Chapter 1:

Financial Statements and

Making Business Decisions
Who are the users of financial statements?

• Accounting is the process of identifying, measuring, recording, and

communicating information about a company’s business activities so that
decision makers can make informed decisions.
• Financial statements are a summary of the firm’s activity and transactions
• Financial statements are useful because they assist different users in
answering their questions and making better decisions.
Different Users and Questions
Businesses:
Forms of Organization and Activities
Business Activities
 Operating Activities

• Once a corporation has acquired the assets that it needs, it can begin to operate.
• While different businesses have different purposes, they all want to generate revenue.
• Revenue is the increase in assets that results from the sale of products or services.
• To earn revenue, a corporation will incur various costs or expenses.
• Expenses are the cost of assets used, or liabilities created, in the operation of the business.
• If revenues are greater than expenses, a corporation has earned net income.
• If expenses are greater than revenues, a corporation has incurred a net loss.
 Financing Activities

• A company's financing activities include obtaining the funds necessary to begin and operate a
business.
• These funds come from either issuing shares (equity) or borrowing money (debt).
• Most companies use both types of financing to obtain funds.
• The person to whom the corporation owes money is called a creditor.
• This obligation to repay a creditor is termed a liability.
• Claims of the shareholders are called shareholders' equity.
 Investing Activities

• Once a corporation has obtained funds through its financing activities, it buys assets that enable it to
operate.
• The purchase (and sale) of the assets that are used in operations (commonly referred to as property,
plant, and equipment) are a corporation’s investing activities.
 Financial Statements

• Companies prepare four basic financial statements:

• The statement of financial position reports the resources (assets) owned by a company and the
claims against those resources (liabilities and shareholders' equity) at a specific point in time.
• The statement of comprehensive income reports how well a company has performed its operations
(revenues, expenses, and income) over a period of time.
• The statement of changes in equity reports how much of the company's net earnings was retained in
the business, dividend distributions to owners, the dollar amount of shares issued and repurchased,
and other changes in equity over a period of time.
• The statement of cash flows reports the sources and uses of a company's cash over a period of time.
Timing of Financial Statements
 The Basic Accounting Equation
The left side of the accounting The right side of the accounting
equation shows the assets, or equation indicates who has a claim
economic resources, of a on the company's assets
company. .

Creditor claims are Owner claims are in

liabilities. the form of shareholders'
equity.
The Classified Statement of Financial Position
► The purpose of the statement of financial position is to report the financial position of a company (its assets,
liabilities, and shareholders' equity) at a specific point in time.
► The relationship between the elements of the statement of financial position is given by the basic accounting
equation.
► The statement of financial position is organized, or classified, to help users identify the basic economic similarities
and differences between the various items within the statement of financial position.
 How do we determine the difference
between current and noncurrent?

• Most common to use 1 year as the marker between current and

noncurrent
• If the operating cycle of a company is longer than one year, it may
be necessary to extend this dividing line beyond one year so that
it corresponds to the length of the operating cycle.
• The operating cycle of a company is the average time that it takes
a company to purchase goods, resell the goods, and collect the
cash from customers.
 Current assets consist of cash and other assets that are
reasonably expected to be converted into cash within one year
or one operating cycle, whichever is longer.

Current assets are listed on the statement of financial position

in order of liquidity or nearness to cash.

Current Assets Common types of current assets are

• Cash
• Short-term investments or marketable securities—investments in the debt
and shares of other companies as well as government securities
• Accounts receivable—the right to collect an amount due from customers
• Inventories—goods or product held for resale to customers
• Other current assets—a ‘‘catch-all’’ category that includes items such as
prepaid expenses and supplies
 Assets that are not classified as current are
classified as long-term or noncurrent assets.

These include long-term investments; property,

plant, and equipment; intangible assets; and
Noncurrent other noncurrent assets.
Assets • Long-term investments are similar to short-term
investments except for the duration of holding; they can
include land and buildings not currently used in operations.
• Property, plant, and equipment includes tangible productive
assets used in operations, like land, buildings, equipment,
and furniture.
• Intangible assets lack physical substance and include patent,
trademarks, copyrights, and goodwill.
 Current liabilities consist of obligations that will be
satisfied, through the payment of cash or by providing
goods or services, within one year or the operating cycle,
whichever is longer.

Current liabilities are typically listed in the order in which

Current they will be paid and include

Liabilities • Accounts payable—an obligation to repay a vendor or supplier for

merchandise supplied to the company
• Salaries payable—an obligation to pay an employee for services
performed
• Unearned revenue—an obligation to deliver goods or perform a
service for which a company has already been paid
• Interest payable—an obligation to pay interest on money that a
company has borrowed
• Income taxes payable—an obligation to pay taxes on income
 Long-Term Liabilities and Shareholders' Equity

• Long-term liabilities are the obligations of the company that will require payment beyond one year or the operating cycle,
whichever is longer.
• Common examples are
• Loans or notes payable—an obligation to repay borrowed cash at a future date
• Bonds payable—a form of an interest-bearing note payable issued by corporations to attract a large amount of investors
• Shareholders' equity is the last major classification on a company's statement of financial position.
• Shareholders' equity arises primarily from two sources:
• Contributed capital—the owners' contributions of cash and other assets to the company (includes the common and
preferred share of a company)
• Retained earnings—the accumulated net income of a company that has not been distributed to owners in the form of
dividends
Statement of Financial Position - Example
SIERRA CORPORATION
Statement of Financial Position, October 31, 2022

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Statement of Financial Position - Example
SIERRA CORPORATION
Statement of Financial Position, October 31, 2022

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Using Statement of Financial
Position Information
• Use it to measure the financial health of an organization
• How much debt to they carry? What type of assets do they
have?
• Creditors can determine if the organization is a good credit risk.
Will they be able to pay the bills.
• liquidity—is the ability to pay obligations as they become due.
Working Capital / Current Ratio
• Working capital is a measure of liquidity, computed as

Working capital = Current assets – Current liabilities

• Working capital signals that a company has adequate funds with which to pay its
current obligations and is expressed in dollar amounts.

• The current ratio allows comparisons to be made between different companies and
is computed as

Current ratio = Current assets ÷ Current liabilities

Statement of Earnings
• The statement of earnings reports the results of a company's
operations—the sale of goods and services and the associated
expenses of operating the company—for a given period.
• The long-term survival of a company depends on its ability to
produce net earnings, or net income.
• The past net earnings or net income reported on a company's
statement of earnings provides investors with information about a
company's ability to earn future income.

• Statement of Comprehensive Income – includes Statement of

earnings plus other unrealized gains/losses
Elements of the Statement of
Earnings
• The statement of earnings consists of two major elements: revenues and expenses.
• Revenues are the increase in assets that results from the sale of products or services.
• They include
• Sales revenue from products or services
• Interest revenue from investments
• Expenses are the cost of resources used to earn revenues during a period. They include
• Cost of goods sold or cost of sales—the cost to the seller of all goods sold
• Selling and general administrative expenses—expenses to manage the company that
are not direct product or service costs
• Research and development expense—the cost of developing new products
 Statement of Earnings Formats
• Companies prepare their statement of earnings in one of two different formats:
single-step or multiple-step.
• In a single-step statement of earnings, there are only two categories: total
revenues and total expenses.
• The multiple-step statement of earnings provides classifications of revenues
and expenses that financial statement users find useful, with three important
subtotals:
• Gross margin (gross profit) = Net sales – Cost of goods sold
• Income from operations = Gross margin – Operating expenses
• Net income = Income from operations – (Nonoperating revenues – Nonoperating expenses)
Statement of Earnings- Single Step
SIERRA CORPORATION
INCOME STATEMENT, MONTH ENDED OCTOBER 31, 2022

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Multi-step
example
Statement of Earnings Formats
 • A company's ability to generate current income is useful in predicting
its ability to generate future income.
Using • Investors' and creditors' estimates of the future profitability and
growth of a company are often based on how a company has earned
Statement of its revenue and managed its expenses.

Earnings • A useful measure of a company's ability to generate profit is the net

profit margin (or return on sales).
Information • Net profit margin shows the percentage of profit in each dollar of
sales computed as
Net profit margin = Net income ÷ Sales revenue

Can be useful to make comparisons with prior years or with other

companies
Statement of • Public companies prepare a statement of changes in equity, which
reports how profit, dividends, share capital increases (decreases),
Changes in and other changes in shareholders' equity have affected the
company's statement of financial position.
Equity • Private companies prepare a statement of retained earnings,
which presents only the changes in the retained earnings account
during the period.
Statement of ►The owners of a company contribute capital in one of two ways:
►Directly, though purchases of common shares from the
Changes in company, and
►Indirectly, by the company retaining some or all of the net
Equity income earned each year rather than paying it out in dividends.
►Net income earned by the company but not paid out in the form of
dividends is called retained earnings.
►The statement of retained earnings summarizes and explains the
changes in retained earnings during the accounting period.
Statement of Changes in Equity - Example

SIERRA CORPORATION
Statement of Changes in Equity, Month Ended October 31, 2022

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 Reports the cash receipts and payments for a
specific period of time

Changes in cash should be categorized as one of the following

activities:
Statement of
Cash flows Operating Investing Financing

Reconcile the change in cash to the

beginning and ending cash balances
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 Operating activities are the
main day-to-day activities
of the business
Operating
Activities

Examples
Related accounts
Revenues Expenses • Accounts payable,
accounts receivable,
inventory etc.

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 Obtaining the resources or
assets needed to operate the
business for the long term
Investing
Activities

Examples
Purchase or sale of long-lived
Purchase or sale of assets such as property, plant
investments and equipment and intangible
assets

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 Obtaining (and repaying) funds
to finance the operations of the
business

Financing
Activities

Examples
Borrowing money or Selling or repurchasing
repaying loans (debt) shares (equity)

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Statement of Cash Flows - Example
SIERRA CORPORATION
Statement of Cash Flows, Month Ended October 31, 2022

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Relationships Among the Financial Statements

Statement of Earnings– Net Income

Statement of Changes in Equity

- Add net income

Statement of Financial Position

- Report equity

Cash Flow Statement

- Report cash balance from balance sheet

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Relationships among the Financial Statements
 • The four financial statement are reported to users in an annual
report.
• The notes to the financial statements (or footnotes) clarify and
expand upon the information presented in the financial
statements.
• The information contained in the notes can be either
quantitative (numerical) or qualitative (nonnumerical).
Annual Report • Management's Discussion and Analysis, also presented in the
annual report, is management's explanation used to highlight
favourable and unfavourable trends and significant risks facing
the company.
• The auditor's opinion of the financial statements is presented in
the form of an audit report.
 • In order to make it easier to use financial statements over time and
across companies, common rules and conventions have been
developed to guide the preparation of financial statements.
International • These rules and conventions, called generally accepted accounting
Financial principles (GAAP), were developed by several different
organizations over a number of years.
Reporting • In Canada, the provincial securities commissions work closely with
the Accounting Standards Board (AcSB) of the Canadian Institute of
Standards Chartered Accountants (CICA) now part of CPA Canada.
• The AcSB in Canada establishes accounting principles for publicly
accountable enterprises, private enterprises, government entities,
and not-for-profit organizations.
• The use of international financial reporting standards (IFRS) in
Canada is now mandatory for all publicly accountable enterprises.
 • Public corporations whose securities trade on a stock exchange must use
IFRS. Private corporations can choose to follow IFRS or ASPE, but the
Significant choice, once made, must be applied consistently each year.
• Under IFRS, the statement of financial position title is used by most.
Differences Under ASPE, most private companies, and some public companies, use
the title of “balance sheet” to refer to this same financial statement.
between IFRS • IRFS requires that a statement of changes in equity be prepared detailing
the changes in each component of shareholders' equity for the period.
and ASPE ASPE requires that a statement of retained earnings be prepared
detailing only the changes in the retained earnings account for the
period.
• Public companies prepare a statement of comprehensive income. Private
companies prepare a statement of earnings, which includes all revenues,
expenses, gains, and losses for the period. Comprehensive income or
loss is not reported by private companies.