Chapter 1 Flashcards
Define financial accounting and understand its relationship to economic decision-making. 2. Identify the main users of financial accounting information and explain how they use this information. 3. Describe the major forms of business organization and explain the key distinctions between them. 4. Explain the three categories of business activities and identify examples of transactions related to each category. 5. Identify and explain the content and reporting objectives of the four basic financ
Describe the role that accounting plays in the management
of a business.
Accounting, as an information system, provides economic information to users to allow them to determine whether the entity is operating effectively and efficiently. In addition, accounting facilitates important decision making in the management of the entity, such as whether new assets should be purchased or leased, or whether equity financing should be used as opposed to debt financing
Describe the owner’s legal liability and the taxation of
income in the following forms of business: corporation, proprietorship, and partnership
The owner’s legal liability is as follows for each form of business:
- Proprietorship: The owner (or proprietor) is responsible for the debts of the business. His or her personal assets are at risk in the event of legal action.
- Partnership: The owners (or partners) are responsible for the debts of the business. Their personal assets are at risk in event of legal action.
- Corporation: The owners (or shareholders) are only responsible for the debts of the corporation to the extent of their investment in the company’s shares. Any debts in excess of this amount are not their responsibility.
The taxation of income is as follows for each form of business:
- Proprietorship: The income of a proprietorship is taxed in the hands of the owner (i.e. the proprietor).
- Partnership: The income of a partnership is taxed in the hands of the owners (i.e. the partners).
- Corporation: The income of a corporation is taxed separately (i.e. the corporation files its own tax return). Any income distributed to the shareholders (i.e. dividends) is then taxed in the hands of the owners (i.e. the shareholders).
Describe the circumstances in which it may make sense for an entrepreneur to operate their business as a proprietorship rather than as a corporation.
If an entrepreneur has a relatively simple business with low liability risk, it may be better to operate the business as a proprietorship. If the entrepreneur is not looking to borrow any money he or she will not assume the personal risk. Proprietorships are easy to form and do not have any organizational costs. If the entrepreneur has no intention of expanding the business or selling the business, a proprietorship makes sense
Explain the difference between a public corporation and a
private corporation
A private corporation is one whose shares are held by a small number of individuals. This makes the transfer of ownership more difficult, as the shares do not trade on a public stock exchange. A public corporation has shares held by a larger number of individuals or entities and these shares are bought and sold on a public stock exchange (such as the Toronto Stock Exchange)
Explain why public companies are required to publicly disclose their financial statements, while private companies are not
Public companies have their shares traded on a public stock exchange. The federal and provincial governments have regulations related to how public companies report their financial statements and are interested in ensuring that these regulations are followed. The stock exchanges also have regulations about the timing and format of information that companies must convey to them and to investors.
Identify at least three major users of corporate financial
statements, and briefly state how these users might use the information from the statements
Shareholders – These users are interested in the performance of their investment in the company. They will use the financial statements to evaluate how well management is handling their investment. Individual shareholders may also use the financial statements in assessing whether to continue to hold the shares, purchases more or sell the shares they have.
Creditors (i.e. Financial Institutions) – These users are interested in
evaluating the company to decide whether to lend money to it. They will use the statements to evaluate the risk that will be taken in making the loan. This includes assessing the company’s ability to service the debt (i.e. pay interest and repay principal)
Taxing Authorities – These users establish the rules for how taxable income will be measured. They are interested in the fair measurement of the financial performance of the company so that the appropriate tax will be paid. Note, however, that income taxes are not paid based on the net earnings reported in the financial statements; rather, income taxes are based on taxable income. In preparing the tax return, the financial statements’ net income is the starting point and is then adjusted to arrive at taxable income.
Financial Analysts – These users provide investment advice to their customers. They are interested in evaluating the investment potential of various companies. They will want to evaluate not only individual companies, but also make comparisons between companies, likely in the same industry.
(Note: there are other users discussed in the chapter that would be equally acceptable answers to this question).
Explain how investors expect to receive a return on the
investment they make in a corporation
Shareholders invest in the shares of a company. They may expect to receive dividends, which are a distribution of past profits to
shareholders. They also expect to eventually sell their shares at a
higher price than they paid for them, due to capital appreciation.
What is capital appreciation and how can an investor realize
this type of return?
Capital appreciation is an increase in the market value of the shares of a company. Investors realize this type of return by purchasing shares in a company, and then later selling the shares at a higher market price than they had originally paid. Capital appreciation often results from a company’s growth (i.e. increased revenues and increased profits)
Creditors are ultimately concerned with receiving two streams of cash in relation to the loans they make. Explain each of them
When creditors loan money to a company, they expect to receive their money back. That is one cash stream, called return of principal. The other cash stream is periodic interest that creditors receive for time they have allowed the company to use their money.
Describe and illustrate the three major types of activities in
which all companies engage
The three major types of activities in which all companies engage are financing, investing, and operating activities.
- Financing refers to the activity of obtaining funds for the company to operate. Two primary sources of funds are owners and creditors. Some typical financing activities are: short- and long-term borrowing, repayment of debt, dividend payments, and the issuance of additional shares.
- Investing refers to the activity of using funds generated by financing activities to acquire assets that will generate profits in the future. Investments include the purchase of property, plant, and equipment and the purchase and sale of investments in other companies.
- Operating activities are associated with developing, producing,
marketing, and selling the products and/or services of the company. Operating activities are mainly concerned with the day-to-day activities of the company.
Describe and illustrate the three major categories of items
that appear in a typical statement of financial position.
The three major categories of items that appear in a typical statement of financial position (balance sheet) are assets, liabilities, and shareholders’ equity
Assets are resources owned by a company that will be used or sold for its the future economic benefit. In order to have an asset, the event that gave the company the control of the resource must have already happened. The company is able to perform its activities and thereby generate profits with the help of its assets. This means that they are income earning. Assets may be current or non-current. Current assets will be used or converted into cash within the next year or operating cycle. Examples include cash, inventory, and accounts receivable. Non-current assets are those assets whose benefits may be realized over a period longer than one year or operating cycle. Examples include property, plant, and equipment, patents, trademarks, etc.
Liabilities are the amounts that the company owes to others and which require a probable future outflow or sacrifice of resources to settle an obligation that exists as a result of a transaction that has already taken place. Liabilities may be classified as current and non- current. Current liabilities include notes payable due within one year, accounts payable, accrued expenses, and dividends payable. Non- current liabilities include long-term debt, long-term warranties payable, and pension liabilities.
Shareholders’ Equity represents the wealth or the ownership interest of the owners. Shareholders’ equity may also be defined as the difference between the assets and liabilities of a company:
Shareholders’ Equity = Assets – Liabilities
There are two major shareholders’ equity accounts: share capital and retained earnings. Share capital represents the amount that investors originally paid for the shares that the company issued. Retained earnings consist of the cumulative earnings of the company less the dividends distributed to shareholders.
How do the activities that are considered to be operating
activities differ from those considered to be investing activities?
Operating activities relate to the day-to-day activities of a company. This includes generating revenues and incurring expenses, which are the most crucial activities in relation to the long-term sustainability of a company. Investing activities occur on a more sporadic basis and include the purchase or disposal of property, plant, and equipment as well as the purchase and resale of shares in other companies.
How do the activities that are considered to be operating
activities differ from those considered to be financing activities?
Operating activities relate to the day-to-day activities of a company. This includes generating revenue and incurring expenses, which are the most crucial to the long-term sustainability of a company. Financing activities are those actions taken by a company to obtain the funding necessary to purchase assets such as buildings and equipment and investments. Financing activities also include the repayment of loan principal and payment of dividends. Financing activities are required in order to start a business. Without financing, most businesses would not be able to begin to engage in operating activities. Financing needs generally continue throughout the life of a company as it grows and expands.
Explain whether the costs related to hiring and training a
company’s employees are considered to be an operating or investing
activity
Costs relating to hiring and training a company’s employees are
considered an operating activity. The employees will perform and maintain operations so all costs related to them will be operating activities. Investing activities are related to the purchase or sale of property, plant, and equipment and shares in other companies
Would we normally expect a company to have an overall
inflow or an overall outflow of cash from its operating activities?
Explain why
We would normally expect a company to have an overall inflow of cash from its operating activities. Unless a company is successful at generating positive cash inflows from its operations, it will ultimately run out of cash. Financing sources will dry up because the company will be unable to attract new investors or lenders. Eventually it will have to sell the property, plant, and equipment it uses to generate revenue
Would we normally expect a company to have an overall inflow or an overall outflow of cash from its investing activities?
Explain why
We would normally expect a company to have an overall cash
outflow from its investing activities. These activities include the purchase of property, plant, and equipment that are purchased to
generate operating revenue. Cash inflows from investing activities
require the sale of investments or property, plant and equipment.
Companies that are financially healthy and growing typically spend more cash on acquiring new assets than the proceeds they
generate from selling the property, plant and equipment they have finished using
How is the statement of income related to the three major
types of business activities?
The statement of income describes the results of the operating
activities from the beginning of the current period to its end. Net
income is defined as revenues less expenses. Revenues are cash
or resources that flow into the company from operating activities.
Expenses are cash or resources that flow out of company from
operating activities. Investing and financing activities are typically
depicted on statement of financial position.
Compare and contrast the purpose of the statement of
income and the statement of cash flows.
The purpose of the statement of income is to measure the company’s performance by the results of its operating activities for a month, a quarter, or a year. The sum of these operating activities is known as the company’s profit, which is revenue less expenses. The purpose of a statement of cash flows is to present the cash related to the three categories of business activities and its objective is to enable financial statement users to assess the company’s inflows and outflows relative to each of these activities. The statement of income allows users to assess how well management has operated its business and if it is profitable where as the statement of cash flows allows users to assess how well management has managed its cash and whether they will have enough cash in the future to run the business effectively.
How does the statement of changes in equity relate to the
statement of income? Which of these statements would need to be prepared first?
The statement of changes in equity provides details on how each
component of shareholders’ equity changed during the period.
Retained earnings, a component of shareholders’ equity, changes
each period by the net income reported on the statement of income, less any dividends that were declared by the board of directors during the period. As a result, the statement of income must be prepared first.
Explain whether or not shareholders’ equity represents the
interests of owners after external claims have been satisfied.
The accounting equation is Assets = Liabilities + Shareholders’ Equity. Shareholders’ Equity does represent the interests of the owners or residual value left in the business after the external claims or liabilities have been paid. This is supported by the reorganization of the accounting equation: Shareholders’ Equity = Assets – Liabilities.
Describe the purpose of the four main financial statements
that are contained in annual reports.
The four main financial statements contained in all annual reports are the statement of income, the statement of changes in equity, the statement of financial position, and the statement of cash flows.
Statement of Income: The statement of income records the inflow of revenues and gains and the outflow of expenses and losses over the year (or specified period). The statement helps investors evaluate the performance of the company during the period and it is useful in forecasting the future results of the company.
Statement of Changes in Equity: The statement of changes in equity provides details on how each component of shareholders’ equity changed during the period. This includes any changes in share capital, and any income generated by the company less amounts distributed to shareholders as dividends.
Statement of Financial Position: The statement of financial position gives the financial status of the company at a particular point in time. Since it presents the details of assets, liabilities, and shareholders’ equity, it gives users a fair idea of the riskiness of the mix of assets and liabilities of the company.
Statement of Cash Flows: This statement measures the inflow and
outflow of cash during a specific period of time. It is very useful in
measuring the performance of the company as well as predicting future cash flows since it gives details about the inflow and outflow of cash broken down into operating, investing, and financing activities. It explains the change in cash between the beginning and the end of the period
Explain the purpose of the notes to the financial statements
The notes to the financial statements provide more detailed information on items in the financial statements and are cross-referenced. The first, second or sometimes third note to the financial statements often discusses the Summary of Significant Accounting Policies, which describes the choices made by management from among the possible choices and judgments acceptable under accounting standards. The notes help keep the financial statements free of excessive detail, while providing meaningful information to financial statement users
What role does the management discussion and analysis
section of an annual report play in informing users about a company?
The management discussion and analysis (MD&A) section of the
annual report provides an overview of the previous year, a discussion of the risks facing the company, and some information about business plans for the future. Many companies use this part of the report to make more extensive, detailed comments on the company and its operating results. Often the information is presented from the company’s perspective
