Chapter
15
Understanding Accounting
and Financial Statements
Learning Objectives
LO 15.1 Explain the functions of
accounting, and identify the three
basic activities involving accounting.
LO 15.2 Describe the roles played
by public, management,
government, and not-for-profit
accountants.
LO 15.3 Identify the foundations of
the accounting system, including
GAAP, IFRS, and the role of the
Accounting Standards Board
(AcSB).
LO 15.4 Outline the steps in the
accounting cycle, and define doubleentry bookkeeping and the
accounting equation.
LO 15.5 Explain the functions and
major components of the four
principal financial statements: the
balance sheet, the income
statement, the statement of owner’s
equity, and the statement of cash
flows.
LO 15.6 Discuss how financial ratios
are used to analyze a company’s
financial strengths and weaknesses.
LO 15.7 Describe the role of
budgets in a business.
LO 15.8 Outline accounting issues
facing global business.
Users of Accounting Information
Accounting: The process of measuring, interpreting,
and communicating financial information to support
internal and external business decision-making
Open Book Management
Open-book management is sharing
sensitive financial information with employees
and teaching them how to understand and
use financial statements.
Viewing financial information may help them
better understand how their work contributes
to the company’s success.
Outsiders use financial data to evaluate
investment opportunities.
Business Activities Involving
Accounting
Financing activities provide necessary funds to
start a business and expand it after it begins
operating.
Investing activities provide valuable assets
required to run a business.
Operating activities focus on selling goods and
services, but they also consider expenses as
important elements of sound financial
management.
Accounting Professionals
Public accountant: An accountant who provides
accounting services to other organizations
Auditing, tax preparation, consulting
Provided to individuals or business firms for a fee
Chartered Accountants (CA)
Management accountants provide timely, relevant,
accurate, and concise information that executives can
use to operate their firms profitably and effectively
Certified Management Accountant (CMA)
Government and not-for-profit accountants
The Foundation of the
Accounting System
Generally accepted accounting principles (GAAP): Principles that
outline the conventions, rules, and procedures for deciding on the
acceptable accounting practices at a particular time
Accounting Standards Board (AcSB): The organization that
interprets and modifies GAAP in Canada for private and not-for-profit
businesses
Canadian public companies are required to use International
Financial Reporting Standards (IFRS). These standards allow for
financial statements to be more easily compared from country to
country.
Senior executives must personally certify that the financial
information reported by the company is correct.
Corruption of Foreign Public Officials Act: A federal law that
prohibits Canadian citizens and companies from bribing foreign
officials to win or continue business.
Test Your Knowledge
Because of the increasing amount of worldwide trade, many
Canadian public firms are moving from _______ to
________ when constructing financial statements.
a. GAAP; IRS
b. IFRS; GAAP
c. GATT; IFRS
d. GAAP; IFRS
Test Your Knowledge
Because of the increasing amount of worldwide trade, many
Canadian public firms are moving from _______ to
________ when constructing financial statements.
a. GAAP; IRS
b. IFRS; GAAP
c. GATT; IFRS
d. GAAP; IFRS
Answer: D
The Accounting Cycle
Accounting cycle: The set of activities involved in
converting information and individual transactions into
financial statements
The Accounting Equation
Asset: anything with future benefit owned or controlled by a
firm
Liability: A claim against a firm’s assets by creditors
Owner’s equity: The funds that owners invest in the business
plus any profits not paid to owners in the form of cash
dividends
Accounting equation: The relationship that should reflect a
firm ’s financial position at any time: assets should always
equal the sum of liabilities and owners’ equity
Double-entry bookkeeping: The process used to record
accounting transactions; each individual transaction is always
balanced by another transaction
The Impact of Computers and the
Internet on the Accounting Process
Simplifies the accounting process by automating data
entry and calculations.
Available products are customized for businesses of
different sizes.
Entrepreneurs and small businesses use QuickBooks and Sage
50 (formerly Simply Accounting).
Larger firms use more sophisticated software packages like
Oracle and SAP.
Software that handles accounting information (other
languages/currencies for international businesses is
another option.
Some systems offer Web-based packages for small and
medium-sized businesses.
Financial Statements
Balance sheet: A statement of a firm’s
financial position—what it owns and the
claims against its assets—at a particular point
in time
Photograph of firm’s assets together with its
liabilities and owner’s equity
Follows the accounting equation
Test Your Knowledge
The Macro Corporation has purchased land for
$100,000, and has financed 50% of the cost using longterm debt. The effect on its balance sheet is
a. an increase in assets of $50,000; an increase in
liabilities of $50,000.
b. an increase in assets of $100,000; a decrease in
owners’ equity of $100,000.
c. an increase in assets of $100,000; an increase in
liabilities of $50,000.
d. a decrease in assets of $50,000; a decrease in
owners’ equity of $50,000.
Test Your Knowledge
The Macro Corporation has purchased land for
$100,000, and has financed 50% of the cost using longterm debt. The effect on its balance sheet is
a. an increase in assets of $50,000; an increase in
liabilities of $50,000.
b. an increase in assets of $100,000; a decrease in
owners’ equity of $100,000.
c. an increase in assets of $100,000; an increase in
liabilities of $50,000.
d. a decrease in assets of $50,000; a decrease in
owners’ equity of $50,000.
Answer: A
The Balance Sheet
The Income Statement
Income statement: A financial record of a
company’s revenues, expenses, and profits
over a specific period of time
Reports profit or loss
Focus on revenues and costs associated with
revenues
The Income Statement
Statement of Changes in Equity
Statement of changes in equity: A record of
the change in equity from the end of one fiscal
period to the end of the next fiscal period
Begins with the amount of equity shown on the
balance sheet
Net income is added, and cash dividends paid
to owners are subtracted
Statement of Changes in Equity
Statement of Cash Flows
Statement of cash flows: A record of the
sources and uses of cash during a period of
time
Accrual accounting: An accounting method
that records revenue and expenses when they
occur, not when cash actually changes hands
Statement of Cash Flows
Test Your Knowledge
Many former owners of failed firms blame
______ for their company’s failure.
a.
b.
c.
d.
GAAP rules
inaccurate budgeting
inadequate cash flows
excessive government regulation
Test Your Knowledge
Many former owners of failed firms blame
______ for their company’s failure.
a.
b.
c.
d.
GAAP rules
inaccurate budgeting
inadequate cash flows
excessive government regulation
Answer: C
Financial Ratio Analysis
Ratio analysis is a tool for measuring a firm’s liquidity,
profitability, and reliance on debt financing, and how
effectively management uses the firm’s resources
Liquidity Ratios
Liquidity ratios measure a firm’s ability to meet its short-term obligations.
Current ratio compares current assets to current liabilities.
Acid-test (or quick) ratio measures the ability of a firm to meet its debt
payments on short notice.
Activity Ratios
Activity ratios measure how effectively management uses the
firm’s resources.
Inventory turnover ratio indicates the number of times merchandise moves
through a business.
Total asset turnover ratio indicates how much in sales each dollar
invested in assets generates.
Profitability Ratios
Profitability ratios measure the organization’s overall
financial performance by evaluating its ability to
generate revenues in excess of operating costs and
other expenses.
Leverage Ratios
Leverage ratios measure how much a firm relies on
debt financing.
A total liabilities to total assets ratio (debt ratio) greater than
50 percent indicates that a firm is relying more on borrowed
money than owners’ equity.
Budgeting
Budget: An organization’s plans for how it will raise and
spend money during a specific period of time
Shows the firm’s expected sales revenues, operating
expenses, cash receipts, and cash expenses.
Budgets are a financial blueprint that serves as a
financial plan.
The cash budget tracks the firm’s cash inflows and
outflows.
Budgeting
International Accounting
Accounting procedures and practices must be adapted to
accommodate an international business environment.
Exchange rates are the value of one country ’s currency
in terms of the currencies of other countries.
Consolidated financial statements must reflect gains
and losses due to changes in exchange rates
Can have significant impact on financial statement
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