Chapter 3: financial statements Flashcards
what is accounting
an organized way of summarizing the activities of a business
why do internal and external users of accounting rely on accounting information
to make decisions
why do fiancial managers require a strong understanding of accounting
they use that information to make significant decisions that will affect the firm
why is it important to report financial performance in a consistent manner between firms
it enhances the usefulness of those reports, allowing comparative analysis
what does IFRS stand for
international financial reporting standards
what is IFRS
a new set of accounting principles
who must use IFRS
publicly accountable companies in Canada
does IFRS replace GAAP
yes
How can private companies report?
they can use IFRS or ASPE
What is ASPE
accounting standards for private enterprises
which private companies are more likely to use IFRS
larger private companies
Which private companies are more likely to use ASPE
small to mid-size companies
has USA adopted IFRS
no, they use US GAAP
can any Canadian company use US GAAP
public companies who stock is listed on both Canadian and US stock Exchanges can use IFRS or US GAAP
Why was Sarbane-Oxley act (SOX) passed
due to scandals involving companies like Enron and worldcom
- was passed in an attempt to restore investor’s confidence by imposing new requirements for financial disclosure and oversight
What are the main provisions of Sarbanes Oxley (2002)
- A new public company accounting oversight board
- register and inspect accounting firms
- establish audit standards - separation of the audit function from other services provided by auditing firms
- improved standards for corporate governance
- separate board committees for finance and audit
- require external auditors to report to the audit committee
- require audit committee independence and financial expertise with membership dominated by external directors - new requirement that annual reports indicate the state of a firm’s internal controls and asses their effectiveness
- the CEO and CFO must certify that the firm’s financial statements “fairly present in all material respect the operations and financial conditions of the issuer)
what is bookkeeping
the mechanical act of managing and recording transactions
what is accounting
the application of GAAp and conventions to bookkeeping data to produce financial statements that fairly represent the financial condition and operations of the economic entity
what are the most basic accounting principles
- the entity concept
- going concern principle
- A period of analysis
- a monetary value
- matching principle
- Revenue recognition
what is the entity concept
accounting is for a specific economic entity
what is the going concern principle
statements are prepared on the basis that the entity will continue to operate into the future; therefore liquidation of values are irrelevant
what is a period of analysis
usually a fiscal year
- although quarterly and monthly f.s. are also produced
what is monetary value
historical costs are usually used because of the objectivity inherent in arms length transactions
what is the matching principle
revenue must be matched to expenses in the same period (period they are incurred or earned)
What is revenue recognition
revenue is recognized in the period it is earned, even though the cash may not yet have been received
what should financial information have
- relevance
2. faith representation
what is relevance
information is relevant if it could potentially affect a user’s decisions and has a predictive and/or confirmatory power
what is faithful representation
the information provided should be free from bias and free form error
to enhance relevance and faithful representation information should have the following characteristics
- comparability
- verifiability
- timeliness
- understandability
what is comparability
consistent comparisons can be made across entities and across time (one year to the next)
what is verifiability
information can be verified by an independent knowledgeable party
what is timeliness
information is presented in a timely manner
what is understandability
the information is clear and concise
what is the balance sheet
a snapshot at one point in time
- usually dated for the last day of the firm’s fiscal year
- shows what the firm owns (assets) and what it owes (Liabilities)
- and how those assets were financed (liabilities and onwer’s equity)
- items are listed vertically in order of liquidity
- fixed assets like machinery are listed last
what is the income statement also called
profit and loss statement
what is the income statement
income earned over a given period of time (usually a monthly, yearly or quarterly)
what principle is applied ot income statement
matching principle
how is the income statement setup
revenues is the top line and expenses are listed below
- expenses are often reported separately by type (variable/direct, indirect/fixed, interest, amortization, income taxes ect)
GAAP provides flexibility in the accounting treatment of economic events such as
- when to recognize revenue
- when to capitalize an expense (as an asset)
- what rate to use for depreciation
Managers often face considerable pressure to make the firm’s financial performance appear as good as possible this causes what
- managers may change accounting policies within the limits allowed by GAAp to suit their needs
if there is a change in the application of GAAP what must happen
it must be disclosed in the audited F.s. and could jeopardize the audit opinion offered by the external auditors if it is not in compliance with GAAP
How do companys report income statements to the government
they report to CRA and remit income taxes in accordance with the income tax act (ITA)
what does cra require business to sue for asset depreciation
CCA
capital cost allowance
- specified in the ITA’s regulations
firms in Canada tend to produce how many sets of f.s?
two
1. for shareholders
and one for CRA according to tax rules
what kind of method is CCA for depreciation
accelerated method and assets are often replaced more frequently than they are fully depreciated
actual income tax liabilities based on the ITA and CCA is usually what
less than what is estimated when reporting to shareholders under GAAP
What does CCA create
a difference in tax liability called deferred taxes which is capitalized on balance sheet when reporting to shareholders
what does deferred tax not mean
does not mean the firm has an unpaid tax liability
deferred tax means
??
What is the cash flow statement show
helps to provide a clearer picture of sources and uses of cash (cash doesn’t lie)
- analysts are very interested in cash flow because it indicates a firm’s solvency
What are the two methods to prepare the cash flow statement
- examine the changes in the balance sheet accounts and reconcile them through the cash account
(Formula) - add non-cash items to net income
the federal and provincial governments in Canada tax individuals and corporations based on what
income earned
corporations pay income taxes and then use after0tax income for what
to distribute dividends to shareholders
how are dividends taxed?
dividends received by shareholders are taxed again as one form of personal investment income
due to double taxation of dividends what happens to corporations
they get some partial relief through the dividend gross0up tax credit
- dividends received from non-Canadian companies do not qualify for this special tax treatment
how are corporate taxes taxed
paid at a flat or fixed ate on taxable income
- small business are defined as those which earn income of $300,00 or less, and usually pay a lower rate of tax (depending on province)
what does the income statement show
shows the variable costs and period overhead costs can be subtracted to determine earnings before interest and taxes (EBIT)
interest expenses on debt borrowed to earn income is what
generally deductible form taxable income
since CCA affects a firm’s net income and its net cash flow, what must be addressed
taxation issues in each financial decision a firm makes and decision makers need to understand CCA
what does CCA give rise to
tax-shield benefit
What is CCA
is a non-cash deduction from income that would otherwise be subject to income tax. taxable income is reduced as a result of the deduction and the result is a savings in tax payable
what is the calculation for tax shield benefit
corporate tax rate x dollar amount of claimed CCA
. A firm with a 40% Corporate tax rate and a $2,000 CCA deduction will save how much in taxes
$800
- Because of the ½ year rule
o Only one half of the CCA rate can be applied to net acquisitions to an asset class in the year the asset is acquired
o So, the first year CCA is less than the second year’s CCA
what are the characteristics of CCA
- similar assets are grouped into pools or classes
- each asset classes CCA rate is specified in the regulations to the ITA and approximates the economic wastage fo the asset
- no estimate of useful life or salvage value is necessary
- as long as the firm remains a going concern and assets remain in the pool, residual undepreciated capital cost (UCC) values remain in the pool
what are the characteristics of accounting depreciation
- firm choose the method that best represents the economic wastage of the asset
- assets are depreciated individually, not in a group
- estimates of useful life and salvage values are necessary
what is CCA like
is like a declining balance method and change each year
- the largest benefit occurs in the early years of the asset’s life
- residual values always remain in the pool, even after the asset is disposed
when does taxable capital gain occur
if the firm sold a depreciable asset for greater than its original cost
how is capital gain calculated
original cost base - salvage value
what is recapture of depreciation
if salvage value of the asset exceeds the underpeciated capital cost (UCC) of the asset pool, there is a recapture of deprecation which is subject to tax
- an asset pool is closed when the last physical asset in the pool is sold and not replaced
what is terminal loss
if there is a positive UCC balance remaining in the pool when it closes, that balance is called a terminal loss and is deductible from taxable income in the year the last asset is disposed of
- terminal losses are non-cash deductions just like CCA
In Canada how is personal income tax taxed
on their worldwide income
what is the personal taxation year
the calendar year
Canada the tax system is ?
progressive in most provinces
- tax rates increase as the amount of a person’s income increases
investment income can be earned by investors in one of 3 different forms of which is taxed differently
what are the 3 different forms
- interest
- dividends
- capital gains
Personal tax - interest income
is taxed at the person’s marginal personal tax rate
- which is the same rate at which employment and business income is taxed
marginal personal tax rates depend on what
the amount of income earned in a progressive tax system
the marginal tax rates on interest income are usually
higher than those on dividends and capital gains (depending on a person’s circumstances)
all sources of interest must be claimed in each calendar year
both cash interest payments received and interest that has accrued but not yet been paid (eg Canada savings bonds that have not yet been redeemed)
what is the tax treatment for personal tax on dividends
receive a special treatment called the grow-up tax credit
what is the gross -up tax credit
cash dividends form eligible corporations are grossed up by 45% and this total amount is included in taxable income
- federal and provincial tax credits, which vary form province to province are deducted form grossed up amount
federal tax credit: 18.97%
- provincial tax credits vary form a low of 14.55% in alberta to a high of 29.69% in Quebec
- tax credits reduce the marginal tax rate applied to dividend income
personal tax - how are capital gains taxed
only realized capital gains are taxed which means that unrealized capital gains do not trigger tax until investments are sold
- investors can therofre defer capital gains taxes until funds are required
- only 1/2 of the realized capital gain is subject to income tax at the person’s marginal tax rate
- capital losses can be used to offset taxable gains
- at higher marginal tax rates, investors prefer to receive investment income in the form of capital gains and dividends because these often taxed at a lower marginal rate than interest income
what is traditional cash flow
net income plus non-cash expenses, such as depreciation and deferred taxes
what is free cash flow
the result of subtracting capital expenditures from cash flow form operations
