1 - The Purpose and Use of Financial Statements Flashcards
1
Q
What is accounting?
A
The information system that identifies and records the economic events of an organization, and then communicates them to a wide variety of interested users.
2
Q
What are the two broad categories of users of accounting information?
A
- Internal users
- External users
3
Q
What are the roles of internal users of accounting information?
A
They work for the company.
Internal users of accounting information plan, organize, and run companies.
4
Q
What are the four main domains of internal users of accounting information?
A
- Finance
- Marketing
- Human Resources
- Production
5
Q
What kind of financial questions concern internal users of accounting information?
A
Is there enough cash to pay the bills?
6
Q
What kind of marketing questions concern internal users of accounting information?
A
At what price should we sell to maximize profit?
7
Q
What kind of human resource questions concern internal users of accounting information?
A
How many employees can we afford to hire this year?
8
Q
What kind of production questions concern internal users of accounting information?
A
Which product line is most profitable?
9
Q
What kind of internal reports does accounting provide for internal users? (4)
A
- Financial comparisons of operating alternatives
- Projections of profit from new sales campaigns
- Analyses of sales costs
- Forecasts of cash needs
10
Q
Who are the primary external users of accounting information? (3)
A
- Investors
- Lenders
- Other creditors
11
Q
What basic question would investors ask?
A
Should I purchase shares of this company?
12
Q
What basic question would lenders and other creditors ask?
A
Will the company be able to pay its debt as they come due?
13
Q
What are the three forms of business organization?
A
- Proprietorships
- Partnerships
- Corporations
14
Q
What is a proprietorship?
A
A business owned by one person.
15
Q
What are some advantages of proprietorships? (4)
A
- Proprietorships are easy to set up
- Gives the owner control over the business
- Only a relatively small amount of money needed (in most cases)
- Owner receives all of the profit
16
Q
What are some disadvantages of proprietorships? (4)
A
- Suffer any loss should they occur
- Unlimited liability (personally liable for all debts of the business)
- No legal distinction between the business as an economic unit and the owner
- Life of proprietorship limited to the life of the owner
17
Q
What is the reporting entity concept?
A
The reporting entity concept requires that the economic activity that can be identified with a particular company be kept separate and distinct from the activities of the owner and of all other economic entities.
18
Q
How are the business profits of proprietorships reported and taxed?
A
Business profits are reported as self-employment income and taxed on the owner’s personal income tax return. However, for accounting purposes, the business records of the proprietorship must be kept separate from those related to the owner’s personal activities.
19
Q
What is a partnership?
A
A business owned by more than one person
20
Q
What are the usual causes of forming partnerships rather than proprietorships? (2)
A
- Because one person doesn’t have enough economic resources to start or expand the business
- Because partners bring unique skills or other resources to the partnership.
21
Q
Partnerships are normally formalized in a written partnership agreement that outlines… (6)
A
- The formation of the partnership
- Partners’ contributions
- How profits and losses are shared
- Provisions for withdrawals of assets and/or partners
- Dispute resolution
- Partnership liquidation
22
Q
What is the main disadvantage of partnerships?
A
Each partner generally has unlimited liability for all debts of the partnership, even if one of the other partners created the debt.
23
Q
How are the business profits of partnerships reported and taxed?
A
Like proprietorships, business profits are reported as self-employment income and taxed on each partner’s personal income tax return
24
Q
What are partnerships typically used for?
A
To organize professional service businesses.
25
What is a corporation?
A corporation is a business organized as a separate legal entity owned by shareholders.
26
What is an alternative terminology for shares?
Stock
27
Describe the distinction between corporation's life and a partnership or a proprietorship's.
Since a corporation is a separate legal entity, its like is indefinite. It continues on regardless of who owns its shares.
28
How are shareholders liable for corporate debt?
Shareholders are not responsible for corporate debt unless they have personally guaranteed them. So most shareholders enjoy limited liability since they only risk losing the amount they have invested in the company's shares.
29
Which 3 advantages, when taken together, can make it easier for corporations, especially large corporations, to raise capital (cash) compared with proprietorships and partnerships?
- Indefinite life
- Ease of transferring ownership
- Limited liability
30
What are public corporations required to do?
To distribute their financial statements to investors, lenders, other creditors, other interested parties, and the general public.
31
What sets private corporations apart from public ones?
Private corporations also issue shares, but they do not make them available to the general public nor are they traded on public stock exchanges.
32
What's the main difference in what private and public corporations are required to do?
Private corporations aren't required to, almost never do, distribute their financial statements publicly.
33
What are two alternative terminologies for accounting principles?
- Accounting standards
| - Accounting policies
34
What is GAAP?
The generally accepted accounting principles are rules and practices that are organized as a general guide for financial reporting purposes.
35
How do generally accepted accounting principles differ depending on the form of business' organization?
- Publicly traded corporations must use IFRS
| - Private corporations have the choice of IFRS or ASPE
36
What is IFRS?
The international financial reporting standards are a set of global accounting standards developed by the International Accounting Standards Board.
37
What is ASPE?
The Accounting Standards for Private Enterprises, developed by the Canadian Accounting Standards Board.
38
Which accounting principles do private corporations, proprietorships, and partnerships tend to use?
ASPE
39
What's a difference in the accounting principles between proprietorships/partnerships and corporations?
Proprietorships and partnerships often prepare financial statements only for the internal use of the owner(s), in which case they don't have to follow any particular set of accounting standards.
40
What 3 types of business activities do all business engage in?
- Financing
- Investing
- Operating
41
What do financing activities include?
Borrowing cash from lenders by issuing debt, or conversely, using cash to repay debt, Cash can also be raised from shareholders by issuing shares, or paid to shareholders or distributing dividends.
42
What do investing activities include?
Purchasing and disposing of long-lived assets that a company needs in order to operate such as property, plant, and equipment and purchasing and selling long-term investments.
43
What do operating activities include?
Operating activities result from day-to-day operations and include revenues and expenses and related accounts such as receivables, supplies, inventory, and payables.
44
What are the 2 primary ways of raising outside funds for corporations?
- Borrowing money (debt financing)
| - Issuing (selling) shares (equity financing) in exchange for cash.
45
What are liabilities?
Amounts owed to lenders and other creditors in the form of debt and obligations. Obligations that result from past transactions.
46
What is an operating line of credit?
A type of liability which is a pre-arranged bank loan for a maximum amount that allows a company to draw more money than there is on hand in its bank account.
47
What is bank indebtedness?
A type of liability which results when a company uses its operating line of credit to cover cash shortfalls and overdraws its bank account.
48
What is a loan payable also known as?
A note payable.
49
What are the 4 main categories of long-term debt?
- Mortgages payable
- Bonds payable
- Finance lease obligations
- Other types of debt securities borrowed for longer periods of time.
50
How can a corporation obtain equity financing?
By selling shares of ownership to investors.
51
What is a common share?
The term used to describe the amount paid by investors for shares of ownership in a company.
52
How can companies use cash for financing activities?
- Repaying debt
| - Repurchasing shares from investors
53
What are the legal rights of lenders and creditors?
As a lender or creditor, you have a legal right to be paid at the agreed time. In in the event of nonpayment, you may force the company to sell assets to pay its debt.
54
When do shareholders have a claim to corporate resources?
Only after the claims of lenders and other creditors are satisfied.
55
Describe a main distinction between financing through share issuance and debt obligation.
Once shares are issued, the company has no obligation to buy them back, although it may choose to do so. On the other hand debt obligations must be repaid.
56
What are dividends?
Regular payments to shareholders issued by most companies as a return on their investment as long as there is enough cash to cover required payments to lenders and other creditors.
57
What are assets?
Resources that a company owns or controls.
58
What is a defining feature of all assets?
Every asset is capable of providing future economic benefits that can be short or long-lived.
59
What do investing activities generally involve?
Long-lived assets.
60
What are the 3 main types of long-lived assets?
- Property
- Plant
- Equipment
61
What are the 3 other kinds of assets?
- Goodwill
- Intangible assets
- Cash
62
What is goodwill?
Goodwil results from the acquisition of another company when the price paid is higher than the value of the purchased company's net identifiable assets.
63
What are intangible assets?
Assets that do not have any physical substance themselves but represent a privilege or a right granted to, or held by, a company. ex: patents, copyrights, trademarks.
64
Why is cash one of the most important assets a company can have?
Is a company has excess cash that it doesn't need in the short term, it might choose to invest it in debt securities (such as bonds) or equity securities (such as shares) of other corporations or organizations these are called investments.
65
What's the main distinction between the term investment in the context of accounting and business activity versus the everyday lexicon?
Investing activities means investing in the long-lived assets necessary to run the company and not just purchasing an investment on which to earn a return for the long term, such as interest or dividends.
66
What is revenue in accounting language?
Increases in economic benefit - normally an increase in an asset but sometimes a decrease in a liability - that results from the sale of a product or service in the normal course of business.
67
What are the 4 most common sources of revenue for a business?
- Sales revenue
- Service revenue
- Interest revenue
- Rent revenue
68
What is an account receivable?
The right to receive money in the future. Accounts receivable are assets because they will result in a future benefit - cash - when the amounts owed are eventually collected.
69
What are 3 other types of receivables?
- Interest receivables
- Rent receivables
- Income tax receivables (deferred tax assets)
70
What are supplies?
Short-term assets used in day-to-day operations as inventory including consumable items.
71
What is inventory or merchandise inventory?
Items (assets) that are held for future sale to customers.
72
What happens once inventory is sold?
When the goods are sold, they are no longer an asset with future benefits but an expense. More specifically, the cost of the inventory sold is an expense called cost of goods sold.
73
What are expenses in accounting language?
The costs of assets that are consumed or services that are used in the process of generating revenues.
74
What are 4 examples of common business expenses?
- Cost of goods sold
- Operating and administrative expenses
- Interest expense
- Income tax expense
75
What are 7 short-term liabilities resulting from various business expenses (accrued payables)?
- Accounts payable
- Interest payable
- Dividends payable
- Salaries payable
- Property tax payable
- Sales tax payable
- Income tax payable
76
How does a company determine if it's earned profits?
By comparing the revenues earned in a period with the expenses incurred in that same period.
77
What is the goal of every business?
To sell a good or service for a price that is greater than the cost of producing or purchasing the good or providing the service plus the cost of operating the business.
78
What is profit also commonly known as?
- Net earnings
| - Net income
79
Which four financial statements are the backbone of financial reporting?
- Income statement
- Statement of changes in equity
- Statement of financial position
- Statement of cashflows
80
What is an income statement?
An income statement reports revenues and expenses to show how successfully a company performed during a period of time.
81
`What is a statement of changes in equity?
A statement in changes in equity shows the changes in each component of shareholders' equity (usually known as common shares and retained earnings), as well as total equity, during a period of time.
82
What is a statement of financial position?
A statement of financial position presents a picture of what a company owns (its assets), what it owes (its liabilities), and the resulting difference (its shareholders' equity) at a specific point in time.
83
What is a statement of cashflows?
A statement of cashflows shows where a company obtained cash during a period of time and how that cash was used.
84
What are notes to the financial statements?
Additional reported information that is cross-referenced to the four statements. These explanatory notes clarify information presented in the financial statements and provide additional detail. They are essential to understanding a company's financial performance and position.
85
When must financial statements be produced?
Financial statements must be produced annually, as well as quarterly, by public corporations. Financial statements are often produced monthly as well for internal use.
86
What is a fiscal year?
An accounting time period that is one year in length.
87
How is an income statement organized?
An income statement lists the company's revenues first and then it's expenses. Expenses are deducted from revenues to determine profit before income tax. Income tax expense is usually shown separately, immediately following the profit before income ax line. Finally, profit is determined by deducting the income tax expense.
88
Why aren't cents included in the dollar figures recorded in financial statements?
Although they are used in recording transactions, external reporting condenses and simplifies information so that it is easier for the reader to understand.
89
Why are investors interested in a company's income statement?
Investors are interested in a company's past profit because these numbers provide information that may help predict future profitability.
90
Why are Lenders and Other creditors interested in a company's income statement?
Lenders and Other creditors must try to predict whether the company will stay in business long enough, and be profitable enough, to repay the loan and any interest charges.
91
Why is it advantageous for companies to end their accounting year when their inventory or operations are low?
Because gathering accounting information required a lot of time and effort from managers. They would rather do it when they are not too busy operating the business.
92
What would really help a company raise additional cash when borrowing or issuing shares?
Financial statements which report recurring and increasing profits.
93
How is the statement of changes in equity structured?
It starts with the account balances at the beginning of the period and ends with the account balances at the end of the period. The time period is the same as for the income statement.
94
What is shareholder equity?
The ownership interest in a company which includes share capital, retained earnings and other types of accounts.
95
What is share capital?
Share capital represents amounts contributed by the shareholders in exchange for shares of ownership. If there is only one type of shares issued, it's called common shares.
96
What two classes of shares combine to form the company's share capital?
- Common shares
| - Preferred shares
97
How is the statement of changes in equity structured?
It starts with the beginning balance of share capital. The statement then goes on to add any changes in share capital due to new shares issued during the period to arrive at the ending balance of share capital.
98
What is the equation format for changes in share equity?
Common shares (beginning of period) + Common shares issued (sold) - Common shares repurchased = Common shares end of period.
99
What are retained earnings?
retained earnings represent the cumulative profit that has been retained in the corporation. It's the profit that has not been paid out to shareholders that has accumulated since the company's date of incorporation.
100
What does the statement of changes in equity show in addition to changes in share capital during the period?
The amounts and causes of changes in retained earnings.
101
How are retained earnings at the end of the period calculated?
Retained earnings (beginning) + Profit - Dividends = Retained earnings (end)
102
What's important to understand about dividends and financial statements?
Dividends are not reported as an expense in the income statement. They are not an expense incurred to generate revenue. Instead, dividends are a distribution of retained earnings to shareholders and reported in the statement of changes in equity.
103
Why would users of financial statements monitor the statements of changes in equity of public corporations?
To evaluate the use of equity for financing purposes and to evaluate a company's dividend payment practices.
104
What's the first set of questions answered by statements of changes in equity?
- Is the company expanding or contracting its share capital?
| - Did the company issue or repurchase shares?
105
How do we answer the questions of whether a company is expanding/contracting its share capital?
If share capital is increasing, the company may have expansion plans.
106
What's the second set of questions answered by statements of changes in equity?
- What is the company's policy on dividends and growth?
| - How much did the company pay out in dividends to shareholders?
107
How do we answer the questions of what is a company's policy on dividends and growth?
A company looking for rapid growth will pay no, or a low, dividend.
108
Which question is answered by income statements?
-Are the company's operations profitable?
109
What's an alternative term for a statement of financial position?
The Balance Sheet. Especially for ASPE.
110
Claims to assets are subdivided into which two categories?
- Claims of lenders and other creditors
| - Claims of shareholders
111
What is the basic accounting equation?
Assets = Liabilities + Shareholder Equity
112
What do lenders and other creditors use a statement of financial position for?
To determine the likelihood that they will be repaid. They carefully evaluate the nature of the company's assets and liabilities.
113
What's the first reason managers use statements of financial position?
To determine whether inventory is adequate to support future sales and whether cash on hand is sufficient for immediate cash needs.
114
What's the second reason managers use statements of financial position?
To look at the relationship between total liabilities and shareholders' equity to determine whether they have the best proportion of debt and equity financing.
115
To help investors, lenders and other creditors, and others in their analysis of a company's cash position, the statement of cash flows reports...
```
The effects on cash of a company's
-Operating activities
-Investing activities
-Financing activities
during the period of time.
```
116
How are statements of cash flows structured?
Operating activities are normally presented first in the statement of cash flows, followed by investing and financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the cash amount at the end of the period.
117
Why is it desirable for operating activities to provide cash rather than use cash?
A positive source of cash from operating activities can help pay for investments to grow the business.
118
Why is it imperative that financial statements be prepared in a certain order?
Because each financial statement depends on information contained in another statement.
119
In which order must financial statements be prepared?
1. Income statement
2. Statement of changes in equity
3. Statement of financial position
4. Statement of cash flows
120
What must public corporations provide each year?
An annual report.
121
What is a public corporation's annual report and what's contained in it?
The annual report is a document that includes useful nonfinancial information about the company, as well as financial information.
122
What kind of nonfinancial information is included in a company's annual report?
The company's mission statement, goals and objectives, products, and people.
123
What kind of financial information is normally included in a corporations annual report? (6)
- Management discussion and analysis (MD&A)
- A statement of management responsibility for the financial statements
- An auditors' report
- The 4 financial statements for at least 2 years
- Explanatory notes to the financial statements
- A historical summary of key financial ratios and indicators.
