEMENT OF CHANGES IN EQUITY The statement of changes in equity is used to record changes to each component of equity, including share capital and retained earnings (items 11 and 12 on the statement of financial position). It also records any change in non- controlling interest (item 13 on the statement of financial position). RETAINED EARNINGS Retained earnings are profits earned over the years that have not been paid out to shareholders as dividends. These retained profits accrue to the shareholders, but the directors have decided to reinvest them in the business for now. Retained earnings provide a record of the total comprehensive income kept in the business year after year. A portion of the total comprehensive income for the current year is added to (or, in the event of a loss, subtracted from) the balance of retained earnings shown in the statement of financial position from the previous year. Dividends declared during the year are subtracted from retained earnings in the statement of changes in equity. A new final retained earnings figure is determined and carried to the statement of financial position where it appears in the equity section (item 12). The statement of changes in equity is important because it provides a link between the statement of comprehensive income and the statement of financial position. The consolidated statement of changes in equity also discloses the profit or loss to the non-controlling interests and to the parent company. (In our example, the parent company is Trans-Canada Retail.) TOTAL COMPREHENSIVE INCOME The statement of changes in equity shows the company’s total comprehensive income in the form of retained earnings. It also shows the amount of total comprehensive income that is attributable to non-controlling interests. The total comprehensive income attributable to the owners of the company represents the total comprehensive income of the company minus the total comprehensive income attributable to the non-controlling interests. © CANADIAN SECURITIES INSTITUTE 11 20 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLE A company owns 80% of the shares of a subsidiary, and the subsidiary had total comprehensive income of $1,000,000 last year. The subsidiary’s total comprehensive income of $1,000,000 is included in the total comprehensive income of the parent company. The statement of comprehensive income shows $200,000 as income attributable to non-controlling interests, which represents the 20% of the subsidiary that is not owned by the parent company. STATEMENT OF CASH FLOWS As we discussed earlier, the statement of financial position shows a company’s financial position at a specific point in time, and the statement of comprehensive income summarizes the company’s operating activities for the year. Neither statement, however, shows how the company’s financial position changed from one period to the next. The statement of cash flows fills this gap by showing how the company generated and spent its cash during the year. The statement of cash flows helps the reader to evaluate the liquidity and solvency of a company and assess its overall quality. The assessment should address the following questions: Can the company pay its creditors, especially in business downturns? Can it fund its needs internally, if necessary? Can it reinvest while continuing to pay dividends to shareholders? A review of the statement of cash flows over a number of years may illustrate trends that might otherwise go unnoticed. This statement often provides a clearer picture of the viability of a company than does the statement of comprehensive income because it measures actual cash generated from the business. For the purposes of the statement of cash flows, the item cash and cash equivalents includes cash on hand or in the company’s bank accounts as well as short-term, highly liquid investments that are readily convertible into known amounts of cash (with little risk of a change in value). The statement of cash flows details the changes in cash and cash equivalents and the reasons for those changes. STRUCTURE OF THE STATEMENT OF CASH FLOWS A statement of cash flows shows the company’s cash flows for the period under the following three headings: Operating Activities Financing Activities Investing Activities This statement also shows the increase or decrease in cash in the current fiscal year. The various categories of the Trans-Canada Retail Statement of Cash Flows are explained in detail below. ITEMS 34 TO 37: OPERATING ACTIVITIES The statement of cash flows begins by looking at those accounts that directly reflect the business activities of the company. Those activities are actions that require an inflow or outflow of cash and that generate sales and expenses during the year. The statement begins with profit (item 34). Added back to profit are all items not involving cash, such as depreciation and amortization. Share of profit of associates (item 32) is subtracted because it is not an actual cash transaction for the company. Item 37, change in net working capital, represents changes in the various asset and liability accounts that appear on the statement of financial position. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 21 Net working capital items include the following accounts: Trade receivables Inventories Trade payables Interest payable Taxes payable The dollar amounts of these accounts in the current year are compared to the same amounts in the previous year. The change in each account is then recorded in the statement of cash flows. Note: Because the previous year’s financial statements of Trans-Canada Retail are not provided, the calculation of change in net working capital (item 37) is not shown in the text. EXAMPLE The trade receivables account at Ajax Inc. records invoices that have been sent to customers but not yet paid. The company includes the sales in revenue but has not yet received the money. When the invoice is paid, the receivables account declines as the cash account increases. These changes must be tracked in the statement of cash flows to show an accurate picture of the company’s position. For example, if trade receivables increase substantially in the current year, the company’s sales revenue will be much higher than the amount of cash collected over the period. This discrepancy may require further investigation on the part of the analyst. It could indicate that the receivables department is poorly managed or that the company is extending credit to customers that are unable to pay. More importantly, a company needs a regular stream of cash flowing into the business to maintain its operations. If credit sales go uncollected for an extended period, the company may have difficulty paying its bills or meeting interest charges. The company may look good on paper because its revenues are up. However, as demonstrated by the statement of comprehensive income, it may soon be in serious financial difficulty, if it cannot generate enough cash to pay its creditors. ITEMS 38 TO 41: FINANCING ACTIVITIES Cash flows from financing activities involve transactions used to finance the company. If the company has issued new share capital (item 38) or debt (item 40), cash flows into the company. If the company repays debt (item 39) or pays dividends to the shareholders (item 41), cash flows out of the company. This section is of particular interest to the shareholders of the company because it highlights changes to a company’s capital structure—the overall use of debt and equity financing. A substantial increase in debt, or issuance of new shares, may negatively affect the shareholders’ equity in the company. Note: Dividends paid to shareholders could be placed in either the operating activities section or the financing activities section. Trans-Canada Retail has chosen to place them in the financing activities section. ITEMS 42 TO 44: INVESTING ACTIVITIES Investing activities highlight what the company did with any money not used in its direct operation. This section includes any investments made in the company itself, such as the purchase of new capital assets (item 42) or disposal of such assets (item 43). As well, this part includes any dividends actually received from associates (item 44). © CANADIAN SECURITIES INSTITUTE 11 22 CANADIAN SECURITIES COURSE      VOLUME 1 Note: Dividends from associates could be placed in either the operating activities section or the investing activities section. Trans-Canada Retail has chosen to place them in the investing activities section. ITEMS 45 AND 46: THE CHANGE IN CASH FLOW The final section of the statement of cash flows sums up the cash flows from operating, investing, and financing activities to arrive at the increase or decrease in cash (item 45) for the current fiscal year. Because the statement of cash flows looks at the actual change in the cash position for the year, the final balance in cash and cash equivalents (item 46) comprises cash and cash equivalents found in the year-end statement of financial position for Trans- Canada Retail (item 8). Ideally, the company should always have a positive net cash flow. If it does not, it is important to find out why. The IFRS accounting approach requires additional disclosures not normally seen with the Canadian GAAP approach. For example, the company should disclose whether the financial statements represent a single entity or a group of entities, and whether the measurement basis is historical cost or fair value. These disclosures help the reader to understand the rationale behind the presentation of facts. THE ANNUAL REPORT 4 | Summarize the two key components of a company’s annual report. A corporation’s annual report is a publication for shareholders that provides an overview of the firm’s finances and a review of its activities over the course of the previous year. Two important components of a company’s annual report are the notes to financial statements and the auditor’s report. NOTES TO THE FINANCIAL STATEMENTS A considerable amount of detailed information about a company’s financial condition must be disclosed in the shareholders’ interest. Much of this information is shown in a series of notes to the financial statements, rather than in the statements themselves. The company’s notes include the following items: its statement of compliance with IFRS; the accounting policies used; more detailed descriptions of fixed assets, share capital, and long-term debt; and commitments and contingencies. Potential investors should also look in the notes to ascertain whether the company uses derivatives for hedging or other purposes. THE AUDITOR’S REPORT Canadian corporate law requires that every limited company appoint an auditor to represent shareholders and report to them annually on the company’s financial statements. The auditor must express an opinion in writing as to the fairness of those statements. The auditor is appointed at the company’s annual meeting by a resolution of the shareholders and may also be dismissed by them. The only exception to this requirement is for privately held corporations, where all shareholders have agreed that an audit is not necessary. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 23 PUBLIC COMPANY DISCLOSURES AND INVESTOR RIGHTS 5 | Describe the rules for public company disclosure and the statutory rights of investors. Securities legislation in each of the provinces requires the continuous disclosure of certain prescribed information concerning the business and affairs of public companies. This disclosure usually consists of periodic financial statements (including management discussion and analysis), insider trading reports, information circulars required in proxy solicitation, the annual information form, press releases, and material change reports. The principle of disclosure is also evident in the requirements of the acts, regulations, and policy statements of most provinces covering a distribution of securities. Generally, every person or corporation that sells or offers to sell to the public securities that have not previously been distributed to the public, or which come from a control position, is required to file with, and obtain the approval of, the administrator in the province. The seller must deliver to the purchaser a prospectus containing full, true, and plain disclosure of all material facts related to the issue. DID YOU KNOW? A control position refers to ownership of more than 20% of the voting stock in a company that is sufficient to materially affect its affairs. CONTINUOUS DISCLOSURE A reporting issuer is a corporation that has issued securities to the public and must comply with the timely and continuous public disclosure requirements of the securities acts. The primary disclosure requirements include issuing a press release and filing a material change report with the administrators, if a material change occurs. A material change is a change in the business, operations, or capital of an issuer that would reasonably be expected to have a significant effect on the market price or value of its securities. Issuers must also file with the administrators annual and interim financial statements that meet prescribed standards of disclosure. Companies are required to ensure that no confidential material information is selectively disclosed to third parties. Situations where such disclosure might occur include meetings with financial analysts and restricted conference calls with institutional investors. By taping all such discussions and reviewing the tapes immediately after all meetings or conference calls, a company can determine whether any previously undisclosed confidential material information was inadvertently disclosed. If it was, an immediate press release by one of its responsible officers should be released, and the appropriate regulators should be notified of the inadvertent disclosure. Most companies usually provide financial statements in the required form to all shareholders and send additional copies to the appropriate administrators. The financial disclosure provisions also require that shareholders and administrators be provided with the following information: Comparative audited annual financial statements should be sent within 120 days of the financial year-end for companies listed on the TSX Venture Exchange, or within 90 days for issuers on the TSX. Comparative unaudited quarterly interim financial statements should be sent within 60 days of the end of each of the first three quarters of the financial year, for companies listed on the TSX Venture Exchange, or within 45 days, for issuers on the TSX. © CANADIAN SECURITIES INSTITUTE 11 24 CANADIAN SECURITIES COURSE      VOLUME 1 STATUTORY RIGHTS OF INVESTORS The Canadian Securities Administrators have adopted a statement of withdrawal and rescission rights for purchasers to be included in all prospectuses (National Instrument 41-101 General Prospectus Requirements). These rights can be summarized according to the conditions described below. RIGHT OF WITHDRAWAL Securities legislation in all provinces provides purchasers with the right to withdraw from an agreement to purchase securities within two business days after receipt or deemed receipt of a prospectus or any amendment to the prospectus. The purchaser must give notice to the vendor or its agent. Where a distribution requiring a prospectus is completed without a prospectus, most provinces permit a purchaser who still owns the security to revoke the transaction, subject to applicable time limits. In Quebec, the purchaser can apply for an adjustment of the purchase price. RIGHT OF RESCISSION Securities legislation gives purchasers the right to rescind or cancel a completed contract for the purchase of securities if the prospectus or amended prospectus offering the security contains a misrepresentation. This right is provided on condition that the action to enforce it is brought within the applicable time limits. In most provinces, a purchaser alleging misrepresentation must choose between the remedy of rescission and the alternative of damages. RIGHT OF ACTION FOR DAMAGES The right of action for damages as granted by most securities legislation provides that an issuer and its directors, and anyone who signs a prospectus, may be liable for damages if the prospectus contains a misrepresentation. The same liability applies to an expert (such as an auditor, lawyer, geologist, or appraiser), whose report or opinion appears with his or her consent in a prospectus. Experts are only liable if the misrepresentation is with respect to their report or opinion. Legislation provides a number of defences to an action for rescission or damages based on a misrepresentation. For example, if the underwriter or directors conducted a thorough enough investigation to provide reasonable grounds to believe that there has been no misrepresentation, they cannot be held liable. A defence is also available if the person or company can prove that the purchaser bought the securities with knowledge of the misrepresentation. Furthermore, securities legislation imposes certain limitations with respect to maximum liability, as well as time limits during which an action may be brought. TAKEOVER BIDS AND INSIDER TRADING 6 | Explain the general regulatory and disclosure requirements for takeover bids and insider trading. The securities legislation of most provinces contains provisions regulating takeover bids. This legislation is designed to safeguard the position of shareholders of a company that is the target of a takeover by ensuring that each shareholder has a reasonable opportunity and adequate information to consider the bid. Most provinces also require insiders of a reporting issuer to file reports of their trading in its securities. This requirement is based on the principle that shareholders and other interested persons should be regularly informed of the market activity of insiders. In addition, insiders who make use of undisclosed information must give an accounting of their profits and may be liable for damages. Takeover bids and insider trading are explained in detail below. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 25 TAKEOVER BIDS A takeover bid is an offer to purchase from a company’s shareholders more than 20% of the outstanding voting securities of the company (or a number of shares that, when combined with the offeror’s existing shares, exceeds 20%). Outstanding voting securities are those voting shares that are owned by shareholders and are available for trading. In a takeover, the company or individual making the offer, if successful, obtains enough shares to control the targeted company. The definition of a takeover includes an offer to purchase, an acceptance of an offer to sell, and a combination of the two. A takeover bid must comply with provincial legislation, unless it is exempted under the relevant act. EARLY WARNING DISCLOSURE Most provincial acts state that every person or company accumulating 10% or more of the outstanding voting securities of any class of a reporting issuer, or securities convertible into such securities, must issue a press release immediately. The press release and report must include a statement of the purpose of the acquisition and any future intentions to increase ownership or control. After a formal bid is made for voting securities of a reporting issuer, and before the expiry of the bid, every person or company acquiring 5% or more of the securities of the class subject to the bid (other than the offeror under the bid) must issue a press release reporting this information. INSIDER TRADING DEFINITION OF INSIDERS For the purposes of disclosure, insiders generally include any of the following entities: the directors of the issuer; the senior officers of the issuer, who are defined as the chair or vice-chair of the board of directors, the president, any vice-president, the secretary, the treasurer or the general manager of the issuer, or any other individual who performs functions for the issuer similar to those normally performed by an individual occupying any such office, and each of the five highest paid employees of the issuer, including any individual referred to above; any person or company (excluding underwriters in the course of public distribution) beneficially owning, directly or indirectly, or controlling or directing more than 10% of the voting rights attached to all voting securities; and any director or senior officer of a company that is a subsidiary of the issuer or is itself an insider due to ownership, control or direction over more than 10% of the voting rights attached to all voting securities of the issuer involved. In some circumstances, if a corporation becomes an insider of a second corporation, an insider of the first corporation may be deemed to be an insider of the second corporation as well. When dealing with trades relating to securities of a company that has been involved in such transactions, care should be taken to ascertain whether the persons involved are deemed under the relevant legislation to be insiders. The securities acts and the Canada Business Corporations Act contain provisions that deem certain persons or companies that become insiders of an issuer to have been insiders of the issuer for a period of up to six months before the event. © CANADIAN SECURITIES INSTITUTE 11 26 CANADIAN SECURITIES COURSE      VOLUME 1 INSIDER REPORTING Insiders must inform the relevant securities commissions when they become insiders and when they transact in securities of the company in which they are insiders. Reports must state the extent of the insider’s direct or indirect beneficial ownership of, or control or direction over, securities of the company. Securities firms should be aware that most acts require an insider who transfers securities of a reporting issuer into the name of an agent, nominee, or custodian to file a report with the administrator. Transfers for the purpose of collateral for a debt are exempt from this rule. All reports filed with the administrator are open for public inspection, and in some cases summaries are published in the administrator’s regular publication. Failing to file an insider report, giving false information, or providing misleading information are offences under the acts and are usually punishable by a fine. FINANCIAL STATEMENTS REVIEW How well do you understand the key features of the various financial statements? Complete the online learning activity to assess your knowledge. CASE STUDY: NFR INC. In this case study activity, you’ll review the background of NFR Inc., a fictitious Canadian company that operates in the retail segment. You’ll then have the opportunity to practice categorizing and calculating specific financial statement items, and you’ll decide on which financial statement the item belongs. This activity will help you interpret a corporation’s financial statements and understand the company’s current financial position. Complete the online learning activity to assess your knowledge. CASE SCENARIO Your friend Kamila has asked you to help her understand some accounting concepts. Can you help her with her understanding of non-cash items? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 27 SUMMARY In this chapter, we discussed the following key aspects of corporations and their financial statements: Unlike the owners of a sole proprietorship or partnership, 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. Property of the corporation belongs to the corporation, not to the shareholders. Corporations can raise funds by issuing debt or equity. 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: The statement of financial position presents a snapshot of a company’s operations at a specific date. The statement shows the book value of its assets (what the business owns), liabilities (what the business owes), and equity (the claim on the company’s assets by its owners). The statement of comprehensive income shows a company’s profitability in terms of the revenue received from selling its products, the expenses incurred to generate the revenue, and the profit for the company. The statement of changes in equity records the profits kept in the business and provides a direct link with the statement of comprehensive income and statement of financial position. The statement of cash flows shows how a company generated and spent its cash during the period and reports the net change in the cash account over the period. A corporation’s annual report 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 in this report provide important details about the company’s financial condition not reported in the actual financial statements. The auditor’s report presents an independent opinion on the financial statements of the company being audited. After distributing securities to the public, a reporting issuer must comply with the timely and continuous public disclosure of information. Disclosure can include issuing a press release or filing a material change report when significant changes to the company’s operations occur. Investors in the securities of a public company have three statutory rights: 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. A takeover bid must comply with provincial legislation unless it is exempted under the relevant act. Likewise, any trading activity by insiders of a corporation is subject to regulations regarding reporting and disclosure. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 11 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 11 FAQs. © CANADIAN SECURITIES INSTITUTE 11 28 CANADIAN SECURITIES COURSE      VOLUME 1 APPENDIX A – SAMPLE FINANCIAL STATEMENTS The financial statements on the following pages should be referred to when reviewing this chapter. To make them easier to understand, these financial statements differ from real financial statements in the following ways: Comparative (previous year’s) figures are not shown. Notes to Financial Statements are not included. The consecutive numbers on the left-hand side of the statements, which are used in explaining ratio calculations, do not appear in real reports. Note: Trans-Canada Retail Stores Ltd. is assumed to be a non-food retail chain. Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF FINANCIAL POSITION as at December 31, 20XX ASSETS 1. Property, plant, and equipment $ 6,149,000 2. Goodwill 150,000 3. Investments in associates 917,000 4. TOTAL NON-CURRENT ASSETS 7,216,000 5. Inventories 9,035,000 6. Prepaid expenses 59,000 7. Trade receivables 975,000 8. Cash and cash equivalents 2,169,000 9. TOTAL CURRENT ASSETS 12,238,000 10. TOTAL ASSETS $ 19,454,000 EQUITY AND LIABILITIES 11. Share capital $ 2,314,000 12. Retained earnings 10,835,000 13,149,000 13. Non-controlling interest 157,000 14. TOTAL EQUITY $ 13,306,000 15. Long-term debt 1,350,000 16. Deferred tax liabilities 485,000 17. TOTAL NON-CURRENT LIABILITIES $ 1,835,000 18. Current portion of long-term debt 120,000 19. Taxes payable 398,000 20. Trade payables 2,165,000 21. Short-term borrowings 1,630,000 22. TOTAL CURRENT LIABILITIES $ 4,313,000 23. TOTAL EQUITY AND LIABILITIES $ 19,454,000 Approved on behalf of the Board: [Signature], Director [Signature], Director © CANADIAN SECURITIES INSTITUTE  CHAPTER 11      CORPORATIONS AND THEIR FINANCIAL STATEMENTS 11 29 Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME For the year ended December 31, 20XX OPERATING SECTION 24. Revenue $ 43,800,000 25. Cost of sales (28,250,000) 26. Gross Profit 15,550,000 27. Other income 130,000 28. Distribution costs (7,984,800) 29. Administration expenses (4,657,800) 30. Other expenses (665,400) 31. Finance costs (289,000) 32. Share of profit of associates 5,000 33. Income tax expense (880,000) 34. Profit 1,208,000 Other comprehensive income 0 35. Total comprehensive income $ 1,208,000 Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF CHANGES IN EQUITY For the year ended December 31, 20XX Share Retained Non-controlling Capital Earnings Total Interests Total Equity Balance at January 1, 20XX 1,564,000 10,026,500 11,590,500 145,000 11,735,500 Changes in equity for 20XX Issue of share capital 750,000 750,000 750,000 Dividends (387,500) (387,500) (387,500) Total comprehens