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Financial Statements

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  1. Financial Statements Andrew Graham Queens University School of Policy Studies Two Lectures

  2. Cash Flows Income Statement S/H Equity Stmt Balance Sheet Comp. Inc. The Road to Financial Statement Enlightenment Should I stop and ask for directions? Canadian Public Sector Financial Management

  3. Warning! All numbers are not the same! A number must be kept in context with the financial statement where it is presented… Canadian Public Sector Financial Management

  4. Beware of Financial Vertigo • Easy to get confused with terminology • Much of what passes for complexity in financial statements is a terminology issue • Sometimes this is counterintuitive – debits and credits as an example • Terminology used often has the same meaning, e.g. revenue and income do not mean the same thing Canadian Public Sector Financial Management

  5. Purpose of Financial Statements • To establish the basic rules and assumptions that are used to provide financial information • They will tell the accountant and end user what financial items are to be measured and when and how to measure them. Canadian Public Sector Financial Management

  6. Source: Public Service Accounting Board, CICA Canadian Public Sector Financial Management

  7. Section 1The Accounting Cycle Canadian Public Sector Financial Management

  8. Canadian Public Sector Financial Management

  9. The Accounting Cycle The accounting process is a series of activities that begins with a transaction and ends with the closing of the books. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps: • Identify the transaction or other recognizable event. • Prepare the transaction's source document such as a purchase order or invoice. • Analyze and classify the transaction. • Record the transaction by making entries in the appropriate journal. Such entries are made in chronological order. Canadian Public Sector Financial Management

  10. The Accounting Cycle • Post general journal entries to the ledger accounts. The above steps are performed throughout the accounting period as transactions occur or in periodic batch processes. The following steps are performed at the end of the accounting period: • Prepare the trial balance to make sure that debits equal credits. • Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include: • posting of the wrong amount, • omitting a posting, • posting in the wrong column, or • posting more than once. Canadian Public Sector Financial Management

  11. The Accounting Cycle • Prepare adjusting entries to record accrued, deferred, and estimated amounts. • Post adjusting entries to the ledger accounts. • Prepare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found. • Prepare the financial statements. • Income statement: prepared from the revenue, expenses, gains, and losses. • Balance sheet: prepared from the assets, liabilities, and equity accounts. • Cash flow statement: derived from the other financial statements using either the direct or indirect method. Canadian Public Sector Financial Management

  12. The Accounting Cycle • Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. • Post closing entries to the ledger accounts. Canadian Public Sector Financial Management

  13. The Accounting Cycle • Prepare the after-closing trial balance to make sure that debits equal credits. • Prepare reversing journal entries (optional). Canadian Public Sector Financial Management

  14. Section 2The Fundamental Accounting Equation Canadian Public Sector Financial Management

  15. The Fundamental Accounting Equation - Definitions The Basic Logic of the Equation: What you have minus what you is what you are worth. • Assets = Have • Economic resources owned by the organization that are expected to be of benefit to it in the future • Rights owed that have a monetary value e.g. right to collect fees • Cash. Office supplies, inventory, furniture, land and buildings Canadian Public Sector Financial Management

  16. The Fundamental Accounting Equation - Definitions Grouping of assets for presentation on Financial Reports: • Very liquid – cash and securities • Assets for immediate use - inventory • Productive Assets – plant and machinery • Accounts receivable • Fixed Assets – capital holdings • Restricted Assets – non-mission holdings or assets held subject to highly restrictive conditions. Canadian Public Sector Financial Management

  17. The Fundamental Accounting Equation - Definitions • Liabilities = Owe • Outsider claims which are economic obligations payable to outsiders • Outside parties are called creditors Canadian Public Sector Financial Management

  18. The Fundamental Accounting Equation - Definitions • Equity or Capital = Value to Owners = Worth • Insider claims to the organization’s assets • From a public sector perspective, it reflects the public holdings that remain after transactions – these can be both assets and debts • An owner has a claim to the entity’s assets because he or she has invested in the business • Amount of an entity’s assets that remain after the liabilities are subtracted • Often referred to as net assets Canadian Public Sector Financial Management

  19. The Fundamental Accounting Equation - Definitions • All receivables are assets • All payables are liabilities Canadian Public Sector Financial Management

  20. The Fundamental Accounting Equation - Definitions • Capital stock – amount invested in the corporation by its owners • Retained Earnings – amount earned by income-producing activities and kept for use in the organization • Net Income, Earnings, Profit or Loss – result of taking total revenues and total expenses into account over a specified period Canadian Public Sector Financial Management

  21. The Fundamental Accounting Equation Assets = Liabilities + Equity or Assets - Liabilities = Equity What you own minus what you owe is what you are worth. Canadian Public Sector Financial Management

  22. Assets = Liabilities + Equity What you own - What you owe = What you are worth The Fundamental Accounting Equation Claims by Outsiders Resources Sources of Resources Equation must always be in balance! Canadian Public Sector Financial Management

  23. Components of Retained Earnings: Flow Chart to Better Understand Financial Statements Revenues of the Period minus Expenses for the Period equals Net Income (or Net Loss) for the Period Beginning Balance of Retained Earnings Ending Balance of Retained Earnings Dividends for the Period plus or minus minus equals Canadian Public Sector Financial Management

  24. Section 3Recording Financial Information Canadian Public Sector Financial Management

  25. Recording Financial Information • A financial event is one that affects the fundamental accounting equation by changing any of its components: Assets = Liabilities + Net Assets • A journal is a chronological listing of every financial event that occurs in an organization. • Every type of asset, liability, revenue, or expense is referred to as an account. Organizations may have as many accounts as they need. Canadian Public Sector Financial Management

  26. Recording Financial Information – Debits and Credits • Financial events are recorded as a series of debitsand credits • Increases in assets are recorded by debits and decreases are recorded by credits. • Increases in liabilities and in owner's equity are recorded by credits and decreases are recorded by debits. Canadian Public Sector Financial Management

  27. Recording Financial Information – Debits and Credits • Notice that the debit and credit rules are related to an account's location in the balance sheet. If the account appears on the left-hand side of the balance sheet (asset accounts), increases in the account balance are recorded by left-side entries (debits). • If the account appears on the right-hand side of the balance sheet (liability and owner's equity accounts), increases are recorded by right-side entries (credits). Canadian Public Sector Financial Management

  28. Debits, Credits and the T-Account Increases are recorded on one side of the T-account, and decreases are recorded on the other side. Title of Account Left or Debit Side Right or Credit Side Canadian Public Sector Financial Management

  29. Canadian Public Sector Financial Management

  30. ASSETS LIABILITIES NET ASSETS Debit for Increase Credit for Decrease Debit for Decrease Credit for Increase Debit for Decrease Credit for Increase Debit and Credit Rules Debits and credits affect accounts as follows: A=L+NA Canadian Public Sector Financial Management

  31. A Sample Transaction • Suppose HOS buys inventory for $2,000. We could just add it to assets. But, that puts the Fundamental Equation out of balance. Assets = Liabilities + Net Assets $2,000 = no change + no change • In a sense, we have not "paid" for the supplies. Suppose the seller sent HOS a bill. We would record the full transaction as: Assets = Liabilities + Net Assets Supplies Accounts Payable + $2,000 = + $2,000 + no change • To record a financial event, at least two elements of the fundamental equation must change! Canadian Public Sector Financial Management

  32. A One-Sided Change Example • Not every financial event (transaction) results in changes to both sides of the fundamental equation. Suppose HOS paid for the inventory in cash. Then the transaction would have been recorded as follows:Assets = Liabilities + Net Assets Inventory Cash + $2,000 - $2,000 = no change + no change • The fundamental equation is still in balance. But, all of the changes occurred on the left side of the equation. Canadian Public Sector Financial Management

  33. Recording Transactions • The first step in recording a transaction is determining what has happened and what accounts will be impacted. • Suppose near the end of the year, HOS buys a one-year insurance policy for $100 and pays for the policy in cash. Two things have happened: - Cash has gone down by $100. - HOS owns a new $100 asset called "prepaid insurance." • Here's the way the transaction would be recorded:Assets = Liabilities + Net Assets P/I Cash + $100 - $100 = no change + no change Canadian Public Sector Financial Management

  34. Another Example • HOS mails a cheque to its bedpan supplier for $2,000 to pay part of the $7,000 it owed them at the start of the year. Two things have happened: - Cash has gone down by $2,000. - HOS's accounts payable have decreased by $2,000. • Here's the way the transaction would be recorded:Assets = Liabilities + Net Assets Cash = Accounts Payable - $2,000 = - $2,000 + no change Canadian Public Sector Financial Management

  35. A Non Transaction • HOS signs a binding contract to buy an X-Ray machine that will cost $50,000. • This event will not give rise to a journal entry because it does not meet the rules for recognition. - The value of the transaction is known. - The timing of the transaction is known. - But, HOS does not yet own the equipment. There has been no exchange. So HOS does not owe the money. No liability unless we owe the creditor. Canadian Public Sector Financial Management

  36. Section 4The Long March Through Financial Statements beginning with the Statement of Financial Position or Balance Sheet Canadian Public Sector Financial Management

  37. Balance Sheet Balance Sheet Cumulative Transactions Income Statement Income Statement Current Period Transactions There are only 5 types of accounts in the accounting world Assets Liabilities Equity Revenue Expense Canadian Public Sector Financial Management

  38. There are only 5 Formal Financial Statements Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity Statement of Comprehensive Income Canadian Public Sector Financial Management

  39. Balance Sheet Income Statement Statement of Cash Flows The Principal Financial Statements of an Organization All Governed by Accounting Policies of the Organization – an integral part of the financial statements Canadian Public Sector Financial Management

  40. Describes where the organization stands at a specific date. Balance Sheet Income Statement Statement of Cash Flows Canadian Public Sector Financial Management

  41. Balance Sheet Depicts the revenue and expenses for a designated period of time. Income Statement Statement of Cash Flows Canadian Public Sector Financial Management

  42. Balance Sheet Income Statement Statement of Cash Flows Depicts the ways cash has changed during a designated period of time. Canadian Public Sector Financial Management

  43. The Balance Sheet Assets = Liabilities + Equity The Income Statement Revenues - Expenses = Net Income Statement of Cash Flows Reconciliation of the Change in Cash and Cash Equivalents Statement of Shareholders’ Equity Reconciliation of the Changes in the Owners’ Equity Accounts Statement of Comprehensive Income Reconciliation of Fair Value Changes and Adjustments Operating Liabs Short-term & Long-term Debt Paid-in Capital + Retained Earnings + Accum. Other Comprehensive Income Canadian Public Sector Financial Management

  44. Statement of Financial Position or The Balance Sheet The Balance Sheet reports: Has Today = Owes today + Worth today A Snapshot in time Canadian Public Sector Financial Management

  45. Statement of Financial Position (The Balance Sheet) Balance sheets report: - what an organization owns (Assets), - what it owes to outsiders (Liabilities), and - the portion of the organization's assets owned by its owners. Called: • Owner's Equity, Partner's Equity, Net Worth, or Stockholders’ Equity (for-profit organizations). • Net Assets or Fund Balance (not-for-profit and governments). • at a specific point in time. • For example, at the end of the organization's Fiscal Year. Canadian Public Sector Financial Management

  46. Meals for the Homeless Balance Sheet Canadian Public Sector Financial Management

  47. Current and Long-Term Assets • Assets on the balance sheet are divided into current or short-term (those that are cash or cash-equivalents or are expected to become cash or will be used up within twelve months) and long-term (those that will not). • Short-Term or Current Assets are listed in order of declining liquidity and normally include: - cash and cash equivalents, - marketable securities, - accounts receivable, - inventory, and - prepaid expenses (long-term prepaid expenses are called Deferred Charges) Canadian Public Sector Financial Management

  48. Cash and Cash Equivalents • The ultimate liquid assets • Includes all forms of immediately available funds, including bank deposits • Always denominated in Canadian funds even if foreign currencies being held Canadian Public Sector Financial Management

  49. Marketable Securities • Marketable securities include equity and debt instruments that can be bought and sold in public and private markets. • The values of marketable securities are reported by governments and not-for-profit organizations at fair market value. • If there is any dispute about fair market value, then cost is used to provide a value. Canadian Public Sector Financial Management

  50. Accounts Receivable • When an organization produces a product, service or obligation for another entity and it is transferred to the entity, the organization acquires the right to collect the money from that entity – this establishes a receivable account • An accounts receivable entry is made when this occurs but before the entity pays for it • Knowing what the outstanding accounts receivable are for the organization is an important indicator of its anticipated income, the degree to which is it efficiently collecting for its services and the degree to which it is carrying debt that it should collect Canadian Public Sector Financial Management