Chapter 1

The Purpose and Use of

Financial Statements

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Learning Objectives
After studying this chapter, you should be able to:
Identify the different users and their information needs
Describe the information conveyed to different decision
makers in each of the 4 financial statements namely:

Statement of Financial Position

Statement of Comprehensive Income

Statement of Changes in Equity

Statement of Cash Flow

3. Define GAAP- IFRS or ASPE?
4. Explain the role of managers and auditors in the
accounting communication process
5. Understand the importance of ethics, reputation and
legal liability in accounting
1.
2.

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Users Perspective
OBJECTIVES OF FINANCIAL
ACCOUNTING
Identifies and records the economic events
of an organization
Communicates financial information to
those running the business and outsiders
Both quantitative and qualitative information
about the operation or business entity
Financial statements- financial information
about a company to outside parties about a
business organization.
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Who are the users of

Financial Statement
Internal Users:
Information?
Management
Board of Directors

Manage, plan, organize and run a

business
External Users:
Shareholders
Potential Investors
Creditors
Regulators/tax authorities
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What are some examples of

users information needs?
Business owners/
investors/
shareholders
look for two things:
1.

2.

Increase value of
organization for future
sale long term goal
Converting Earnings to
Dividends- short term
goal

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Creditors
lend money to a
company for a
specific length of
time:
1. Earn interest
2. Received debt
repayment

There are 3 different forms

of business organizations
(Appendix
1a)
Sole Proprietorships
Owner personally responsible for business debt. Not

a legal entity separate from owners

Partnerships
Partners personally responsible for all partnership

debts

Corporation
Separate legal entity, corporation responsible for its

own debt
May be public or private
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Collects and process

information
Accounting System Reports information to
decision makers
Financial Accounting System
(preparation of four basic
financial statements)

Managerial Accounting System

(preparation of detailed plans,
forecasts, standard costing
and reports)

Communicates to
External Decision Makers

Communicates to
Internal Decision Makers

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Responsibilities for the

Accounting Communication
Preparer of the information must effectively
Process
communicate to the reader/users on a timely basis
Financial Statement is the accounting report for
outsiders
Financial Statement helps readers judge liquidity,
profitability and future prospects of business

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Decision makers (readers/users)

need to understand
accounting measurement rules.

What Information is
Conveyed in Financial
The
four basic financial statements . . .
Statements
1. Statement of Financial Position- concise
2.
3.
4.
5.

picture of financial position of the company at a

point in time
Statement of Comprehensive Statementconcise picture of profitability (income or loss) for a
period of time
Statement of Changes in Equity
Statement of Cash Flow- what happened to cash
Notes to the financial statements

Most companies prepare F/S

monthly, quarterly and
annually.

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MAXIDRIVE CORPORATION
Statement of Financial Position
December 31, 2011
Assets
Cash $ 1,400
Accounts receivable
4,000
Supplies
1,800
Equipment
16,000
Total assets
$23,200
Liabilities and Shareholders Equity
Liabilities
Accounts payable
$ 2,000
Notes payable
5,000
Total liabilities
7,000
Shareholders equity
Common shares
10,000
Retained earnings
6,200
Total shareholders equity
16,200
Total liabilities and shareholders equity
$23,200
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10

Statement of Financial
Position:
Assets
Assets
Body
of
Statement

Things
owned
Things owned and
and controlled
controlled by
by the
the business
business
Liabilities
Liabilities

Debts or obligations that resulted from PAST

Debts or obligations that resulted from PAST

transactions.
transactions. Benefits
Benefits receivedreceived- will
will use
use up
up
future
future resources
resources later
later (ie:
(ie: cash)
cash)

Shareholders
Shareholders Equity
Equity

Amount financed by owners of the

Amount financed by owners of the

corporation
corporation (Share
(Share Capital)
Capital) and
and accumulated
accumulated
earnings
earnings retained
retained in
in the
the business
business (Retained
(Retained
Earnings)
Earnings)

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11

Statement of Financial
Position: a different view
Basic Accounting Equation

Assets
Assets

== Liabilities
Liabilities ++ Shareholders
ShareholdersEquity
Equity

Economic
resources =

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Sources of financing . . .
Liabilities: from creditors
Equity: from shareholders.

12

Statement of
Comprehensive
Income
Net income= Revenue- Expenses
Revenues
Sale of goods and services provided to

customers as part of the major operation of

the business
Expenses
Dollar amount of goods and services used

up by the entity to earn revenue during a

period
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13

Note the
title of
the
statemen
t
The income statement is divided into three major captions.

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14

Shows cumulative
earnings that have been
retained less dividends

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15

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16

Operating activities
result from transactions that
create revenues and
expenses
Investing activities
acquiring the resources
(such as property, plant,
and equipment) that are
needed to run the business.
Financing activities
collecting the necessary
funds (through debt or
equity) to support the
business
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Cash Flow Information is

needed because:
Revenue does not equal
cash collected
Expenses reported does
not equal cash paid
Net Income is not equal to
change in cash for the
period
The Concept of Cash
versus Accrual basis of
Accounting

17

Relationships Among the

Statements

1. Profit from the income statement results

in an increase in ending retained earnings

on the statement of changes in equity.

Income Statement
$
Revenues 108,927
97,134
$
11,793

Expenses
Profit

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Statement of Changes in Equity

Beginning retained
$
earnings
58,646
Profit
Dividends
Ending retained

11,793
(5,779)
$

18

Relationships Among the

Statements
2. Ending retained earnings from the statement of

changes in equity is one of the three components

of shareholders equity on the statement of
financial position.

Statement of Changes in Equity

Retained
Earnings
Beginning retained
earnings
$ 58,646

Statement of Financial Position

$
Cash
5,825

Other assets

Total assets

(5,779)

Liabilities

105,091
$
110,916
$
57,285

Ending retained earnings $ 64,660

Share capital

6,248

Retained earnings
Other equity

64,660

Profit

11,793

Dividends

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19

Relationships Among the

Statements
3. The change in cash on the statement of cash

flows is added to the beginning-of-year

balance in cash to arrive at end-of-year cash
on the statement of financial position.
Statement of Cash Flows

Cash flows from operating

activities
$ 17,934
Cash flows from investing
activities
(5,399)
Cash flows from financing
activities
(12,545)
$
Change in cash
(10)

Beginning cash balance

Ending cash balance
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5,835
$
5,825

Balance Sheet
Cash
Other assets
Total assets
Liabilities

$
5,825
105,091
$
110,916
$
16,156

Share capital

6,248

Retained earnings

64,660
20

Notes to the Financial

Statements
Notes provide supplemental
information about the financial
condition of a company.
Three types . . .
Describe

accounting rules applied.

Present additional detail about an item on
the financial statements.
Provide additional information about an
item not on the financial statements.
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What is Generally Accepted

Accounting Principles
Broad rules adopted by the accounting
(GAAP)?
profession as a guide in:
MEASURING
RECORDING
REPORTING
PRESENTATION
the financial activities of a business

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Companies are interested in GAAP

because methods of reporting can
have the following economic
consequences . . .
Affect the selling price of shares.
Affect the amount of bonuses received
by managers and other employees.
Cause a loss of competitive advantage.

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Field of AccountingPrivate versus Public

Public Accounting
Auditing
Tax planning and
preparation
Management
consulting (cost
accounting, budgeting,
info system design)
Accounting services
(booking, production of
F/S)

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Private Accounting
Cost Accounting
Budgeting
Info Systems
design
Internal Auditing

24

Different Professional
Accounting Organizations in
Canadian Institute of Chartered Accountants
Canada
(CAs)
CMA Canada: Certified Management

Accountants (CMAs)
Certified General Accountants Association of
Canada (CGAs)

Each Accounting bodies

require that all members
adhere to a professional code
of ethics.

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25

Discuss steps taken to ensure the

safekeeping of assets, practice of ethical
responsibility of management and accuracy
of the companys records:

Management maintains a system of

controls.
Management hires an outside
independent auditor.
The board of directors reviews these two
safeguards.
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Independent Auditors
Express an opinion as to the fairness of the

financial statement presentation.

Responsibilities that extend to the general public.
Audit involves . . .
Examining the financial reports to ensure
compliance with GAAP (IFRS or ASPE).
Examining the underlying transactions
incorporated into the financial statements.
Expressing an opinion as to the fairness of
presentation of financial information using CAS.

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27

Players in the
Accounting
Communication
Process

Management
Management
Preparation
Preparation
CFO,
CFO,CEO,
CEO,Accounting
AccountingStaff
Staff
Guided
Guidedby
byGAAP/IFRS
GAAP/IFRS
Independent
IndependentAuditors
Auditors
Verification
Verification
Partners,
Partners,Managers,
Managers,Staff
Staff
Guided
Guidedby
byCAS
CAS

Information
Information
Intermediaries
Intermediaries
Analysisand
andAdvice
Advice
Analysis
Financialanalysis,
analysis,
Financial
Informationservices
services
Information

Government
GovernmentRegulators
Regulators
Verification
Verification
Provincial
Provincialsecurities
securitiesstaff
staff
Guided
Guidedby
bysecurities
securities
regulations
regulations
Users
Users
Analysis
Analysisand
andDecision
Decision
Investors,
Investors,Lenders,
Lenders,etc.
etc.

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Public
companies only
28

Annual Reports
For
For privately
privately held
held
companies,
companies, annual
annual
reports
reports are
are simple
simple
documents
documents that
that
include:
include:

Four
Four basic
basic financial
financial

statements
statements

Related
Related footnotes
footnotes

Report
Report of
of
independent
independent
accountants
accountants
(auditors
(auditors opinion)
opinion)
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For
For public
public companies,
companies,
annual
annual reports
reports are
are more
more
elaborate
elaborate with
with greater
greater
SEC
SEC requirements
requirements than
than
private
private companies:
companies:

A
A Non-financial
Non-financial Section
Section

A
A letter
letter to
to the
the
shareholders,
shareholders, aa
description
description of
of
managements
managements
philosophy,
philosophy, products,
products,
successes,
successes, etc.
etc.

A
A Financial
Financial Section
Section

See
See next
next slide
slide for
for aa

29

Annual Reports

The Financial Section of a public companys

annual report includes:

Summarized
Summarized financial
financial

data
data

Management
Management
Discussion
Discussion and
and Analysis
Analysis

The
The four
four basic
basic financial
financial
statements
statements

Notes
Notes

Independent
Independent
Accountants
Accountants Report
Report
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Recent
Recent stock
stock price
price

information
information

Summaries
Summaries of
of the
the
unaudited
unaudited quarterly
quarterly
financial
financial data
data

Lists
Lists of
of directors
directors and
and
officers
officers of
of the
the company
company
and
and relevant
relevant addresses
addresses
30