Chapter 1: The Financial Statements – Foundations of Financial Accounting

Financial Accounting: The Language of Business

Introduction to Financial Statements

Financial accounting is the process of recording, summarizing, and reporting the myriad of transactions resulting from business operations over a period of time. The primary output of this process is the set of financial statements, which communicate the financial performance and position of a business to various stakeholders.

• Financial Statements are business documents used to report results to user groups.

• The main financial statements are:

  • Income Statement

  • Statement of Retained Earnings

  • Balance Sheet

  • Statement of Cash Flows

Flow of Accounting Information

The accounting process follows a logical flow:

• People make decisions → Business transactions occur → Companies report results (via financial statements)

Users of Accounting Information

Accounting information is used by a variety of stakeholders:

• Managers

• Investors and Creditors

• Government and Regulatory Bodies

• Individuals

• Not-For-Profit Organizations

Kinds of Accounting

Financial vs. Management Accounting

• Financial Accounting provides information for both internal and external users (e.g., managers, investors, creditors, government agencies, the public).

• Management Accounting provides information for internal users only and includes budgets, forecasts, and projections.

Organizing a Business

Forms of Business Organization

Businesses can be organized in several ways, each with different implications for ownership and liability.

	Proprietorship	Partnership	Corporation
Owner(s)	Proprietor - one	Partners – two or more	Shareholders – usually many
Personal liability for business debts	Proprietor is personally liable	Partners are usually personally liable	Shareholders are NOT personally liable

• Proprietorship: Single owner, common for small businesses, owner is personally liable.

• Partnership: Two or more co-owners, not a taxpaying entity, income passes through to partners, partners usually personally liable (limited liability partnerships can lessen risk).

• Corporation: Owned by shareholders, can raise large sums of capital, legally distinct from owners, subject to double taxation (corporate income and shareholder dividends), shareholders elect a board of directors.

The Financial Statements

Overview and Purpose

Each financial statement answers a specific question about the business:

Question	Financial Statement	Answer
How much income did the company earn during the year?	Income Statement	Revenues + gains – Expenses – losses = Net income (or net loss)
Why did the company’s retained earnings change during the year?	Statement of Retained Earnings	Beginning retained earnings + Net income + Other comprehensive income – Dividends = Ending retained earnings
What is the company’s financial position at the end of the year?	Balance Sheet	Assets = Liabilities + Owners’ equity
How much cash did the company generate and spend during the year?	Statement of Cash Flows	Operating cash flows +/- Investing cash flows +/- Financing cash flows = Increase (decrease) in cash

Accounting Standards

• Accountants follow Generally Accepted Accounting Principles (GAAP).

• The CPA Handbook is the official source of GAAP in Canada.

• There are multiple sets of GAAP:

  • International Financial Reporting Standards (IFRS): For publicly accountable enterprises.

  • Accounting Standards for Private Enterprises (ASPE): For private enterprises.

Detailed Examination of Financial Statements

Income Statement

The Income Statement (also called the statement of profit and loss) reports a company’s revenues and expenses over a specific period, showing the net income or net loss.

• Net income is the most important item in the financial statements.

• Formula:

  • $\text{Net Income} = \text{Revenues} + \text{Gains} - \text{Expenses} - \text{Losses}$

Example Income Statement Structure:

ABC Corporation Income Statement For the Year Ended December 31, 20XX
Net sales	$XX,XXX
Other revenue	+XX,XXX
Total revenues	XX,XXX
Cost of goods sold	(XX,XXX)
Gross margin	XX,XXX
Selling, general, and administrative expenses	(XX,XXX)
Income from operations	XX,XXX
Interest expense	(XX,XXX)
Income before income taxes	XX,XXX
Income tax expense	(XX,XXX)
Net Income	$XX,XXX

Statement of Retained Earnings

The Statement of Retained Earnings shows changes in retained earnings over a period. Retained earnings represent the portion of net income kept in the company rather than distributed as dividends.

• Positive balance: revenues exceeded expenses.

• Accumulated deficit: expenses exceeded revenues.

• Net income (or loss) flows from the Income Statement to this statement.

• Formula:

  • $\text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends}$

Example Statement of Retained Earnings:

ABC Corporation Statement of Retained Earnings For the Year Ended December 31, 20X2
Retained earnings, December 31, 20X1	$XX,XXX
Plus: Net income	XX,XXX
Less: Dividends	XX,XXX
Retained earnings, December 31, 20X2	$XX,XXX

Balance Sheet

The Balance Sheet (Statement of Financial Position) reports a company’s assets, liabilities, and owners’ equity at a specific point in time. It demonstrates the fundamental accounting equation:

• $\text{Assets} = \text{Liabilities} + \text{Owners' Equity}$

• Retained earnings (from the Statement of Retained Earnings) are included in owners’ equity.

Example Balance Sheet Structure:

Assets	Liabilities and Shareholders' Equity
Cash and cash equivalents	Accounts payable
Merchandise inventory	Taxes payable
Prepaid expenses	Total current liabilities
Total current assets	Long-term debt
Property and Equipment	Total liabilities
Less: accumulated depreciation	Common shares
Net Property and Equipment	Retained earnings
Other assets	Total shareholders' equity
Total assets	Total liabilities & shareholders' equity

Assets on the Balance Sheet

• Current Assets: Expected to be converted to cash, sold, or consumed within one year or the operating cycle (whichever is longer). Includes cash, cash equivalents, short-term investments, accounts and notes receivable, inventory, and prepaid expenses.

• Non-Current Assets: Held longer than one year. Includes property and equipment (land, buildings, computers, equipment), intangibles, and long-term investments.

Liabilities on the Balance Sheet

• Current Liabilities: Debts payable within one year or the operating cycle. Includes accounts payable, income taxes payable, accrued expenses, and current maturities of long-term debt.

• Non-Current Liabilities: Debts payable more than one year from the balance sheet date. Includes long-term notes payable and bonds payable.

Owners’ Equity on the Balance Sheet

• Represents ownership of net business assets.

• In a corporation, consists of common shares and retained earnings.

Statement of Cash Flows

The Statement of Cash Flows measures cash receipts and payments over a period, showing whether cash increased or decreased. It categorizes cash flows into three activities:

• Operating activities: Cash from selling goods and services.

• Investing activities: Cash from purchasing and selling long-term assets.

• Financing activities: Cash from issuing shares, paying dividends, borrowing, and repaying funds.

Notes to the Financial Statements

• Integral part of the financial statements.

• Provide information on accounting policies (e.g., inventory and depreciation methods).

• Should be read carefully alongside the statements.

Financial Reporting Responsibilities

• Company management is responsible for preparing the financial statements.

• Auditors gather evidence and determine if statements comply with GAAP, providing a signed report on their fairness.

Relationships Among Financial Statements

The four main financial statements are interrelated:

• Net income from the Income Statement flows to the Statement of Retained Earnings.

• Ending retained earnings from the Statement of Retained Earnings appears in the Balance Sheet.

• Ending cash on the Balance Sheet equals the ending cash on the Statement of Cash Flows.

Underlying Accounting Concepts, Assumptions, and Principles

Conceptual Framework

• Accounting aims to provide useful financial information for decision-making.

• Key qualitative characteristics: relevance, faithful representation, comparability, verifiability, timeliness, understandability.

Key Assumptions & Principles

• Going-Concern Assumption: The entity will continue operating for the foreseeable future.

• Separate-Entity Assumption: The business is a separate economic unit from its owners.

• Historical-Cost Assumption: Assets are recorded at their purchase price.

• Stable-Monetary-Unit Assumption: The value of the currency is stable over time.

Ethics in Accounting

• Business decisions are influenced by economic, legal, and ethical considerations.

• Ethical analysis involves honesty, compassion, community, and fairness to stakeholders.

• Professional organizations (e.g., CPA Ontario) have codes of conduct for ethical guidance.

Tools and Technologies in Accounting

• Common tools: spreadsheets, data analytics, artificial intelligence, machine learning, robotic process automation (RPA).

• Risks: improper use can lead to errors or missing data, affecting decision-making.

Sample Table: Comparison of Business Organizations

Type	Owner(s)	Liability	Taxation
Proprietorship	One	Personal	Personal tax return
Partnership	Two or more	Usually personal	Income passes through to partners
Corporation	Many (shareholders)	Limited (not personal)	Double taxation (corporate and dividends)

Key Equations and Formulas

• Net Income: $\text{Net Income} = \text{Revenues} + \text{Gains} - \text{Expenses} - \text{Losses}$

• Ending Retained Earnings: $\text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends}$

• Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Owners' Equity}$