Introduction to Financial Accounting

Purpose of Financial Accounting Documents

Financial accounting documents are used by companies to report the results of their business activities to various user groups. These documents provide essential information for decision-making and accountability.

• Investors/Creditors:

  • Investors: Want to know how much money they should expect back.

  • Creditors: Want to know when and how they will be paid back.

• Managers: Use accounting information to make business decisions.

• Government and Regulatory Bodies: Ensure companies are paying the correct amount of tax.

• Individuals: Use accounting for personal budgeting.

• Not-For-Profit Organizations:

  • Examples: Churches, hospitals, charities.

  • Base their operating activities on accounting information.

Kinds of Accounting

Financial Accounting

Financial accounting focuses on reporting the financial activities of a business. It is essential for providing relevant, reliable, and accurate information to stakeholders.

• Key Requirements:

  • Information must be relevant, faithfully represented, reliable, and accurate.

  • Materiality: Information is material if its omission or misstatement could influence decisions.

  • Completeness: Information should be complete, neutral, and free from error.

• Users:

  • Internal: Managers.

  • External: Investors, government agencies, public, creditors.

Management Accounting

Management accounting provides information for internal users, such as managers, to assist in budgeting, forecasting, and projections.

• Focuses on internal decision-making.

• Includes budgets, forecasts, and projections.

Assumptions and Principles in Financial Accounting

Key Assumptions

• Going Concern Assumption:

  • Assumes the entity will continue operating normally for the foreseeable future.

• Separate Entity Assumption:

  • A business is a separate economic unit from its owners.

• Historical Cost Principle:

  • Assets are recorded at their purchase price.

• Stable Monetary Unit Assumption:

  • The value of the currency is stable over time.

Organizing a Business

Types of Business Organizations

• Proprietorship:

  • Owned by one person (proprietor).

  • Proprietor is personally liable for business debts.

  • Typically small businesses.

• Partnership:

  • Owned by two or more people.

  • Partners are personally liable for business debts (unless limited liability partnership).

  • Income passes through partners who then pay tax.

• Corporation:

  • Owned by shareholders.

  • Shareholders are not personally liable for business debts.

  • Corporations can raise funds by issuing shares.

  • Double taxation: Corporate income taxed, and shareholders taxed on dividends.

  • Governed by federal or provincial law.

  • Board of directors sets policies and appoints CEO/Chairperson.

Ethical, Legal, and Economic Considerations

Economic

• Maximize economic benefit for society.

• Selfish maximization of business benefits the economy.

Legal

• Free societies are governed by laws.

Ethical

• Ethics go beyond legality and economic benefit.

• Not all legal and economically beneficial actions are ethical.

Financial Statements Overview

The Four Main Financial Statements

Financial statements are the primary means of communicating financial information to users. Each statement serves a specific purpose.

Income Statement

• Also referred to as the statement of profit and loss.

• Reports income (revenues and gains) and expenses (losses).

• Shows net income or net loss for the period.

• Net income is a key indicator of future performance.

• Not all expenses are listed (e.g., cost of goods sold).

Statement of Retained Earnings

• Shows the portion of net income a company keeps over the years.

• Positive balance means revenues exceeded expenses.

• Accumulated deficit indicates expenses have exceeded revenues.

• Net income (or loss) flows from the income statement to the statement of retained earnings.

Balance Sheet

Purpose and Structure

The balance sheet, also known as the statement of financial position, reports the following:

• Assets

• Liabilities

• Owners Equity

It shows that assets equal the sum of liabilities and owners equity:

Assets on the Balance Sheet

• Current Assets:

  • Easily liquidated.

  • Expected to be converted to cash, sold, or used within one year.

  • Examples: Cash, cash equivalents, short-term investments, accounts and notes receivable, inventory, prepaid expenses.

• Non-Current Assets:

  • Held longer than one year.

  • Examples: Property, equipment, land, buildings, computers, equipment, intangibles, long-term investments.

Liabilities on the Balance Sheet

• Current Liabilities:

  • Debts that can be paid in the next year.

• Non-Current Liabilities:

  • Debts that cannot be paid in the next year.

Owners Equity on the Balance Sheet

• Represents ownership of the net business assets.

• In a corporation, consists of:

  • Common Shares

  • Retained Earnings

Statement of Cash Flows

Purpose and Structure

The statement of cash flows measures cash receipts and cash payments, showing how cash increased or decreased during the year. It reports ending cash as shown on the balance sheet.

• Operating Activities:

  • Cash receipts and payments from selling goods and services.

• Investing Activities:

  • Purchasing and selling long-term assets.

• Financing Activities:

  • Issuing shares, paying dividends, borrowing, and repayment of borrowed funds.

Financial Statement Notes

Purpose of Notes

• Add detail, explanations, and context to the financial statements.

• Integral part of the financial statements.

• Should be read carefully with the financial statements.

• Provide information on accounting policies used.

Financial Reporting Responsibilities

• Companies must have their financial statements audited.

• Management is responsible for preparing the financial statements.

• Auditors provide evidence and decide whether the information reported complies with applicable GAAP.

• Auditor provides a signed report stating its opinion on the fairness of the financial statements.

Accounting Standards

• Accountants follow Generally Accepted Accounting Principles (GAAP).

• GAAP specifies how accountants must record, measure, and report financial information.

• GAAP is established in Canada by Chartered Professional Accountants (CPA).

• Publicly accountable enterprises use International Financial Reporting Standards (IFRS).

• Private enterprises can choose between IFRS and Accounting Standards for Private Enterprises (ASPE).

Financial Information Flow

Financial information flows through the following sequence:

• Income Statement → Statement of Retained Earnings → Balance Sheet → Statement of Cash Flows

Net income from the income statement flows to the statement of retained earnings. Ending retained earnings appear in the equity section of the balance sheet. Cash balance in assets section of the balance sheet matches the ending cash balance in the statement of cash flows.

Example:

Additional info: Some explanations and examples have been expanded for clarity and completeness.