{"id":125,"date":"2020-11-02T13:36:06","date_gmt":"2020-11-02T18:36:06","guid":{"rendered":"https:\/\/pressbooks.bccampus.ca\/fundamentalsbusiness\/chapter\/accounting\/"},"modified":"2024-12-06T15:14:15","modified_gmt":"2024-12-06T20:14:15","slug":"accounting","status":"publish","type":"chapter","link":"https:\/\/pressbooks.bccampus.ca\/fundamentalsbusiness\/chapter\/accounting\/","title":{"raw":"Chapter 15 - Accounting and Financial Information","rendered":"Chapter 15 – Accounting and Financial Information"},"content":{"raw":"
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Learning Objectives<\/h1>\r\n<\/header>\r\n
\r\n\r\nBy the end of the chapter, you should be able to:\r\n
    \r\n \t
  1. explain the differences between managerial accounting and financial accounting;<\/li>\r\n \t
  2. identify some of the users of accounting information and explain how they use it;<\/li>\r\n \t
  3. explain the function of the income statement;<\/li>\r\n \t
  4. calculate revenue, expenses and net profit;<\/li>\r\n \t
  5. explain the function of the balance sheet;<\/li>\r\n \t
  6. calculate assets, liabilities, and shareholders' equity;<\/li>\r\n \t
  7. explain the function of the cash flow statement;<\/li>\r\n \t
  8. calculate a breakeven point given the necessary information;<\/li>\r\n \t
  9. evaluate a company\u2019s performance using financial statements and ratio analysis; and<\/li>\r\n \t
  10. explain [pb_glossary id=\"456\"]key terms[\/pb_glossary] in the chapter.<\/li>\r\n<\/ol>\r\n<\/div>\r\n<\/div>\r\n\"\"\r\n\r\n \r\n

    Show What You Know<\/h2>\r\n

    [h5p id=\"38\"]<\/p>\r\n\r\n

    <\/div>\r\n

    Most Valuable Player<\/h1>\r\n[caption id=\"attachment_142\" align=\"aligncenter\" width=\"661\"]\"Photograph Figure 15.1 Apple Headquarters in Cupertino, California. (Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)[\/caption]\r\n

    Apple Inc. is the most valuable company in the world. This statement is based on market value, which in April 2018 was roughly $841 billion. Although markets can fluctuate, sometimes wildly, it is not unlikely that Apple will have retained its leadership position. Its value as of April 2018 was more than $80 billion greater than that of the next largest company, Amazon. Apple has briefly ceded the leadership position to Alphabet, the parent company of Google, on a couple of occasions, but for the most part, it has been the leader for quite some time.[footnote]Yahoo Finance (2018). Apple Inc. (AAPL)<\/em>. https:\/\/finance.yahoo.com\/quote\/AAPL\/[\/footnote]<\/p>\r\n

    You may wonder what kind of information is used to make these determinations. How does the market know that Apple should be valued more than $120 billion higher than Alphabet?[footnote]Yahoo Finance (2018, April 30). Alphabet Inc. (GOOG)<\/em>. https:\/\/finance.yahoo.com\/quote\/GOOG\/[\/footnote] Do investors just make their decisions on instinct? Well, some do, but it\u2019s not a formula for sustained success. In most cases, in deciding how much to pay for a company, investors rely on published accounting and financial information released by publicly traded companies. This chapter will introduce you to the subject of accounting and financial information so you can begin to get an understanding of how the valuation process works.<\/span><\/p>\r\n\r\n

    The Role of Accounting<\/span><\/h1>\r\n

    [pb_glossary id=\"502\"]Accounting[\/pb_glossary]<\/span> is often called \u201cthe language of business\u201d because it communicates so much of the information that owners, managers, and investors need to evaluate a company\u2019s financial performance. These people are stakeholders in the business \u2014 they\u2019re interested in its activities because they\u2019re affected by them. The financial futures of owners and other investors may depend heavily on strong financial performance from the business, and when performance is poor, managers may be replaced or laid off in a downsizing. In fact, a key purpose of accounting is to help stakeholders make better business decisions by providing them with financial information. You should not try to run an organization or make investment decisions without accurate and timely financial information, and it is the accountant who prepares this information. More importantly, accountants make sure that stakeholders understand the meaning of financial information, and they work with both individuals and organizations to help them use financial information to deal with business problems. Actually, collecting all the numbers is the easy part. The hard part is analyzing, interpreting, and communicating the information. Of course, you also have to present everything clearly while effectively interacting with people from every business discipline. In any case, we are now ready to define accounting<\/span>\u00a0as the process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers.<\/span><\/p>\r\n\r\n

    Fields of Accounting<\/span><\/h2>\r\n

    Accountants<\/span>\u00a0typically work in one of two major fields. Management accountants<\/span>\u00a0provide information and analysis to decision makers inside the organization in order to help them run it. Financial accountants<\/span>\u00a0furnish information to individuals and groups both inside and outside the organization in order to help them assess its financial performance. Their primary focus, however, is on external parties. In other words, management accounting helps you keep your business running while financial accounting tells the outside world how well you\u2019re running it.<\/span><\/p>\r\n\r\n

    Management Accounting<\/h3>\r\n

    [pb_glossary id=\"793\"]Management accounting[\/pb_glossary]<\/span>, also known as managerial accounting, plays a key role in helping managers carry out their responsibilities. Because the information that it provides is intended for use by people who perform a wide variety of jobs, the format for reporting information is flexible. Reports are tailored to the needs of individual managers, and the purpose of such reports is to supply relevant, accurate, timely information that will aid managers in making decisions. In preparing, analyzing, and communicating such information, accountants work with individuals from all the functional areas of the organization\u2014human resources, operations, marketing, etc.<\/span><\/p>\r\n\r\n\r\n[caption id=\"attachment_120\" align=\"aligncenter\" width=\"1024\"]\"Graphic Chart 15.1 Role of Managerial Accounting. (Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)[\/caption]\r\n

    Financial Accounting<\/span><\/h3>\r\n

    [pb_glossary id=\"794\"]Financial accounting[\/pb_glossary]<\/span>\u00a0is responsible for preparing the organization\u2019s financial statements <\/span>\u2014 including the income statement<\/span>\u00a0(<\/span>also called the\u00a0<\/span>profit\/loss statement)<\/span>, the statement of owner\u2019s equity<\/span>, the balance sheet<\/span>, and the statement of cash flows <\/span>\u2014 that summarize a company\u2019s past performance and evaluate its current financial condition. If a company is traded publicly on a stock market such as the TSX (Toronto Stock Exchange), these financial statements must be made public, which is not true of the internal reports produced by management accountants. In preparing financial statements, Canadian financial accountants adhere to a uniform set of rules called international financial reporting standards (IFRS) \u2014 the basic principles for financial reporting issued by an independent agency called the Financial Accounting Standards Board<\/span>\u00a0(FASB). Users want to be sure that financial statements have been prepared according to IFRS because they want to be sure that the information reported in them is accurate. They also know that when financial statements have been prepared by the same rules, they can be compared from one company to another.<\/span><\/p>\r\n\r\n

    Who Uses Financial Accounting Information?<\/span><\/h2>\r\n

    The users of managerial accounting information are pretty easy to identify\u2014basically, they are a firm\u2019s managers. We need to look a little more closely, however, at the users of financial accounting information, and we also need to know a little more about what they do with the information that accountants provide them. Publicly Traded companies will provide their financial accounting information to a wider set of stakeholders, including shareholders, potential investors, etc., than compared to a privately held company that will generate a single set of financial statements according to the International Financial Reporting Standards. Publicly Traded companies will also provide their financial accounting information to the general public in order to showcase to potential investors the company\u2019s performance. Therefore, Publicly Traded companies will typically generate two sets of financial statements, one set of detailed statements in accordance with Canadian International Financial Reporting Standards (IFRS)\u00a0and another set of simplified financial statements that can be more easily consumed by the general public. For example, Tim Hortons provides access to their simplified financial statements through annual reports which can be found at<\/span>\u00a0<\/span>http:\/\/www.rbi.com\/Annual-Reports<\/a><\/span><\/p>\r\n\r\n

    Owners and Managers<\/span><\/h3>\r\n

    In summarizing the outcomes of a company\u2019s financial activities over a specified period of time, financial statements are, in effect, report cards for owners and managers. They show, for example, whether the company did or didn\u2019t make a profit and furnish other information about the firm\u2019s financial condition. They also provide some information that managers and owners can use in order to take corrective action, though reports produced by management accountants offer much more depth.<\/span><\/p>\r\n\r\n

    Investors and Creditors<\/span><\/h3>\r\n[caption id=\"attachment_144\" align=\"alignright\" width=\"199\"]\"\" Figure 15.2 Warren Buffet, Presidential Medal of Freedom recipient in 2011. Pixabay[\/caption]\r\n

    Investors<\/span>\u00a0and creditors<\/span>\u00a0furnish the money that a company needs to operate, and not surprisingly, they want to know how that business is performing. Because they know that it\u2019s impossible to make smart investment and loan decisions without accurate reports on an organization\u2019s financial health, they study financial statements to assess a company\u2019s performance and to make decisions about continued investment.<\/span><\/p>\r\n

    According to the world\u2019s most successful investor, Warren Buffett, the best way to prepare yourself to be an investor is to learn all the accounting you can. Buffett, chairman and CEO of Berkshire Hathaway, a company that invests in other companies, turned an original investment of $10,000 into a net worth of $66 billion[footnote]Forbes (2016). Warren Buffett<\/em>. http:\/\/www.forbes.com\/profile\/warren-buffett\/[\/footnote] in four decades, and he did it, in large part, by paying close attention to financial accounting reports.<\/span><\/p>\r\n\r\n

    Government Agencies<\/span><\/h3>\r\n

    Businesses are required to furnish financial information to a number of government agencies. Publicly-owned companies, for example \u2014 the ones whose shares are traded on a stock exchange \u2014 must provide annual financial reports to their respective provincial Securities Commission. For example, companies located in Ontario would provide financial reports to the Ontario Securities Commission (OSC), a federal agency that regulates stock trades and which is charged with ensuring that companies tell the truth with respect to their financial positions. Companies must also provide financial information to the Canadian Revenue Agency (CRA).<\/span><\/p>\r\n\r\n\r\n[caption id=\"attachment_122\" align=\"aligncenter\" width=\"1024\"]\"Graphic Chart 15.2 The Role of Financial Accounting. (Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)[\/caption]\r\n

    Other Users<\/span><\/h3>\r\n

    A number of other external users have an interest in a company\u2019s financial statements. Suppliers, for example, need to know if the company to which they sell their goods is having trouble paying its bills or may even be at risk of going under. Employees and labour unions are interested because salaries and other forms of compensation are dependent on an employer\u2019s performance.<\/span><\/p>\r\n

    The previous figures illustrate the main users of management and financial accounting and the types of information produced by accountants in the two areas. In the rest of this chapter, we\u2019ll learn how to prepare a set of financial statements and how to interpret them. We\u2019ll also discuss issues of ethics in the accounting communities and career opportunities in the accounting profession.<\/p>\r\n\r\n

    Understanding Financial Statements <\/span><\/h1>\r\n

    We hope that, so far, at least one thing is clear: If you are in business, you need to understand financial statements. The law no longer allows high-ranking executives to plead ignorance or fall back on delegation of authority when it comes to responsibility for a firm\u2019s financial reporting. In a business environment tainted by episodes of fraudulent financial reporting and other corporate misdeeds, top managers are now being held responsible for the financial statements issued by the people who report to them. Top managers need to know how well the company is performing. Financial information helps managers identify signs of impending trouble before it is too late.<\/span><\/p>\r\n\r\n

    The Function of Financial Statements<\/span><\/h2>\r\n

    Put yourself in the place of Connor, who runs Connor\u2019s Confections out of his home. He loves what he does, and he feels that he\u2019s doing pretty well. In fact, he has an opportunity to take over a nearby store at very reasonable rent, and he can expand by getting a modest bank loan and investing some more of his own money. So it is decision time for Connor: He knows that the survival rate for start-ups isn\u2019t very good, and before taking the next step, he\u2019d like to get a better idea of whether he\u2019s actually doing well enough to justify the risk. The basic financial statements will give him some answers. Here, three common statement types are introduced. <\/span><\/p>\r\n

    Income Statement<\/strong> \u2014 s<\/span>hows sales, expenses, and whether or not a profit was made.<\/p>\r\n

    Balance Sheet<\/strong> \u2014 s<\/span>hows assets and liabilities, the amount invested in the business.<\/p>\r\n

    Statement of Cash Flow<\/strong>\u00a0\u2014 <\/span> shows how much cash is coming in and going out.<\/p>\r\n

    Even from this basic overview, match which financial statement answers each of Connor's questions.\r\n<\/span><\/p>\r\n

    [h5p id=\"37\"]<\/p>\r\n

    [h5p id=\"48\"]<\/p>\r\n

    Since this book is for an introductory course, its emphasis is on the income statement, balance sheet, and cash flow statement only, even though other financial statements are mentioned.<\/p>\r\n\r\n

    Toying with a Business Idea<\/span><\/h2>\r\n

    To bring this concept closer to home, let us assume that you need to earn money while you\u2019re in college and that you\u2019ve decided to start a small business. Your business will involve selling stuff to other college students. To keep things simple, we\u2019ll assume that you\u2019re going to operate on a cash basis; you\u2019ll pay for everything with cash, and everyone who buys something from you will pay in cash.<\/span><\/p>\r\nYou may have at least a little cash on you right now \u2014 some currency, or paper money, and coins. In accounting, however, the term cash<\/span> refers to more than just paper money and coins. It also refers to the money that you have in chequing and savings accounts, and includes items that you can deposit in these accounts, such as money orders and different types of cheques.<\/span>\r\n\r\nYour first task is to decide exactly what you are going to sell. You\u2019ve noticed that with homework, exams, social commitments, and the hectic lifestyle of the average college student, you and most of the people you know always seem to be under a lot of stress. Sometimes you wish you could just lie back between meals and bounce a ball off the wall. And that\u2019s when the idea hits you: maybe you could make some money by selling a product called the \u201cStress-Buster Play Pack.\u201d Here is what you have in mind: you will buy small toys and other fun stuff \u2014 instant stress relievers \u2014 at a local dollar store and pack them in a rainbow-colored plastic treasure chest labeled \u201cStress-Buster.\u201d<\/span>\r\n

    And here is where you stand: you have enough cash to buy a month\u2019s worth of plastic treasure chests and toys. After that, you\u2019ll use the cash generated from sales of Stress-Buster Play Packs to replenish your supply. Each plastic chest will cost $1.00, and you\u2019ll fill each one with a variety of five simple toys, all of which you can buy for $1.00 each.<\/span><\/p>\r\n

    You plan to sell each Stress-Buster Play Pack for $10 from a rented table stationed outside a major dining hall. Renting the table will cost you $20 a month. In order to make sure you can complete your school work, you decide to hire fellow students to staff the table at peak traffic periods. They will be on duty from noon until 2:00 p.m. each weekday except Fridays, and you\u2019ll pay them a generous $7.50 an hour. Wages, therefore, will cost you $240 a month (2 hours \u00d7 4 days \u00d7 4 weeks = 32 hours \u00d7 $7.50). Finally, you\u2019ll run ads in the college newspaper at a monthly cost of $40. Thus your total monthly costs will amount to $300 ($20 + $240 + $40).<\/span><\/p>\r\n\r\n

    The Income Statement<\/span><\/h2>\r\n

    Let us say that during your first month, you sell one hundred play packs. Not bad, you say to yourself, but did I make a profit? To find out, you prepare an [pb_glossary id=\"795\"]income statement[\/pb_glossary] showing revenues<\/span>, or sales, and expenses<\/span>\u2014the costs of doing business. You divide your expenses into two categories:<\/span><\/p>\r\n\r\n