Chapter 1: The Purpose and Use of Financial Statements – Study Notes

The Purpose and Use of Financial Statements

Uses and Users of Accounting Information

Accounting is the process of identifying, recording, and communicating the economic events of an organization to interested users. The information produced by accounting is essential for decision-making by various stakeholders.

• Internal Users: Individuals within the organization who use accounting information to manage and operate the business. Examples include company officers, managers, and directors in finance, marketing, human resources, and production.

• External Users: Individuals or entities outside the organization who rely on accounting information to make decisions. Examples include investors, lenders, creditors, customers, employees, labour unions, taxing authorities, and regulators.

Ethics in Financial Reporting: For accounting information to be valuable, preparers must adhere to high ethical standards. Actions should be legal, responsible, and consider the organization’s interests. Accountants and companies often follow codes of conduct to guide ethical behavior.

Data Analytics: The use of software and statistics to analyze data and draw inferences is increasingly common in accounting. The four main types of data analytics are:

• Descriptive: What happened?

• Diagnostic: Why did it happen?

• Predictive: What is likely to happen?

• Prescriptive: What should we do about it?

Forms of Business Organization

Types of Business Organizations

Businesses can be organized in several forms, each with distinct characteristics regarding ownership, liability, taxation, and life span.

• Proprietorship: Owned by one person. Simple to set up, owner has control, limited life, unlimited liability, and income tax is paid by the owner.

• Partnership: Owned by two or more persons. Formalized in a written agreement, limited life, each partner has unlimited liability, and income tax is paid by individual partners.

• Corporation: Separate legal entity owned by shareholders. Indefinite life, ease of raising capital, shareholders enjoy limited liability, corporation pays income tax. Corporations may be public (shares traded publicly) or private (shares not available to the general public).

Generally Accepted Accounting Principles (GAAP): These are rules and practices for preparing financial statements. Publicly-traded corporations use International Financial Reporting Standards (IFRS), while private corporations may use IFRS or Accounting Standards for Private Enterprises (ASPE). Proprietorships and partnerships generally follow ASPE for external reporting.

Types of Business Activities

Three Main Types of Business Activity

All businesses engage in three fundamental types of activities, which are reflected in their financial statements.

• Financing Activities: Obtaining and repaying funds to finance operations. Examples include issuing or repurchasing shares (equity financing) and borrowing or repaying loans (debt financing). Forms of debt include bank loans, mortgages payable, bonds payable, and finance lease obligations.

• Investing Activities: Purchase or sale of long-lived assets needed to operate the company. Examples include property, plant, equipment, intangible assets, and investments in shares or debt securities of other companies.

• Operating Activities: Day-to-day activities that generate income and expenses. Examples include sales revenue, expenses, accounts receivable, and accounts payable.

Financial Statements

Purpose and Content of Financial Statements

Financial statements are formal reports that communicate the financial performance and position of a business. There are four primary financial statements:

• Statement of Income: Reports revenues and expenses for a specific period, showing the net income or loss. Formula: $\text{Net Income (loss)} = \text{Revenues} - \text{Expenses}$

• Statement of Changes in Equity: Shows changes in each component of shareholders’ equity during a period, including share capital, retained earnings (or deficit), and other shareholders’ accounts.

• Statement of Financial Position: Presents assets, liabilities, and shareholders’ equity at a specific point in time. Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}$

• Statement of Cash Flows: Reports the effect on cash from operating, investing, and financing activities over a period, showing the net increase or decrease in cash.

Order of Preparation and Relationships Between Statements

The financial statements are interrelated and typically prepared in the following order:

1. Statement of Income

2. Statement of Changes in Equity

3. Statement of Financial Position

4. Statement of Cash Flows

Key relationships include:

• Net income from the statement of income is reported in the statement of changes in equity.

• Ending balances of shareholders’ equity accounts appear in both the statement of financial position and the statement of changes in equity.

• The statement of cash flows is related to the statement of financial position.

Annual Report

Public corporations must produce an annual report, which includes:

• Financial statements

• Statement of management’s responsibility

• Management discussion and analysis

• Auditor’s report

• Notes to financial statements

• Historical summary of key financial ratios and indicators

Summary Table: Forms of Business Organization

Form	Ownership	Life Span	Liability	Taxation
Proprietorship	One person	Limited	Unlimited	Owner pays
Partnership	Two or more	Limited	Unlimited	Partners pay
Corporation	Shareholders	Indefinite	Limited	Corporation pays

Summary Table: Types of Business Activities

Activity	Description	Examples
Financing	Obtaining/repaying funds	Issuing shares, borrowing money
Investing	Acquiring/selling assets	Buying equipment, selling investments
Operating	Day-to-day operations	Sales, expenses, receivables

Example: Statement of Income

• Revenues: Sales of products or services resulting in asset inflows.

• Expenses: Costs incurred to generate revenues.

• Net Income: The difference between revenues and expenses.

For example, if a company has $100,000 in revenues and $80,000 in expenses, its net income is:

$\text{Net Income} = 100,000 - 80,000 = 20,000$

Example: Statement of Financial Position

• Assets: Cash, accounts receivable, inventory, property, plant, and equipment.

• Liabilities: Accounts payable, loans payable, bonds payable.

• Shareholders’ Equity: Share capital, retained earnings.

Suppose a company has $150,000 in assets, $60,000 in liabilities, and $90,000 in shareholders’ equity. The accounting equation is:

$150,000 = 60,000 + 90,000$

Additional info:

• Publicly-traded corporations must use IFRS, while private corporations may choose between IFRS and ASPE.

• Proprietorships and partnerships generally use ASPE for external reporting but are not required to follow specific standards for internal use.