1-introduction To Financial Statements

Introduction

chapter 1

Introduction to Financial Statements Accounting Matters!

Need Milk? Every time you bite into President’s Choice chocolate-chip cookies, or buy milk at an Independent Grocer, Loblaws, or dozens of other grocery stores, you are shopping at Canada’s #1 grocery retailer and wholesaler: Loblaw Companies Limited. How does a company become one of the biggest names in Canadian business? Through well-planned operating and financial strategies, such as owning its own real estate, re-investing in the business, introducing non-traditional departments and services, and maintaining a strong balance sheet. Strategic acquisitions have also played an important role. In 1956, Garfield Weston acquired a majority of shares in Toronto-based Loblaw Groceterias, and changed its name to Loblaw Companies Limited. Over the next two decades, he steadily acquired dozens of food distributors and wholesalers in both the U.S. and Canada. When Garfield died in 1978, his son Galen took over, continuing Loblaw’s expansion in the 1980s and early 1990s. In 1995 and 1996, Loblaw opened 50 new Canadian locations and moved into the Quebec market by buying the Montreal-based Provigo chain. It also bought more than 80 stores from Agora Foods in Atlantic Canada. Careful not to spread the company too thin, however, Weston let go of the company’s U.S. holdings to focus on this Canadian expansion. Another aspect of Loblaw’s success has been innovation in retailing. Many new stores are massive, boasting flower shops, pharmacies, photo developers, and financial services pavilions, and some even include interior markets, restaurants, and fitness clubs.

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Introduction

Loblaw also introduced private labels in Canada, first with the 1978 launch of the no-name brand, then with President’s Choice, G-R-E-E-N, and Too Good To Be True! In 2001, the company added President’s Choice Organics, followed by President’s Choice general merchandise in 2002. Some 3,500 PC products are available today. President’s Choice products are now sold in the United States, Bermuda, the Cayman Islands, Colombia, Israel, Hong Kong, Trinidad, Jamaica, and several other Caribbean islands. Through innovation, and by ensuring cost-effective operations, the company has enjoyed long-term stable growth. Today, Loblaw Companies Limited is one of Canada’s largest private employers, with nearly 1,700 stores and more than 126,000 employees. None of this happened overnight. The path a huge corporation takes involves many decisions. Should Loblaw purchase a particular distributing operation or introduce a new frozen entrée? Should it sell groceries on-line? Exit a particular market and reallocate assets elsewhere? There are also decisions that executives do not control, such as investors choosing whether or not to purchase Loblaw shares. To make any of these financial decisions, all parties rely on one key tool—accounting.

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Introduction

Loblaw Companies Limited: www.loblaw.com

The Navigator Read Feature Story Scan Study Objectives Read Chapter Preview Read text and answer Before You Go On Work Using the Decision Toolkit

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Introduction

Review Summary of Study Objectives Review the Decision Toolkit—A Summary Work Demonstration Problem Answer Self-Study Questions Complete assignments

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Study Objectives and Preview

Study Objectives After studying this chapter, you should be able to: 1. Explain why accounting is important. 2. Identify the uses and users of accounting 3. Explain the three main types of business activity. 4. Describe the content and purpose of each of the financial statements.

Preview of Chapter 1 How do you start a business? How do you make it grow into a widely recognized brand name like Loblaw? How do you determine whether your business is making or losing money? When you need to expand your operations, where do you get money to finance the expansion— should you borrow, issue shares, or use your own funds? How do you convince lenders to lend you money or investors to buy your shares? To be successful in business, countless decisions have to be made—and decisions require financial information. The purpose of this chapter is to show you accounting’s role in providing reliable financial information. The chapter is organized as follows:

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Accounting Matters!

Accounting Matters! study objective 1 Explain why accounting is important. In the early 2000s, North America saw the collapse of the high-tech industry, a falling stock market, employee layoffs, and the bankruptcy of many well-known companies. Corporate scandals made headlines almost every week. The impact was staggering and it was felt around the world. For example, when the global communications company WorldCom lowered its stated earnings by U.S. $3.8 billion, this restatement contributed to investor losses of U.S. $179.3 billion and 17,000 lost jobs. As tales of fraud unfolded, WorldCom became the biggest bankruptcy in corporate history. Energy trader Enron’s schemes that falsely increased its earnings by U.S. $568 million, leading to financial restatements and bankruptcy, caused investor losses of U.S. $66.4 billion and 6,100 job losses. Improper accounting practices at Nortel Networks Corporation resulted in a U.S. $434-million reduction in its earnings, and in one of Canada’s most widely held shares losing most of its value. These are only three of the many high-profile companies that in a few short years were investigated in different countries because of accusations of accounting misstatements, bogus securities trading, or misleading investors. Regulators, the investment community, and the accounting profession recommended changes to business practices, corporate governance, public oversight, and accountability. The end result of all this is that new requirements now guide business behaviour, as well as accounting and auditing practices. One thing is very evident from all these embarrassing, illegal, and unethical business events— accounting is important. Good accounting is essential to sound business and investing decisions. Bad accounting will not be tolerated. If there is the slightest hint that a company’s accounting practices cannot be trusted, investors sell their holdings and the company’s share price falls dramatically. The world’s economic systems depend on highly transparent, reliable, and accurate financial reporting. Accounting has long been labelled “the language of business.” That language must be understandable, useful, and truthful if it is to be of any value. Recent events such as these reinforce the worth of studying, understanding, and using accounting information. This textbook is your introduction to accounting as a valuable tool for business record keeping, communication, and analysis. Make the most of this course—it will serve you for a lifetime in ways you cannot now imagine.

Ethics in Accounting http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_3.xform?course=crs1562&id=ref (1 of 3)11/02/2008 10:24:17 AM

Accounting Matters!

The corporate scandals of the early 2000s made it very clear that reliable accounting information is essential. These scandals also highlighted the importance of ethics in accounting. The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics. We have seen what happens when you cannot depend on the individuals you deal with to be honest. If managers, customers, investors, co-workers, and creditors act dishonestly, effective communication and economic activity are impossible and information lacks credibility. To help you become aware of ethical situations and to give you practice at solving ethical dilemmas, we look at ethics in a number of ways in this book: (1) Many of the feature stories, as well as other parts of the text, discuss the central importance of ethical behaviour to financial reporting. (2) Accounting Matters! boxes with an ethics perspective highlight ethics questions and issues in actual business situations. (3) In the end-of-chapter material, an ethics case asks you to put yourself in the position of a decision-maker in a particular business situation. As you analyze these ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1-1. 1. Recognize an ethical situation and the ethical issues involved.

2. Identify and analyze the main elements in the situation.

Use your personal ethics or an organization’s code of ethics to identify ethical situations and issues.

Identify the stakeholders —persons or groups who may be harmed or benefited. Ask the question: What are the responsibilities and obligations of the parties involved?

3. Identify the alternatives, and weigh the impact of each alternative on various stakeholders. Select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one possible solution. These situations require an evaluation of each alternative and the selection of the best one.

Illustration 1-1 Steps used to analyze ethical dilemmas

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Accounting Matters!

Accounting Matters! Ethics Perspective Nortel Networks Corporation hired Susan Shepard, a lawyer with 30 years of experience in investigating crime and ethical behaviour, to be the new sheriff in its troubled corporate town. When Nortel’s CEO, Bill Owens, announced the hiring, he described Shepard’s appointment to the newly created post of chief ethics and compliance officer as tangible evidence that the company intends to set a “new tone at the top of this organization.” Recent surveys indicate that about half of North America’s major corporations have ethics officers. This number is expected to rise with the introduction of new requirements that boards of directors and management must be actively involved in monitoring corporate ethics. Source: Shawn McCarthy, “Hiring Ethics Guru Evidence of ‘New Tone’ CEO Says,” The Globe and Mail, January 12, 2005, B7.

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Uses and Users of Accounting

Uses and Users of Accounting study objective 2 Identify the uses and users of accounting. Accounting is the information system that identifies and records the economic events of an organization, and then communicates them to interested users. There are three different types of organizations—proprietorships, partnerships, and corporations—and two types of interested users—internal users and external ones.

Forms of Business Organization Suppose you open your own marketing agency. One of your first decisions is what organizational form your business should take. You have three choices—proprietorship, partnership, or corporation. A business owned by one person is a proprietorship. A business owned by more than one person is a partnership. A business organized as a separate legal entity owned by shareholders is a corporation. You will probably choose the proprietorship form for your marketing agency. It is simple to set up and gives you control over the business. Small owner-operated businesses such as hair salons, service stations, and restaurants are often proprietorships, as are most home-based businesses. Another possibility is for you to join forces with other individuals to form a partnership. Partnerships are often formed because one individual does not have enough economic resources to initiate or expand the business, or because partners bring unique skills or resources to the partnership. Partnerships are used to organize retail and service-type businesses, including professional practices (lawyers, doctors, architects, engineers, and accountants). Alternative Terminology Shares are also known as stock. As a third alternative, you might organize as a corporation. As an investor in a corporation, you receive shares to indicate your ownership claim. Buying shares in a corporation is often more attractive than investing in a partnership because shares are easier to sell. Selling a proprietorship or partnership interest is much more complicated. Also, individuals can become shareholders by investing relatively small amounts of money. This advantage makes it is easier for corporations to raise funds. Successful corporations like Loblaw often have thousands of shareholders, and their shares are traded on organized stock exchanges, such as the Toronto Stock Exchange. Many businesses start as proprietorships or partnerships and eventually incorporate.

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Uses and Users of Accounting

Helpful Hint You can usually tell if a company is a corporation by looking at its name. The words Limited (Ltd.), Incorporated (Inc.), or Corporation (Corp.) normally follow its name. There are other factors that need to be considered when deciding which organizational form to choose. These include legal liability and income taxes. If you choose a proprietorship or partnership, you are personally liable for all debts of the business, whereas corporate shareholders are not. Proprietors and partners pay personal income tax on their respective share of the profits, while corporations pay income taxes as separate legal entities on any corporate profits. Corporations may also receive a more favourable tax treatment than other forms of business organization. We will discuss these issues in more depth in a later chapter. Although the combined number of proprietorships and partnerships in Canada is more than the number of corporations, the revenue produced by corporations is far greater. Most of the largest companies in Canada—for example, General Motors of Canada Ltd., BCE Inc., Nortel Networks Corporation, George Weston Limited, Bombardier Inc., and Loblaw Companies Limited—are corporations. Because the majority of Canadian business is transacted by corporations, this book focuses mostly on the corporate form of organization.

Types of Users Many people have an interest in knowing about the ongoing activities of a business organization. These people are users of accounting information. Users can be divided broadly into two types: internal users and external users.

Internal Users Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, internal users must answer many important questions, as shown in Illustration 1-2.

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Uses and Users of Accounting

Illustration 1-2 Questions asked by Internal Users To answer these and other questions, users need detailed information on a timely basis. For internal users, accounting provides internal reports, such as financial comparisons of operating alternatives, projections of earnings from new sales campaigns, and forecasts of cash needs for the next year.

External Users There are several types of external users of accounting information. Investors (shareholders) use accounting information to make decisions to buy, hold, or sell their shares. Creditors, such as suppliers and bankers, use accounting information to evaluate the risks of granting credit or lending money. Some questions that may be asked by investors and creditors about a company are shown in Illustration 1-3.

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Uses and Users of Accounting

Illustration 1-3 Questions asked by external Users The information needs and questions of other external users vary a lot. Taxing authorities, such as the Canada Revenue Agency, want to know whether the company respects the tax laws. Regulatory agencies, such as provincial securities commissions, want to know whether the company is operating within prescribed rules. Customers are interested in whether a company will continue to honour product warranties and support its product lines. Labour unions want to know whether the company has the ability to pay increased wages and benefits. Economic planners use accounting information to analyze and forecast economic activity.

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Before You Go On #1

Before You Go On . . . Review It 1. Why is good accounting important to decision-making? 2. Why are ethics a fundamental business concept? 3. What are the three forms of business organization and the advantages of each? 4. What are the two main types of users of accounting information? Give examples of each.

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Business Activities

Business Activities study objective 3 Explain the three main types of business activity. All businesses are involved in three types of activity—financing, investing, and operating. For example, Galen Weston needed financing in the 1980s to revitalize and expand Loblaw. To finance this expansion, Loblaw sold shares to investors and borrowed money from outside sources, like banks. The cash obtained was then invested in new supermarkets. These new supermarkets helped increase Loblaw’s operating activities of buying and selling food and other products. Let’s now look at these three types of business activity in more detail.

Financing Activities It takes money to make money. The two primary ways of raising outside funds for corporations are borrowing money and issuing (selling) shares in exchange for cash. Loblaw may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow money from other lenders. The persons or companies that Loblaw owes money to are its creditors. Amounts owed to creditors—in the form of debt and other obligations—are called liabilities. Specific names are given to different types of liabilities, depending on their source. For instance, Loblaw may have taken funds from an operating line of credit with its bank, which results in bank indebtedness. Loblaw may also have a short-term note payable to a bank for the money borrowed to purchase its display cabinets, for example. Loblaw may also have long-term debt, which can include notes payable, mortgages payable, and other types of debt securities borrowed for longer periods of time. A corporation may also obtain financing by selling shares of ownership, or share capital, to investors. As mentioned in the chapter-opening feature story, Garfield Weston purchased shares of ownership in Loblaw Groceterias, which was later renamed Loblaw Companies Limited. Loblaw has issued common shares to other interested investors over the years to raise the cash that was needed to help the business grow. Common shares is the term used to describe the amount paid by investors for shares of ownership in a company. Common shares are just one class or type of share capital that a company can issue. The claims of creditors differ from those of shareholders. If you loan money to a company, you are one http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_6.xform?course=crs1562&id=ref (1 of 3)11/02/2008 10:24:40 AM

Business Activities

of its creditors. In loaning money, you specify a repayment schedule—for example, payment at the end of each month. In addition, interest is normally added to the amount due. As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may force the company to sell its property to pay its debts. The law requires that creditor claims be paid before shareholder claims. Shareholders have no claim to corporate resources until the claims of creditors are satisfied. If you buy a company’s shares instead of loaning it money, you have no legal right to expect any payments until all of its creditors are paid. Also, once shares are issued, the company has no obligation to buy them back, whereas debt obligations must be repaid. Many companies pay shareholders a return on their investment on a regular basis, as long as there is enough cash to cover required payments to creditors. Payments to shareholders are called dividends.

Investing Activities After Loblaw raises money through financing activities, it then uses that money for investing activities. Investing activities involve the purchase of the long-lived resources—called assets—that a company needs to operate. For example, display cabinets, computers, delivery trucks, buildings, and land are all examples of assets that result from investing activities. Together, they are referred to as property, plant, and equipment. Cash is one of the more important assets owned by Loblaw, or any other business. If a company has excess cash that it does not need for a while, it might choose to invest it in debt or equity securities of other corporations or organizations. Investments are another example of an asset and an investing activity.

Operating Activities Most of the company’s longer-lived assets are purchased through investing activities as described above. Other assets with shorter lives, however, result from operating activities. For example, if Loblaw sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future. This right to receive money in the future is called an account receivable. Goods available for future sales to customers are assets called inventory. Loblaw is in the business of selling goods such as groceries and household products. We call the amount earned from the sale of these goods revenues. In accounting language, revenues are increases in economic resources—normally an increase in an asset but sometimes a decrease in a liability—that result from a business’s operating activities. Revenues come from different sources and are identified by various names, depending on the nature of the business. For instance, Loblaw’s main source of revenue is the money it earns from grocery sales to

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Business Activities

consumers. However, it also earns interest revenue on securities held as short-term investments. Sources of revenue that are common to many businesses are sales revenue, service revenue, and interest revenue. Before Loblaw can sell any groceries, it must buy produce, meat, and other food items. It also incurs costs like salaries, utilities, and income taxes. All of these costs, referred to as expenses, are necessary to sell the product. In accounting language, expenses are the cost of assets that are consumed or services that are used in the process of generating revenues. Alternative Terminology Amortization expense is also called depreciation expense. There are many kinds of expenses and they are identified by various names, depending on the type of asset consumed or service used. For example, Loblaw keeps track of these types of expenses: cost of sales, selling and administrative expenses (such as the cost of food products, wages of store employees, advertising costs, office supplies, and utilities), amortization expense (allocation of the cost of using property, plant, and equipment), interest expense (amounts of interest paid on various debts), and income taxes (corporate taxes paid to the provincial and federal governments). Loblaw may also have liabilities that come from these expenses. For example, it may purchase produce on credit from suppliers; the obligations to pay for these goods available for sale to its customers are called accounts payable. Additionally, Loblaw may have interest payable on the outstanding (unpaid) amounts owed to the bank. It may also have wages payable, provincial sales taxes and property taxes payable to the provincial government, and goods and services taxes payable to the federal government. Income tax payable is an example of another liability that is payable to the federal and provincial governments. Alternative Terminology Net earnings are also commonly known as net income. To determine whether it earned a profit, Loblaw compares the revenues of a period with the expenses of that period. When revenues are more than expenses, net earnings result. When expenses exceed revenues, a net loss results.

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Before You Go On #2

Before You Go On . . . Review It 1. What are the three types of business activity? 2. What are assets, liabilities, share capital, dividends, revenues, and expenses? Do It Classify each item first as a financing, investing, or operating activity, and then as an asset, liability, share capital, revenue, or expense: (a) an amount paid to an employee for work performed (b) an amount earned from providing a service (c) an issue of shares (d) a truck that is purchased (e) an amount owed to a bank (f) excess cash invested in a long-term investment Action Plan Distinguish between financing, investing, and operating activities. Understand the distinction between assets, liabilities, share capital, revenues, and expenses. Classify each item based on its economic characteristics. Solution (a) Operating activity; expense (b) Operating activity; revenue (c) Financing activity; share capital (d) Investing activity; asset (e) Financing activity; liability (f) Investing activity; asset

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Before You Go On #2

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Communicating with Users

Communicating with Users study objective 4 Describe the content and purpose of each of the financial statements. Users of accounting information are interested in a company’s assets, liabilities, shareholders’ equity, revenues, and expenses. For reporting purposes, it is customary to arrange this information in four different financial statements that are the backbone of financial reporting: Statement of earnings: A statement of earnings reports revenues and expenses to show how successfully a company performed during a period of time. Statement of retained earnings: A statement of retained earnings indicates how much was distributed to you and the other shareholders of a company in the form of dividends, and how much was retained in the business to allow for future growth. Balance sheet: A balance sheet presents a picture of what a company owns (its assets), what it owes (its liabilities), and its net worth (its shareholders’ equity) at a specific point in time. Cash flow statement: A cash flow statement shows where a company obtained cash during a period of time and how that cash was used. To introduce you to these statements, in the following sections we have prepared the financial statements for a fictitious marketing agency called Sierra Corporation.

Statement of Earnings Alternative Terminology The statement of earnings is also commonly known as the income statement. The statement of earnings reports the success or failure of the company’s operations for a period of time. To indicate that Sierra’s statement of earnings reports the results of operations for a period of time, the statement is dated “Month Ended October 31, 2006.” The statement of earnings lists the company’s revenues followed by its expenses. Expenses are deducted from revenues to determine earnings before income tax (commonly abbreviated as EBIT). Income tax expense is usually shown separately, immediately following earnings before income tax. Finally, the net earnings (or net loss) are determined by deducting the income tax expense. Why are financial statement users interested in net earnings? Investors are interested in a company’s past earnings because they provide information which suggests future earnings. Investors buy and sell shares based on their beliefs about the future performance of a company. If you believe that Sierra will be even more successful in the http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_8.xform?course=crs1562&id=ref (1 of 10)11/02/2008 10:25:18 AM

Communicating with Users

future, and that this success will translate into a higher share price, you should buy Sierra’s shares. Creditors also use the statement of earnings to predict the future. When a bank loans money to a company, it does this because it believes it will be repaid in the future. If it thought it was not going to be repaid, it would not loan the money. Thus, before making the loan, the bank loan officer must try to predict whether the company will be profitable enough to repay it. Note that the issue of shares and distribution of dividends do not affect net earnings. For example, if Sierra Corporation received $10,000 of cash from issuing new shares, it would not be reported as revenue in the statement of earnings. Rather, this transaction would increase cash and common shares in the balance sheet. If dividends of $500 were paid, it would not be regarded as a business expense, because it was not incurred to generate revenue. Instead, dividends are reported as a reduction of retained earnings in the statement of retained earnings. A sample statement of earnings for Sierra Corporation is shown in Illustration 1-4.

Illustration 1-4 Statement of earnings

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Communicating with Users

Helpful Hint The heading of every statement identifies the company, the type of statement, and the time period covered by the statement. Sometimes another line is added to indicate the unit of measure. When it is used, this fourth line usually indicates that the data are presented in thousands or in millions of dollars. Note that cents are not included in the dollar figures recorded in financial statements, such as those illustrated for Sierra Corporation. In reality, it is important to understand that cents should be and are used in recording transactions in a company’s internal accounting records. In contrast, for financial reporting purposes, financial statement amounts are normally rounded to the nearest dollar, thousand dollars, or million dollars, depending on the size of the company. External reporting condenses and simplifies information so that it is easier for the reader to understand. As well, it really does not matter whether the figures are listed in two columns, as they are for Sierra Corporation, or in one column. Companies use a variety of presentation formats, depending on their preference and what they think is easiest for the reader to understand.

Decision Toolkit Decision Checkpoints

Info Needed for Decision

Are the company’s operations profitable?

Statement of earnings

Tools to Use for Decision

The statement of earnings indicates the success or failure of the company’s operating activities by reporting its revenues and expenses.

How to Evaluate Results

If the company’s revenues exceed its expenses, it will report net earnings; otherwise, it will report a net loss.

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Communicating with Users

Statement of Retained Earnings If Sierra is profitable, at the end of each period it must decide what portion of earnings to pay to shareholders in dividends. In theory, it could pay all of its current period earnings, but few companies choose to do this. Why? Because they want to retain part of the earnings or profits in the business so that the company can expand when it chooses to. Retained earnings are the cumulative earnings that have been retained in the corporation; in other words, they are the earnings that have not been paid out to shareholders. The statement of retained earnings shows the amounts and causes of changes in retained earnings during the period. The time period is the same as for the statement of earnings. The beginning retained earnings amount is shown on the first line of the statement. Then net earnings are added and dividends (if any) are deducted to calculate the retained earnings at the end of the period. If a company has a net loss, it is deducted (rather than added) in the statement of retained earnings. By monitoring the statement of retained earnings, financial statement users can evaluate dividend payment practices. Some investors look for companies that pay high dividends. For example, companies such as BCE, Duke Energy, Scotiabank, and Sun Life pay a high dividend rate. Other investors seek companies that pay no dividends and instead reinvest earnings to increase the company’s growth. Companies such as Amazon.com, Biovail, Geac, Indigo Books & Music, and WestJet do not normally pay a dividend. Lenders monitor dividend payments because any money paid in dividends reduces a company’s ability to repay its debts. Illustration 1-5 presents Sierra Corporation’s sample statement of retained earnings.

Illustration 1-5 Statement of retained earnings

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Communicating with Users

Decision Toolkit Decision Checkpoints

Info Needed for Decision

What is the company’s policy on dividends and growth?

Statement of retained earnings

Tools to Use for Decision

How much did the company pay out in dividends to shareholders?

How to Evaluate Results

A company looking for rapid growth will pay no, or a low, dividend.

Balance Sheet The balance sheet reports assets and claims to those assets at a specific point in time. These claims are subdivided into two categories: claims of creditors and claims of shareholders. As noted earlier, claims of creditors are called liabilities. Claims of shareholders, the owners of the company, are called shareholders’ equity. This relationship is shown in equation form in Illustration 1-6. This equation is referred to as the basic accounting equation.

Illustration 1-6 Basic accounting equation This relationship is where the name balance sheet comes from. Assets must be in balance with the claims to the assets. The right-hand side of the equation—the liabilities and equity—shows how the assets have been financed (borrowing from creditors, investing by shareholders, or self-financing through earnings retained in the company). As you can see from looking at Sierra’s balance sheet in Illustration 1-7, assets are listed first, followed by liabilities and shareholders’ equity. Sierra’s assets total $21,867 and include cash, accounts receivable, advertising supplies, prepaid insurance (insurance paid in advance but not yet used), and office equipment. Of these assets, only office equipment would be presented as an investing activity in the cash flow statement, as we will see in the next section. The others (except for cash) are examples of assets coming from operating activities.

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Communicating with Users

Illustration 1-7 Balance sheet Helpful Hint The balance sheet is dated at a specific point in time. The statement of earnings, statement of retained earnings, and cash flow statement cover a period of time. Sierra’s liabilities total $11,375 and consist of notes payable, accounts payable, interest payable, unearned revenue (cash received in advance for which the service has not yet been provided and is therefore still owed), salaries payable, and income tax payable. Of these liabilities, only the notes payable are an example of a financing activity. The others are examples of liabilities coming from operating activities. Shareholders’ equity consists of two parts: (1) share capital and (2) retained earnings. Share capital represents the shareholders’ investments and includes all the classes of shares that a company has issued. If only one class of http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_8.xform?course=crs1562&id=ref (6 of 10)11/02/2008 10:25:18 AM

Communicating with Users

shares is issued, it is always common shares. Retained earnings are the cumulative net earnings retained in the corporation. Sierra has common shares of $10,000 and retained earnings of $492, for total shareholders’ equity of $10,492. Creditors analyze a company’s balance sheet to determine the likelihood that they will be repaid. They carefully evaluate the nature of the company’s assets and liabilities. For example, does the company have assets that could easily be sold, if required, to repay its debts? Managers use the balance sheet to determine whether inventory is adequate to support future sales and whether cash on hand is sufficient for immediate cash needs. Managers also look at the relationship between total liabilities and shareholders’ equity to determine whether they have the best proportion of debt and equity financing.

Decision Toolkit Decision Checkpoints

Does the company rely mainly on debt or equity to finance its assets?

Info Needed for Decision

Tools to Use for Decision

How to Evaluate Results

Balance sheet

The balance sheet reports the company’s resources and claims to those resources. There are two types of claims: liabilities and shareholders’ equity.

Compare the amount of liabilities versus the amount of shareholders’ equity to determine whether the company relies more on creditors or shareholders for its financing.

Cash Flow Statement The main function of a cash flow statement is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. To help investors, creditors, and others in their analysis of a company’s cash position, the cash flow statement reports the effects on cash of a company’s (1) operating activities, (2) investing activities, and (3) financing activities. Operating activities are normally presented first, followed by either investing or financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the cash amount at the end of the period. Users are interested in the cash flow statement because they want to know what is happening to a company’s most important resource. The cash flow statement provides answers to these simple but important questions: Where did cash come from during the period? http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_8.xform?course=crs1562&id=ref (7 of 10)11/02/2008 10:25:18 AM

Communicating with Users

How was cash used during the period? What was the change in the cash balance during the period? The cash flow statement for Sierra, in Illustration 1-8, shows that cash increased by $15,200 during the month. This increase resulted because operating activities (services to clients) increased cash by $5,700, and financing activities increased cash by $14,500. Investing activities used $5,000 of cash for the purchase of office equipment. Note that the positive numbers indicate cash inflows. Numbers in parentheses indicate cash outflows. Parentheses are often used in financial statements to indicate negative amounts.

Illustration 1-8 Cash flow statement For now, you should not worry too much about where the numbers came from. We will learn more about the preparation of cash flow statements in a later chapter.

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Communicating with Users

Decision Toolkit Decision Checkpoints

Does the company generate enough cash from operating activities to fund its investing activities?

Info Needed for Decision

Tools to Use for Decision

How to Evaluate Results

Cash flow statement

The cash flow statement shows the amount of cash provided or used by operating activities, investing activities, and financing activities.

Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash provided by financing activities.

Relationships Between the Statements Because the results on some statements are used as data for other statements, the statements are said to be interrelated (related to each other). These interrelationships are evident in Sierra’s financial statements: 1. The statement of retained earnings depends on the results of the statement of earnings. Sierra reported net earnings of $992 for the period, as shown in Illustration 1-4. This amount is added to the beginning amount of retained earnings as part of the process of determining ending retained earnings in Illustration 1-5. 2. The balance sheet and statement of retained earnings are interrelated because the ending amount of $492 on the statement of retained earnings in Illustration 1-5 is reported as the retained earnings amount on the balance sheet in Illustration 1-7. 3. The cash flow statement and the balance sheet are also interrelated. The cash flow statement presented in Illustration 1-8 shows how the cash account changed during the period by stating the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the amount of cash at the end of the period, $15,200. The ending amount of cash shown on the cash flow statement must agree with the amount of cash on the balance sheet shown in Illustration 1-7. Study these interrelationships carefully. To prepare financial statements, you must understand the sequence in

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Communicating with Users

which these amounts are determined and how each statement affects the next. Because each financial statement depends on information contained in another, financial statements must be prepared in a certain order: (1) statement of earnings; (2) statement of retained earnings; (3) balance sheet; and (4) cash flow statement.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Before You Go On #3

Before You Go On . . . Review It 1. What questions might each of the following decision-makers ask that could be answered by financial information: a bank loan officer, an investor, a labour union, and a government? 2. What are the content and purpose of each statement: the statement of earnings, balance sheet, statement of retained earnings, and cash flow statement? Do It CSU Corporation began operations on January 1, 2006. The following account information is available for CSU Corporation on December 31, 2006: Service Revenue $22,200; Accounts Receivable $4,000; Accounts Payable $2,000; Rent Expense $9,000; Notes Payable $5,000; Common Shares $10,000; Equipment $16,000; Insurance Expense $1,000; Supplies $1,800; Supplies Expense $200; Cash $1,400; Income Tax Expense $5,200; and Dividends $600. Using this information, prepare a statement of earnings, statement of retained earnings, balance sheet, and cash flow statement for the year. For the operating activities section of the cash flow statement, cash receipts from operating activities were $18,200 ($22,200 − $4,000) and cash payments for operating activities were $15,200 ($9,000 + $1,000 + $200 + $5,200 + $1,800 − $2,000). You will have to determine the cash receipts and cash payments for each of the investing and financing activities sections. Assume that all transactions for these activities were cash transactions. Action Plan Classify each account into the following categories: revenues, expenses, dividends, assets, liabilities, and shareholders’ equity. Report revenues and expenses for the period in the statement of earnings. Show the amounts and causes (net earnings and dividends) of the changes in retained earnings for the period in the statement of retained earnings. Present assets and claims to those assets (liabilities and shareholders’ equity) at a specific point in time in the balance sheet. Show the changes in cash for the period, classified as an operating, investing, or financing activity in the cash flow statement. Solution

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Before You Go On #3

See facing page.

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A Quick Look at Loblaws Financial Statements

A Quick Look at Loblaw’s Financial Statements The same relationships that you observed among the financial statements of Sierra Corporation can be seen in the 2003 simplified financial statements of Loblaw Companies Limited, presented in Illustrations 1-9 through 1-12. Loblaw’s actual financial statements are presented in Appendix A at the end of the book. We have simplified the financial statements to assist your learning—but they may look complicated to you anyway. Do not be alarmed by this. By the end of the book, you will have a lot of experience in reading and understanding financial statements such as these, and they will no longer look so complicated. Before examining them, we need to explain a few points: 1. An accounting time period that is one year in length is called a fiscal year. Loblaw’s fiscal year ends on the Saturday nearest the end of the calendar year. Consequently, its year end does not fall on the same date each year. For example, its 2003 year end was actually January 3, 2004. 2. Loblaw, like most companies, presents its financial statements for more than one year. Financial statements that report information for more than one period are called comparative statements. Comparative statements allow users to compare the financial position of a business at the end of one accounting period to the positions of previous periods. 3. Loblaw presents consolidated financial statements. This simply means that Loblaw’s financial results include the results from all the companies owned by Loblaw Companies Limited—Loblaws, Atlantic Superstore, Provigo, Independent Grocer, and other companies representing the 1,700 stores Loblaw owns across Canada. 4. Note that numbers are reported in millions of dollars on Loblaw’s financial statements— that is, the last six zeros (000,000) are omitted. Thus, Loblaw’s net earnings in 2003 are $845,000,000 not $845. Helpful Hint The arrows in this illustration show the relationships between the four financial statements.

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A Quick Look at Loblaws Financial Statements

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A Quick Look at Loblaws Financial Statements

Accounting Matters! Management Perspective About 70% of Canadian companies use December 31 for their year end. Why doesn’t every company use December 31 as its accounting year end? Many companies choose to end their accounting year when the inventory or operations are at a low. This is advantageous because compiling accounting information requires much time and effort by managers. They would rather do it when they aren’t too busy operating the business. Also, inventory is easier and less costly to count when it is low. Some companies whose year ends differ from December 31 are Sears (last Saturday in December), Bombardier (January 31), Intrawest (June 30), and CanWest Global Communications (August 31). Most universities and governments use March 31 for their fiscal year end.

Statement of Earnings A simplified version of Loblaw’s statement of earnings is presented in Illustration 1-9. Sierra is a service company: it provides services to earn its revenue. Loblaw sells a product: its main source of revenue is called sales. For 2003, Loblaw reports sales of $25,220 million. It then subtracts a variety of expenses related to operating the business. These expenses, totalling $23,949 million, include the cost of sales, selling and administrative expenses, amortization expense, and interest expense (payment of interest on debt) to arrive at earnings before income taxes of $1,271 million. After subtracting the income tax expense of $426 million, the company reports net earnings for the period of $845 million. Net earnings represent a 16-percent increase over the results of the previous year.

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A Quick Look at Loblaws Financial Statements

Illustration 1-9 Loblaw statement of earnings

Statement of Retained Earnings Loblaw presents information about its retained earnings in the statement of retained earnings in Illustration 1-10. Unlike Loblaw, some companies use a single statement to present their earnings and retained earnings. Find the line “Retained earnings, beginning of year,” in Illustration 1-10 and you will see that retained earnings at the beginning of 2003 were $2,929 million. Note that this amount agrees with the end-of-year balance for 2002. The next figure for 2003 is net earnings of $845 million. This figure was taken from Loblaw’s statement of earnings, presented in Illustration 1-9. Loblaw paid $165 million in dividends to its shareholders. The 2003 ending balance of retained earnings, after a $71-million adjustment for other items (which we will learn about in a later chapter), is $3,538 million. Find this amount of retained earnings in the shareholders’ equity section near the bottom of Loblaw’s 2003 balance sheet, presented in Illustration 1-11.

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A Quick Look at Loblaws Financial Statements

Illustration 1-10 Loblaw statement of retained earnings

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A Quick Look at Loblaws Financial Statements

Illustration 1-11 Loblaw balance sheet

Balance Sheet Alternative Terminology Fixed assets is another term for property, plant, and equipment. As shown in Loblaw’s balance sheet in Illustration 1-11, Loblaw’s assets include the types of assets mentioned in this chapter, such as cash, short-term investments, accounts receivable, inventories, and fixed assets, plus other types of assets that we will discuss in later chapters, such as prepaid expenses and goodwill. Similarly, its liabilities include bank indebtedness, notes payable, accounts payable, income taxes payable, and long-term debt, as well as items not yet discussed, such as accrued liabilities. Loblaw’s balance sheet shows that total assets increased from $11,110 million on December 28, 2002 (2002 fiscal year), to $12,177 million on January 3, 2004 (2003 fiscal year). You can see that Loblaw relies more on debt financing than equity—it has nearly 60 percent more total liabilities than it has shareholders’ equity. As you learn more about financial statements, we will discuss how to interpret the relationships and changes in financial statement items.

Cash Flow Statement Loblaw’s cash and cash equivalents decreased by $205 million from 2002 to 2003. Cash equivalents are “near” cash items, such as highly liquid short-term investments that can be cashed quickly if there is a sudden need for cash. The reasons for Loblaw’s decline in cash can be determined by examining the cash flow statement in Illustration 1-12. This statement presents Loblaw’s sources and uses of cash during the period.

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A Quick Look at Loblaws Financial Statements

Illustration 1-12 Loblaw cash flow statement Loblaw is in expansion mode. Consequently, it spent considerable cash—$1,448 million—on investing activities. For example, it spent $1,271 million on new fixed assets in order to expand. Note that the cash provided by operating activities—$1,032 million—was enough to finance a large part of this expansion. The rest of its expansion was financed by borrowing and issuing shares. An examination of the $211 million in cash provided by financing activities shows that Loblaw received $763 million from debt financing and $2 million from equity financing. Proceeds from this financing were used to repay some of Loblaw’s other debt and to retire shares. In addition, Loblaw paid $198 million of dividends to its shareholders. The net result of the sources and uses of cash during the year was a cash decrease of $205 million.

Other Elements of an Annual Report Publicly traded companies must give their shareholders an annual report each year. The annual report is a document that includes useful nonfinancial information about the company, as well as financial information. http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_10.xform?course=crs1562&id=ref (7 of 8)11/02/2008 10:25:36 AM

A Quick Look at Loblaws Financial Statements

Nonfinancial information may include the company’s mission, goals and objectives, products, and people. Financial information normally includes a management discussion and analysis, a statement of management responsibility for the financial statements, an auditors’ report, the comparative financial statements introduced in this chapter, notes to the financial statements, and a historical summary of key financial ratios and indicators. No analysis of a company’s financial situation and prospects is complete without a review of each of these items. The elements of Loblaw’s annual report are reviewed in detail on the Toolkit website accompanying this text.

Accounting Matters! Investor Perspective Companies preparing their annual reports have been piling on the paper lately. The reason is simple. They’re trying to ease Enron-type worries on the part of investors. In Canada, Nortel Networks Corporation added an extra two dozen pages to its annual report. Other companies have done the same and annual reports today generally range from 75 to 95 pages.

The trend toward open, frank, and transparent reporting has been a long time coming. However, it is important to remember that annual reports are just one piece of the puzzle that should be scrutinized by investors.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Before You Go On #4

Before You Go On . . . Review It 1. What financial information, in addition to the financial statements, might you expect to find in an annual report? 2. The basic accounting equation is: assets = liabilities + shareholders’ equity. Replacing words with dollar amounts, what is Loblaw’s accounting equation as at January 3, 2004? The answer to this question is at the end of this chapter.

Loblaw’s accounting equation as at January 3, 2004, is (in millions): Assets = Liabilities + Shareholders’ Equity Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved. $12,177 = $7,445 + $4,732

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Using the Decision Toolkit

Using the Decision Toolkit Sobeys Inc. is Canada’s second largest grocery chain, after Loblaw. Imagine that you are asking yourself if you should buy some of Sobeys’ common shares as an investment.

Instructions (a) What financial statements should you request from the company that would help you decide whether to invest or not? (b) What should each of these financial statements tell you? Which financial statement will you likely be most interested in? (c) Loblaw has a fiscal year end of January 3, 2004. Sobeys’ fiscal year end is May 1, 2004. Is it possible to compare financial statements of these companies since they have different fiscal year ends? (d) Simplified financial statements for Sobeys Inc. are shown below. What comparisons can you make between Sobeys and Loblaw in terms of their financial positions and results of operations?

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Using the Decision Toolkit

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Using the Decision Toolkit

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Using the Decision Toolkit

Solution (a) Before you invest, you should investigate the statement of earnings, statement of retained earnings, cash flow statement, balance sheet, and the accompanying notes. (b) You would probably be most interested in the statement of earnings because it shows past performance and this gives an indication of future performance. The statement of retained earnings shows the impact that current earnings and dividends have on the company’s retained earnings. The cash flow statement reveals where the company is getting and spending its cash. This is especially important for a company that wants to grow. Finally, the balance sheet reveals the financial position of the company and the relationship between assets, liabilities, and shareholders’ equity. (c) Both financial statements cover a one-year period, with Loblaw’s fiscal year overlapping Sobeys’ for eight months (May through December 2003). If there have been no substantial changes during the periods that Loblaw’s financial results cover but Sobeys’ do not or vice versa, it really does not matter when each company’s fiscal year ends. It is more important that we compare what each company was able to achieve within an equivalent period of time—whether it be one year, six months, or one quarter. If, however, a major change does occur in the intervening period (the period where the statements do not overlap), such a change would likely reduce the usefulness of a comparison of the financial statements of the two companies. Say, for example, that the mad cow disease scare had happened during the non-overlapping period (it did not). The impact of this change would be reflected in Sobeys’ current statements, but not in Loblaw’s until the following fiscal year. It is important for users to be aware of relevant nonfinancial information such as this before they start their comparisons. (d) Many interesting comparisons can be made between the two companies. Sobeys is much smaller, about one quarter the size of Loblaw. For example, Sobeys has total assets of $3,274.7 million versus $12,177 million for Loblaw. Also, Sobeys has lower revenue—sales of $11,046.8 million versus $25,220 million for Loblaw. Sobeys reported net earnings for its current fiscal year of $167.5 million, compared to Loblaw’s net earnings of $845 million. Sobeys has a balance of $667.9 million of accumulated retained earnings, while Loblaw’s retained earnings of $3,538 million are more than five times this amount. In 2003, Loblaw generated cash from operating activities of $1,032 million whereas Sobeys generated only $364.4 million. While these comparisons are useful, these basic measures are not enough to determine whether one company will be a better investment than the other. In later chapters, you will acquire more tools to help you compare the relative profitability and financial health of these, and other, companies.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Summary of Study Objectives

Summary of Study Objectives 1. Explain why accounting is important. Good accounting is necessary for making sound business and investing decisions. The world’s economic systems depend on reliable and ethical accounting and financial reporting. 2. Identify the uses and users of accounting. The purpose of accounting is to provide useful information for decision-making. There are three types of organizations that use accounting information: proprietorships, partnerships, and corporations. A proprietorship is a business owned by one person. A partnership is a business owned by two or more people. A corporation is a separate legal entity whose shares provide evidence of ownership. There are two types of user groups who use accounting information: internal and external users. Internal users work for the business and need accounting information to plan, organize, and run operations. The primary external users are investors and creditors. Investors (present and future shareholders) use accounting information to help decide whether to buy, hold, or sell shares. Creditors (sup-pliers and bankers) use accounting information to evaluate the risk of granting credit or loaning money to a business. 3. Explain the three main types of business activity. Financing activities involve collecting the necessary funds (through debt or equity) to support the business. Investing activities involve acquiring the resources (such as property, plant, and equipment) that are needed to run the business. Operating activities involve putting the resources of the business into action to generate a profit. 4. Describe the content and purpose of each of the financial statements. A statement of earnings presents the revenues and expenses of a company for a specific period of time. A statement of retained earnings summarizes the changes in retained earnings that have occurred for a specific period of time. Retained earnings are the cumulative earnings (less losses) over the company’s life, less any dividends paid to shareholders. A balance sheet reports the assets, liabilities, and shareholders’ equity of a business at a specific date. A cash flow statement summarizes information on the cash inflows (receipts) and outflows (payments) for a specific period of time

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Decision ToolkitA Summary

Decision Toolkit—A Summary Info Needed for Decision

Tools to Use for Decision

How to Evaluate Results

Are the company’s operations profitable?

Statement of earnings

The statement of earnings indicates the success or failure of the company’s operating activities by reporting its revenues and expenses.

If the company’s revenues exceed its expenses, it will report net earnings; otherwise, it will report a net loss.

What is the company’s policy on dividends and growth?

Statement of retained earnings

How much did the company pay out in dividends to shareholders?

A company looking for rapid growth will pay no, or a low, dividend.

Does the company rely mainly on debt or equity to finance its assets?

Balance sheet

The balance sheet reports the company’s resources and claims to those resources. There are two types of claims: liabilities and shareholders’ equity.

Compare the amount of liabilities versus the amount of shareholders’ equity to determine whether the company relies more on creditors or shareholders for its financing.

Decision Checkpoints

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Decision ToolkitA Summary

Does the company generate enough cash from operating activities to fund its investing activities?

Cash flow statement

The cash flow statement shows the amount of cash provided or used by operating activities, investing activities, and financing activities.

Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash provided by financing activities.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Demonstration Problem

Demonstration Problem Jeff Andringa, a former university hockey player, quit his job and started Ice Camp Ltd., a hockey camp for kids from ages 8 to 18. Eventually he would like to open hockey camps nationwide. Jeff has asked you to help him prepare financial statements at the end of his first year of operations. He tells you the following facts about his business activities. In order to get the business off the ground, he decided to incorporate. He sold common shares to a few close friends and bought some of the shares himself on January 1, 2006. He initially raised $25,000 through the sale of these shares. In addition, the company borrowed $10,000 from a local bank. A used bus for transporting kids was purchased for $12,000 cash. Hockey nets and other miscellaneous equipment were purchased with $1,500 cash. The company earned camp tuition of $100,000 during the year but had collected only $80,000 of this amount. Thus, at the end of the year it was still owed $20,000. The company rents time at a local rink for $50 per hour. Total rink rental costs during the year were $8,000, insurance was $10,000, salaries were $20,000, administrative expenses totalled $9,000, and income taxes amounted to $15,000—all of which were paid in cash. The company incurred $800 in interest expense on the bank loan, which it still owed at the end of the year. The company paid dividends during the year of $5,000 cash. The balance in the corporate bank account at December 31, 2006, was $34,500 ($25,000 + $10,000 − $12,000 − $1,500 + $80,000 − $8,000 + $10,000 − $20,000 − $9,000 − $15,000 − $5,000). Cash payments for operating activities totalled $62,000 ($8,000 + $10,000 + $20,000 + $9,000 + $15,000).

Instructions Prepare a statement of earnings, statement of retained earnings, balance sheet, and cash flow statement for the year.

Action Plan On the statement of earnings, show revenues and expenses for a period of time. On the statement of retained earnings, show the changes in retained earnings for a period of time. On the balance sheet, report assets, liabilities, and shareholders’ equity at a specific date. On the cash flow statement, report sources and uses of cash provided or used by operating, investing, and financing activities for a period of time.

Solution to Demonstration Problem

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Demonstration Problem

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Demonstration Problem

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Demonstration Problem

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Self-Study Questions

Self-Study Questions Answers are at the end of the chapter. (SO 1)

1. Bad accounting can result in: (a) investors purchasing the company’s shares. (b) the company’s share price falling. (c) sound business and investing decisions. (d) reliable and accurate financial reporting.

(SO 2)

2. Ethics are the standards of conduct by which one’s actions are judged to be: (a) decent or indecent. (b) successful or unsuccessful. (c) profitable or unprofitable. (d) right or wrong.

(SO 2)

3. Which is not one of the three forms of business organization? (a) Proprietorship (b) Creditorship (c) Partnership (d) Corporation

(SO 2)

4. What is an advantage of corporations compared to partnerships and proprietorships? (a) Harder to raise funds (b) Harder to transfer ownership (c) Harder to organize (d) Reduced legal liability

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Self-Study Questions

(SO 2)

5. Which statement about users of accounting information is incorrect? (a) Management is an internal user. (b) The Canada Revenue Agency is an external user. (c) Creditors are external users. (d) Investors are internal users.

(SO 3)

6. Which is not one of the three primary business activities? (a) Financing (b) Operating (c) Planning (d) Investing

(SO 3)

7. Which of the following is not an example of a financing activity? (a) Borrowing money from a bank (b) Repaying money to a bank (c) Selling goods on credit (d) Paying dividends

(SO 3)

8. Net earnings will result during a time period when: (a) assets exceed liabilities. (b) assets exceed revenues. (c) expenses exceed revenues. (d) revenues exceed expenses.

(SO 3)

9. Which financial statement reports assets, liabilities, and shareholders’ equity? (a) Statement of earnings (b) Statement of retained earnings (c) Balance sheet (d) Cash flow statement

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Self-Study Questions

(SO 4)

10. As at December 31, Stoneland Corporation has assets of $3,500 and shareholders’ equity of $2,000. What are the liabilities for Stoneland Corporation as at December 31? (a) $1,500 (b) $2,000 (c) $3,500 (d) $5,500

Answers to Self-Study Questions 1.b 2.d 3.b 4.d 5.d 6.c 7.c 8.d 9.c 10.a

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Questions

Questions (SO 1)

1. “Accounting is ingrained in our society and is vital to our economic system.” Do you agree? Explain.

(SO 1)

2. Why are ethics important to the accounting profession? To statement users?

(SO 1)

3. Improper accounting practices can result in stock market losses and employee layoffs. Do you agree? Explain.

(SO 2)

4. (a) What are the three basic forms of business organization? (b) Identify the advantages and disadvantages of each.

(SO 2)

5. (a) Who are the internal users of accounting data? Give examples. (b) Who are the external users? Give examples.

(SO 2)

6. Financial reporting is aimed mostly at two external user groups of accounting— investors and creditors. Distinguish between the needs of each of these groups of users of financial information.

(SO 3)

7. (a) Explain the differences between operating, investing, and financing activities. (b) Give two examples of each kind of activity.

(SO 3)

8. Explain why accounts receivable, an asset, is classified as an operating activity on the cash flow statement and not as an investing activity.

(SO 3)

9.

Why would a bank want to monitor the dividend payment practices of the corporation it lends funds to?

(SO 4)

10. André is puzzled reading Loblaw’s financial statements. He notices that the numbers have all been rounded to the nearest million. He thought financial statements were supposed to be accurate and wonders what happened to the rest of the money. Respond to André’s concern.

(SO 4)

11. Why do you think a balance sheet is prepared as at a specific point in time, while the other financial statements cover a period of time?

(SO 4)

12. What are retained earnings? What items increase the balance in retained earnings? What items decrease the balance in retained earnings?

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Questions

(SO 4)

13. (a) What is the purpose of the cash flow statement? (b) What are the three main categories in the cash flow statement?

(SO 4)

14. How are each of the following pairs of financial statements related? (a) Statement of earnings and statement of retained earnings (b) Statement of retained earnings and balance sheet (c) Balance sheet and cash flow statement

(SO 4)

15. A company’s net earnings appear directly on the statement of earnings and the statement of retained earnings. They are also included indirectly on the company’s balance sheet. Do you agree? Explain.

(SO 4)

16. (a) What is the basic accounting equation? (b) How does the accounting equation relate to the balance sheet?

(SO 4)

17. (a) Define the terms assets, liabilities, and shareholders’ equity. (b) What items affect shareholders’ equity?

(SO 4)

18. Which of these items are liabilities for Kool Stores Inc.? (a) Cash (b) Accounts payable (c) Dividends (d) Accounts receivable (e) Supplies (f) Equipment (g) Income tax payable (h) Service revenue (i) Rent expense (j) Long-term debt

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Questions

(SO 4)

19. Here are some items found in the financial statements of D’Anjou, Inc. Indicate in which financial statement each item would appear. (a) Service revenue (b) Equipment (c) Advertising expense (d) Accounts receivable (e) Common shares (f) Wages payable (g) Cash provided by operating activities (h) Dividends

(SO 4)

20.

Loblaw’s year end is not a fixed date; rather, it can vary slightly from one year to the next. What possible problems does this pose for financial statement users?

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Brief Exercises

Brief Exercises BE1-1 The company accountant is counting the office supplies on hand at the end of the period. She realizes there are more supplies in stock than recorded in the books and decides to take some of the extra supplies home. In her own mind, this is not stealing because it will correct a book error. In addition, she is owed by the company for all the extra unpaid work she has been doing lately anyway.

Discuss ethical issues. (SO 1)

(a) Are the accountant’s actions ethical? Explain why or why not. (b) What could the company do to ensure that all employees use appropriate ethical behaviour?

BE1-2 Write the correct form of business organization—proprietorship (P), partnership (PP), or corporation (C)—beside each set of characteristics.

Describe forms of business organization. (SO 2)

(a) _________ Simple to set up; founder retains control (b) _________ Shared control; increased skills and resources (c) _________ Easier to transfer ownership and raise funds; no personal liability

BE1-3 The following list presents different types of evaluations made by various users of accounting information: 1. Determining if the company respected income tax regulations

Identify users of accounting information. (SO 2)

2. Determining if the company can pay its obligations 3. Determining if a marketing proposal will be cost-effective 4. Determining if the company’s net earnings will result in a share price increase 5. Determining if the company should use debt or equity financing

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Brief Exercises

(a) Write the number of the type of evaluation (1–5) beside the appropriate user of accounting information. (b) Indicate if the user is internal or external.

Investors Marketing managers Creditors Chief financial officer Canada Revenue Agency

(a) Type of Evaluation _________ _________

(b) Type of User

_________ _________

_________ _________

_________

_________

_________ _________

BE1-4 Indicate the section of the cash flow statement—operating activities (O), investing activities (I), or financing activities (F)— in which each of the following items would appear. In addition, indicate whether each item would be reported as a cash inflow (+) or cash outflow (−) on the cash flow statement.

Classify items by activity. (SO 3)

(a) _________ Cash received from customers (b) _________ Cash dividends paid to shareholders (c) _________ Cash received from issuing common shares (d) _________ Cash received from borrowing money (e) _________ Cash paid to purchase an office building (f) _________ Cash paid for income taxes

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Brief Exercises

BE1-5 The Calgary Exhibition and Stampede Limited has the following selected accounts included in its financial statements. In each case, identify whether the item would appear on the balance sheet (BS) or statement of earnings (SE).

Determine on which financial statement items appear. (SO 4)

(a) _________ Accounts receivable (b) _________ Inventories (c) _________ Amortization expense (d) _________ Common shares (e) _________ Building (f) _________ Stampede revenue (g) _________ Horse racing revenue (h) _________ Accounts payable and accrued liabilities (i) _________ Cash and short-term deposits (j) _________ Administration, marketing, and park services expenses (k) _________ Interest expense (l) _________ Prepaid expenses

BE1-6 Indicate which statement—statement of earnings (SE), balance sheet (BS), statement of retained earnings (RE), or cash flow statement (CF)—you would examine to find each of the following items:

Determine on which financial statement items appear. (SO 4)

(a) _________ Revenue earned during the period (b) _________ Supplies on hand at the end of the year (c) _________ Cash received from borrowing money during the period (d) _________ Total debt at the end of the period (e) _________ Dividends paid to shareholders during the period

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Brief Exercises

BE1-7 Use the accounting equation to determine the missing amounts below:

Use accounting equation. (SO 4)

Assets $80,000 (b) $94,000

= Liabilities + Shareholders’ Equity $50,000 $45,000 (c)

(a) $60,000 $52,000

BE1-8 Use the accounting equation to answer these questions: (a) The shareholders’ equity of Sansom Corporation is $100,000. Its total liabilities are $45,000. What is the amount of Sansom’s total assets?

Use accounting equation. (SO 4)

(b) The liabilities of Houle Corporation are $90,000. Houle’s share capital is $150,000 and retained earnings $100,000. What is the amount of Houle’s total assets? (c) The total assets of Pitre Limited are $170,000. Its share capital is $35,000 and retained earnings $65,000. What is the amount of its total liabilities? (d) The total assets of Budovitch Inc. are $500,000 and its liabilities are equal to half of its total assets. What is the amount of Budovitch’s shareholders’ equity?

BE1-9 At the beginning of the year, Lam Ltd. had total assets of $700,000 and total liabilities of $500,000.

Use accounting equation. (SO 4)

(a) If total assets increased by $150,000 during the year and total liabilities decreased by $80,000, what is the amount of shareholders’ equity at the end of the year? (b) During the year, total liabilities increased by $100,000. The company reported net earnings of $50,000, sold additional shares for $10,000, and paid no dividends during the year. What is the amount of total assets at the end of the year? (c) If total assets decreased by $90,000 during the year and shareholders’ equity increased by $120,000, what is the amount of total liabilities at the end of the year?

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Brief Exercises

BE1-10 Indicate whether each of these items is an asset (A), a liability (L), or shareholders’ equity (SE): (a) _________ Accounts receivable

Identify assets, liabilities, and shareholders’ equity. (SO 4)

(b) _________ Salaries payable (c) _________ Equipment (d) _________ Office supplies (e) _________ Common shares (f) _________ Notes payable (g) _________ Retained earnings (h) _________ Cash

BE1-11 Some transactions are presented below. Determine whether each transaction affects common shares (C), dividends (D), revenue (R), expenses (E), or has no effect on any of these shareholders’ equity components (NE).

Determine effect of transactions on shareholders’ equity. (SO 4)

(a) _________ Purchase of equipment (b) _________ Issue of common shares (c) _________ Services performed for cash (d) _________ Services performed on account (e) _________ Costs incurred for income tax (f) _________ Amounts earned by employees (g) _________ Dividends paid to shareholders (h) _________ Interest incurred on note payable

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Exercises

Exercises E1-1 Here is a list of words or phrases discussed in this chapter:

Match words with descriptions.

1. Accounts payable 2. Creditor

(SO 1, 2, 3)

3. Financing activities 4. Retained earnings 5. Dividends 6. Corporation 7. Common shares 8. Accounts receivable 9. Ethics 10. Assets Instructions Match each word or phrase with the best description of it below: (a) _________ A company that raises money by issuing shares (b) _________ Amounts owed to suppliers of goods (c) _________ Resources owned by a company (d) _________ A party a company owes money to (e) _________ Obtaining cash from borrowing money or issuing shares (f) _________ Standards of conduct by which one’s actions are judged as right or wrong (g) _________ Cumulative earnings that have been retained in the company (h) _________ The ownership interest of shareholders in the company (i) _________ Amounts due from customers (j) _________ Distributions of earnings to shareholders

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Exercises

E1-2 Indicate in which section of the cash flow statement—operating activities (O), investing activities (I), or financing activities (F)— for Fairmont Hotels & Resorts Inc. each of the following items would appear. In addition, indicate whether each item would be reported as a cash inflow (+) or cash outflow (−) on the cash flow statement.

Classify items by activity. (SO 3)

(a) Additions to property and equipment (b) Repurchase of common shares (c) Issue of long-term debt (d) Collection of accounts receivable (e) Issue of common shares (f) Sale of investments and properties (g) Dividends (h) Repayment of long-term debt

E1-3 Indicate on which statement—statement of earnings (SE), balance sheet (BS), statement of retained earnings (RE), or cash flow statement (CF)—you would find each of the following accounts or items:

Determine on which financial statement items appear. (SO 4)

(a) _________ Cash (b) _________ Advertising expense (c) _________ Service revenue (d) _________ Inventory (e) _________ Cash paid for income tax (f) _________ Income tax expense (g) _________ Accounts receivable (h) _________ Interest expense (i) _________ Common shares (j) _________ Sales (k) _________ Dividends (l) _________ Cash collected from customers (m) _________ Cash received from the sale of equipment (n) _________ Notes payable http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_19.xform?course=crs1562&id=ref (2 of 8)11/02/2008 12:24:41 PM

Exercises

(o) _________ Equipment (p) _________ Cash borrowed on a note payable

E1-4 Summaries of data from the balance sheets and statements of earnings for three corporations are presented below:

Beginning of year Total assets Total liabilities Total shareholders’ equity End of year Total assets Total liabilities Total shareholders’ equity Changes in shareholders’ equity during year Issue of shares Dividends Total revenues Total expenses

Chiasson Corporation

Maxim Enterprises, Ltd.

K-Os Corporation

$95,000 80,000 (a)

$125,000 (c) 95,000

$60,000 25,000 35,000

160,000 120,000 40,000

180,000 50,000 130,000

(e) 65,000 (f)

(b) 24,000 215,000 175,000

25,000 (d) 100,000 85,000

4,000 30,000 54,000 40,000

Use financial statement relationships to determine missing amounts. (SO 4)

Instructions Determine the missing amounts for (a) to (f).

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Exercises

E1-5 The following items and amounts (in thousands) were taken from the January 27, 2003, balance sheet of The Forzani Group Ltd., Canada’s biggest sporting goods retailer: _________ Accounts payable and accrued liabilities $217,777 _________ Accounts receivable 36,319 _________ Capital assets 160,625 _________ Cash 23,315 _________ Goodwill and other intangibles 39,682 _________ Inventory 267,221 _________ Long-term debt 38,295 _________ Other assets 10,105 _________ Other liabilities 54,389 _________ Prepaid and other expenses 11,292 _________ Retained earnings 106,330 _________ Share capital 131,768

Classify items and prepare accounting equation. (SO 4)

Instructions (a) Classify each item as an asset (A), liability (L), or shareholders’ equity (SE) item. (b) Determine Forzani’s accounting equation by calculating the value of total assets, total liabilities, and total shareholders’ equity.

E1-6 The following items and amounts (in thousands) were taken from CoolBrands International Inc.’s August 31, 2004, statement of earnings and balance sheet:

Identify financial statement components and prepare statement of earnings. (SO 4)

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Exercises

_________ Cash and short-term investments _________ Retained earnings _________ Cost of goods sold _________ Selling, general, and administrative expenses _________ Prepaid expenses _________ Inventories _________ Other expenses

$ 84,700 _________ Receivables 123,192 _________ Income tax expense 438,458 _________ Sales 115,131 _________ Income taxes payable

7,818 _________ Accounts payable 64,618 _________ Franchising revenues 7,663 _________ Drayage (transportation) and other income _________ Interest expense

$ 88,419

30,731 584,951 6,499

49,384 4,786 53,083

1,994

Instructions (a) In each case, identify on the blank line whether the item is an asset (A), liability (L), shareholders’ equity (SE), revenue (R), or expense (E) item. (b) Prepare a statement of earnings for CoolBrands for the year ended August 31, 2004.

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Exercises

E1-7 This information is for Kon Inc. for the year ended December 31, 2006: Retained earnings, January 1, 2006 Advertising expense Dividends Rent expense

$57,000 Service revenue

Prepare statements of earnings and retained earnings.

$58,000 (SO 4)

1,800 Utilities expense 7,000 Salaries expense 10,400 Income tax expense

2,400 28,000 6,000

Instructions After analyzing the data, prepare a statement of earnings and a statement of retained earnings. E1-8 Kit Lucas is the bookkeeper for Aurora Ltd. Kit has been trying to get Aurora’s balance sheet to balance. He finally managed to balance it, as shown below, and believes it to be correct but is not totally sure.

Correct incorrectly prepared balance sheet. (SO 4)

AURORA LTD. Balance Sheet December 31, 2006 Assets Cash Supplies Equipment Dividends

Liabilities and Shareholders’ Equity $18,500 8,000 40,000 7,000

Total assets $73,500

Accounts payable Accounts receivable Common shares Retained earnings Total liabilities and shareholders’ equity

$16,000 (10,000) 40,000 27,500 $73,500

Instructions Prepare a correct balance sheet.

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Exercises

E1-9 Sea Surf Campground, Inc. is a public camping ground in Ocean National Park. It has the following financial information as at December 31, 2006: Revenues—camping fees Revenues—general store Accounts payable Cash Equipment Income tax expense

$137,000 Dividends

Calculate net earnings and prepare statement of retained earnings and balance sheet.

$ 4,000 (SO 4)

25,000 Notes payable 11,000 10,500 119,000 7,000

Operating expenses Supplies Common shares Retained earnings (Jan. 1, 2006)

50,000 138,000 2,500 40,000 18,000

Instructions (a) Determine net earnings for the year ended December 31, 2006. (b) Prepare a statement of retained earnings and balance sheet for the year.

E1-10 This information is for Van Tran Corporation for the year ended December 31, 2006: Cash received from customers Cash paid for new equipment Cash dividends paid

$65,000 Cash received from $20,000 lenders 50,000 Cash paid for 20,000 expenses 6,000 Cash, January 1, 12,000 2006

Prepare cash flow statement. (SO 4)

Instructions Prepare the cash flow statement for Van Tran Corporation.

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Exercises

E1-11 Consider each of the following independent situations: (a) The statement of retained earnings of Yu Corporation shows dividends of $68,000, while net earnings for the year were $75,000.

Interpret financial facts. (SO 4)

(b) The cash flow statement for Surya Corporation shows that cash provided by operating activities was $10,000; cash used by investing activities was $110,000; and cash provided by financing activities was $130,000. (c) Naguib Ltd.’s balance sheet reports $150,000 of total liabilities and $250,000 of shareholders’ equity. Instructions For each company, write a brief interpretation of these financial facts. For example, you might discuss the company’s financial health or what seems to be its growth philosophy.

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Problems: Set A

Problems: Set A P1-1A Presented below are five independent situations: 1. Three computer science professors have formed a business to sell software to reduce and control spam e-mail. Each has contributed an equal amount of cash and knowledge to the venture. While their software looks promising, they are concerned about the legal liabilities that their business might confront.

Determine forms of business organization. (SO 2)

2. Joseph LeBlanc, a student looking for summer employment, has opened a bait shop in a small shed on a local fishing dock. 3. Robert Steven and Tom Cheng each owned a snow board rental business. They have decided to combine their businesses. They expect that in the coming year, they will need funds to expand their operations. 4. Darcy Becker, Ellen Sweet, and Meg Dwyer recently graduated with marketing degrees. Friends since childhood, they have decided to start a marketing consulting business. 5. Hervé Gaudet wants to rent DVD players and DVDs in airports across the country. His idea is that customers will be able to rent equipment and DVDs at one airport, watch the DVDs on their flight, and return the equipment and DVDs at their destination airport. Of course, this will require a substantial investment for equipment and DVDs, as well as employees and locations in each airport. Hervé has no savings or personal assets. He wants to maintain control over the business. Instructions In each case, explain what form of organization the business is likely to take: proprietorship, partnership, or corporation. Give reasons for your choice.

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Problems: Set A

P1-2A Financial decisions often depend on one financial statement more than the others. Consider each of the following independent hypothetical situations:

Identify uses and users of financial statements. (SO 2)

1. The North Face Inc. is considering extending credit to a new customer. The terms of the credit would require the customer to pay within 30 days of receiving goods. 2. An investor is considering purchasing the common shares of Music Online, Inc. The investor plans on holding the investment for at least five years. 3. Caisse d’Économie Base Montréal is thinking about extending a loan to a small company. The company would be required to make interest payments at the end of each year for five years, and to repay the loan at the end of the fifth year. 4. The CEO of Tech Toy Limited is trying to determine whether the company is generating enough cash to increase the amount of dividends paid to investors in this, and future, years. He needs to be sure that Tech Toy will still have enough cash to buy equipment when needed. Instructions For each situation, state whether the individual would pay the most attention to the information provided by the statement of earnings, balance sheet, or cash flow statement. Choose only one financial statement in each case, and briefly give reasons for your choice. P1-3A All businesses are involved in three types of activities— operating, investing, and financing. The names and descriptions of companies in several different industries follow:

Identify business activities. (SO 3)

Indigo Books & Music—book retailer High Liner Foods Incorporated—processor and distributor of seafood products Mountain Equipment Co-op—outdoor equipment retailer Ganong Bros. Limited—maker of candy Royal Bank—banking and financial service provider

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Problems: Set A

The Gap, Inc.—casual clothing retailer Instructions (a) For each of the above companies, provide examples of (1) an operating activity, (2) an investing activity, and (3) a financing activity that the company likely engages in. (b) Which of the activities that you identified in (a) are common to most businesses? Which activities are not?

P1-4A The following accounts have been selected from the financial statements of Maple Leaf Foods Inc.:

Classify accounts. (SO 3, 4)

(a) Accounts payable and accrued charges _________ Accounts receivable _________ Cash and cash equivalents _________ Common shares _________ Income and other taxes payable _________ Interest expense _________ Inventories _________ Long-term debt _________ Property and equipment _________ Sales _________

(b) _________ _________ _________ _________ _________ _________ _________ _________ _________ _________

Instructions (a) Classify each of the above accounts as an asset (A), liability (L), shareholders’ equity (SE), revenue (R), or expense (E) item. (b) Classify each of the above accounts as an operating (O), investing (I), or financing (F) activity. If you believe a particular account does not fit in any of these activities, explain why.

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Problems: Set A

P1-5A Selected information (in millions) is available for Sears Canada Inc. and Hudson’s Bay Company for fiscal 2004:

Use accounting equation. (SO 4)

Beginning of year Total assets Total liabilities Total shareholders’ equity End of year Total assets Total liabilities Total shareholders’ equity Changes during year in shareholders’ equity Issue of shares Dividends Total revenues Total expenses

Sears

Hudson’s Bay

(i) $2,414.4 1,646.9

$4,275.7 (iv) 2,394.7

4,065.7 (ii) 1,810.9

(v) 1,680.1 2,430.6

0.7 25.6 6,222.7 (iii)

3.8 (vi) 7,400.1 7,330.8

Instructions (a) Use the accounting equation to calculate the missing amounts for each company. (b) At the end of fiscal 2004, which company has a higher proportion of debt financing? Of equity financing?

P1-6A On June 1, 2006, One Planet Cosmetics Corp. was formed. Here are the assets, liabilities, and share capital of the company at June 30, and the revenues and expenses for the month of June:

Prepare financial statements. (SO 4)

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Problems: Set A

Cash Accounts receivable Cosmetic supplies Equipment Notes payable Accounts payable Common shares

$ 6,000 4,000 2,400 32,000 14,000 1,375 26,200

Service revenue $8,000 Supplies expense 1,200 Gas and oil expense 900 Advertising expense 500 Utilities expense 300 Income tax expense 1,275

The company paid dividends of $1,000 in June. Instructions Prepare a statement of earnings, statement of retained earnings, and balance sheet for the month of June. P1-7A Presented below is selected financial information for Maison Corporation at December 31, 2006: Cash, January 1, 2006 Inventory Cash paid to suppliers Building Common shares Cash dividends paid

$ 20,000 Cash paid to purchase equipment 25,000 Equipment 100,000 Revenues

$ 15,000

200,000 Cash received from customers 50,000 13,000

137,000

Prepare cash flow statement. (SO 4)

40,000 100,000

Instructions First determine which of the above items should be included in a cash flow statement. Then prepare the statement for Maison Corporation for the year ended December 31, 2006.

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Problems: Set A

Use financial statement relationships to calculate missing amounts; write memo.

P1-8A Here are incomplete financial statements for Baxter, Inc.: BAXTER, INC. Balance Sheet November 30, 2006 Assets

(SO 4)

Liabilities and Shareholders’ Equity

Cash Accounts receivable Land

$ 5,000 Liabilities 10,000 Notes payable

Building

45,000 Total liabilities

Total assets

(ii)

$ 69,600

Accounts payable

(iii) 76,500

$ (i) Shareholders’ equity Common shares Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity

(vi) (v) (iv) $110,000

BAXTER, INC. Statement of Earnings Year Ended November 30, 2006 Revenues Operating expenses

$80,000 (vii)

Earnings before income tax Income tax expense

30,000 10,000

Net earnings

$ (viii)

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Problems: Set A

BAXTER, INC. Statement of Retained Earnings Year Ended November 30, 2006 Beginning retained earnings $12,000 Add: Net earnings (ix) Less: Dividends 5,000 Ending retained earnings

$ (x)

Instructions (a) Calculate the missing amounts (i) to (x). (b) Write a memo explaining (1) the sequence for preparing the financial statements, and (2) the interrelationships between the statement of retained earnings, statement of earnings, and balance sheet.

P1-9A GG Corporation was formed on January 1, 2006. At December 31, 2006, Guy Gélinas, the president and sole employee, decided to prepare a balance sheet, which appeared as follows:

Prepare corrected balance sheet. (SO 4)

GG CORPORATION Balance Sheet Year Ended December 31, 2006 Liabilities and Shareholders’ Equity

Assets Cash Accounts receivable Inventory Boat

$ 20,000 Accounts payable 55,000 Notes payable 30,000 Boat loan payable 18,000 Shareholders’ equity $123,000

$ 40,000 15,000 13,000 55,000 $123,000

Guy willingly admits that he is not an accountant by training. He

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Problems: Set A

is concerned that his balance sheet might not be correct. He has provided you with the following additional information: 1. The boat actually belongs to Guy Gélinas, not to GG Corporation. However, because he thinks he might take customers out on the boat occasionally, he decided to list it as an asset of the corporation. To be consistent, he also listed as a liability of the corporation his personal loan that he took out at the bank to buy the boat. 2. Included in the accounts receivable balance is $10,000 that Guy Gélinas loaned to his brother two years ago. Guy included this in the receivables of GG Corporation so he would remember that his brother owes him money. Instructions (a) Identify any corrections that should be made to the balance sheet, and explain why. (b) Prepare a corrected balance sheet for GG Corporation. (Hint: To get the balance sheet to balance, adjust shareholders’ equity.)

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Problems: Set B

Problems: Set B P1-1B Presented below are five independent situations: 1. Dawn Addington, a student looking for summer employment, has opened a vegetable stand along a busy local highway. Each morning, she buys produce from local farmers, then sells it in the afternoon as people return home from work.

Determine forms of business organization. (SO 2)

2. Joseph Counsell and Sabra Surkis each own a bike shop. They have decided to combine their businesses and try to expand their operations to include skis and snowboards. They expect that in the coming year they will need funds to expand their operations. 3. Three chemistry professors have formed a business which uses bacteria to clean up toxic waste sites. Each has contributed an equal amount of cash and knowledge to the venture. The use of bacteria in this situation is experimental, and legal obligations could result. 4. Abdur Rahim has run a successful but small cooperative health and organic food store for over five years. The increased sales at his store have made him believe that the time is right to open a chain of health and organic food stores across the country. Of course, this will require a substantial investment for inventory and property, plant, and equipment, as well as for employees and other resources. Abdur has no savings or personal assets. 5. Mary Emery, Richard Goedde, and Jigme Tshering recently graduated with graduate degrees in international business. They have decided to start a consulting business aimed at helping Canadian businesses export their products internationally. Instructions In each case, explain what form of organization the business is likely to take: proprietorship, partnership, or corporation. Give reasons for your choice.

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Problems: Set B

P1-2B Financial decisions often depend on one financial statement more than the others. Consider each of the following independent, hypothetical situations:

Identify uses and users of financial statements. (SO 2)

1. An Ontario investor is considering purchasing the common shares of Fight Fat Ltd., which operates 13 fitness centres in the Toronto area. The investor plans on holding the investment for at least three years. 2. Comeau Ltée is considering extending credit to a new customer. The credit terms would require the customer to pay within 45 days of receipt of the goods. 3. The CEO of the Private Label Corporation is trying to determine whether the company is generating enough cash to increase the amount of dividends paid to investors in this, and future, years. He needs to ensure that there will still be enough cash to expand operations when needed. 4. The Laurentian Bank is considering extending a loan to a small company. The company would be required to make interest payments at the end of each year for five years, and to repay the loan at the end of the fifth year. Instructions For each situation, state whether the individual would be most interested in the statement of earnings, balance sheet, or cash flow statement. Choose only one financial statement in each case, and briefly give reasons for your choice. P1-3B All businesses are involved in three types of activities— operating, investing, and financing. The names and descriptions of companies in several different industries follow:

Identify business activities. (SO 3)

Abitibi Consolidated Inc.—manufacturer and marketer of newsprint Wilfrid Laurier University Students’ Union—university student union Biovail Corporation—manufacturer and distributor of pharmaceutical products

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Problems: Set B

Maple Leaf Sports & Entertainment Ltd.—owner of the Toronto Raptors basketball club Grant Thornton LLP—professional accounting and business advisory firm WestJet Airlines Ltd.—discount airline Instructions (a) For each of the above companies, provide examples of (1) an operating activity, (2) an investing activity, and (3) a financing activity that the company likely engages in. (b) Which of the activities that you identified in (a) are common to most businesses? Which activities are not?

P1-4B The Mill Run Golf & Country Club details the following accounts in its financial statements:

Classify accounts. (SO 3, 4)

Bank overdraft Capital assets Income—food and beverage operations Income—golf course operations Inventory Office and general expenses Payables and accruals Receivables Term debt Wages and benefits expense

(a) (b) _________ _________ _________ _________ _________ _________ _________ _________ _________ _________ _________ _________ _________

_________ _________ _________ _________ _________ _________ _________

Instructions (a) Classify each of the above accounts as an asset (A), liability (L), shareholders’ equity (SE), revenue (R), or expense (E) item.

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Problems: Set B

(b) Classify each of the above accounts as an operating (O), investing (I), or financing (F) activity. If you believe a particular account does not fit in any of these activities, explain why.

P1-5B Selected information (in millions) is available for The Jean Coutu Group (PJC) Inc. and Shoppers Drug Mart Corporation for fiscal 2004:

Use accounting equation. (SO 4)

Jean Coutu Shoppers Beginning of year Total assets Total liabilities Total shareholders’ equity End of year Total assets Total liabilities Total shareholders’ equity Changes during year in shareholders’ equity Issue of shares Dividends Total revenues Total expenses

$1,716.6 (i) 1,012.9

(iv) $1,533.6 1,597.5

1,837.8 669.0 (ii)

(v) 1,455.9 (vi)

3.2 (iii) 4,096.1 3,919.2

7.8 0 4,415.2 4,157.5

Instructions (a) Use the accounting equation to calculate the missing amounts for each company. (b) Jean Coutu’s year end is May 31, 2004. Shoppers Drug Mart Corporation’s year-end is January 3, 2004. If you were to compare the two companies, how would these differing yearend dates affect your assessment?

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Problems: Set B

P1-6B Aero Flying School Ltd. started on May 1 with cash of $45,000 and common shares of $45,000. Here are the assets and liabilities of the company on May 31, 2006, and the revenues and expenses for the month of May, its first month of operations: Cash Accounts receivable Equipment Accounts payable Notes payable Service revenue

$ 7,200 11,200 60,300 2,400 27,900 9,600

Prepare financial statements. (SO 4)

Advertising expense $ 900 Rent expense 1,200 Repair expense 700 Fuel expense 3,400 Insurance expense 400 Income tax expense 900

Additional common shares of $1,800 were issued in May, and a cash dividend of $500 was paid. Instructions Prepare a statement of earnings, statement of retained earnings, and balance sheet for the month of May. P1-7B Presented below are selected financial statement items for Frenette Corporation at June 30, 2006: Cash, July 1, 2005 Inventory Cash paid to suppliers Building Common shares Cash paid for income tax

Prepare cash flow statement.

$ 30,000 Cash dividends paid 55,000 Cash paid to buy equipment 89,000 Equipment

$ 7,000 26,000

400,000 Revenues 20,000 Cash received from customers 20,000

200,000 168,000

(SO 4)

40,000

Instructions Determine which of the above items should be included in a cash flow statement, and then prepare the statement for Frenette Corporation for the year ended June 30, 2006. http://edugen.wiley.com/edugen/courses/crs1562/pc/c01/content/kimmel6792c01_1_21.xform?course=crs1562&id=ref (5 of 8)11/02/2008 12:30:01 PM

Problems: Set B

Use financial statement relationships to calculate missing amounts; write memo.

P1-8B Here are incomplete financial statements for Wu, Inc.: WU, INC. Balance Sheet August 31, 2006 Liabilities and Shareholders’ Equity

Assets Cash Accounts receivable Land Building and equipment Total assets

(SO 4)

$ (ii) Liabilities 20,000 Accounts payable

$15,000

15,000 Shareholders’ equity 40,000 Common shares

(iv)

$ (i)

Retained earnings

(iii)

Total liabilities and shareholders’ equity

$85,000

WU, INC. Statement of Earnings Year Ended August 31, 2006 Service revenue Operating expenses Earnings before income tax Income tax expense Net earnings

$75,000 (v) 30,000 9,000 $ (vi)

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Problems: Set B

WU, INC. Statement of Retained Earnings Year Ended August 31, 2006 Beginning retained earnings $10,000 Add: Net earnings (vii) Less: Dividends (viii) Ending retained earnings

$26,000

Instructions (a) Calculate the missing amounts (i) to (viii). (b) Write a memo explaining (1) the sequence for preparing and presenting the financial statements, and (2) the interrelationships between the various financial statements.

P1-9B Pam Bollinger formed the Kettle Corporation late in 2005. The company’s year end is December 31. At the end of the following year, December 31, 2006, Pam prepared a statement of earnings by looking at the financial statements of other companies. Pam found it easy to prepare the statements for 2005 since it was for such a short period of time, but she found the 2006 statement much harder to prepare. She thinks she did a reasonable job but has asked you for advice. Pam’s 2006 statement of earnings is as follows:

Prepare corrected statement of earnings. (SO 4)

KETTLE CORPORATION Statement of Earnings December 31, 2006 Accounts receivable Service revenue

$12,000 60,000

Total revenues

72,000

Rent expense Insurance expense Vacation expense

13,200 5,000 2,000

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Problems: Set B

Total expenses Net earnings

20,200 $51,800

Pam has also provided you with these facts: 1. Included in the revenue account is $7,000 of revenue that the company earned and received payment for in 2005. Pam forgot to include it in the 2005 statement of earnings, so she put it in this year’s statement. 2. Income tax expense for Kettle Corporation for the year ended December 31, 2006, was determined to be $12,000. However, the income tax payment is not due until March 31, 2007, so Pam decided not to record the income tax expense yet. 3. Pam operates her business out of the basement of her parents’ home. They do not charge her anything, but she thinks that if she paid rent it would cost her about $13,200 per year. She therefore included $13,200 of rent expense in the statement. 4. To reward herself for a year of hard work, Pam went skiing for a week at Whistler. She did not use company funds to pay for the trip, but she reported it as an expense on the statement of earnings, since it was her job that made her need the vacation. Instructions (a) Comment on any corrections that are needed for the four items above. (b) Prepare a corrected statement of earnings for Kettle Corporation.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Broadening Your Perspective

Broadening Your Perspective

Financial Reporting and Analysis Financial Reporting Problem: Loblaw BYP1-1 Actual financial statements (rather than the simplified financial statements presented in the chapter) for Loblaw are presented in Appendix A at the end of this book. Instructions (a) What are the dates of Loblaw’s 2003 and 2002 fiscal year ends? Why do these dates differ? (b) What were Loblaw’s total assets at the end of fiscal 2003? At the end of 2002? (c) What proportion of its assets does Loblaw finance with debt? With equity? Did this proportion change a lot between 2002 and 2003? (d) How much cash did Loblaw generate from operating activities in fiscal 2003? In 2002? Was this amount enough to cover Loblaw’s investing activities in either year? (Note that Loblaw presents the operating activities section of its cash flow statement differently than how this section was presented in the chapter. We will learn more about this in Chapter 13.) (e) What were Loblaw’s sales in 2003? In 2002? By what percentage did Loblaw’s sales increase in 2003? (f) Did Loblaw’s net earnings change by roughly the same percentage as sales? If not, identify the main reason for the difference.

Comparative Analysis Problem: Loblaw and Sobeys

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Broadening Your Perspective

BYP1-2 The financial statements for Sobeys are presented in Appendix B, following the financial statements for Loblaw in Appendix A. Instructions (a) Based on the information in these financial statements, determine the following for each company: 1. Loblaw’s total assets, liabilities, and shareholders’ equity at January 3, 2004, and Sobeys’ total assets, liabilities, and shareholders’ equity at May 1, 2004. 2. Loblaw’s and Sobeys’ sales and net earnings for the most recent fiscal year. 3. Loblaw’s and Sobeys’ increase or decrease in cash for the most recent fiscal year. (b) What conclusions about the two companies can you draw from these data?

Research Case BYP1-3 The April 1, 2002, issue of Canadian Business includes an article by John Grey entitled “Hide and Seek” (vol. 75, no. 6, p. 28). The article discusses how accounting tricks make it difficult for investors to get a true picture of a company’s finances. Instructions Read the article and answer the following questions: (a) John Grey discusses ten red flags that investors should look for to ensure that the statement of earnings reflects the company’s bottom line. Name the ten red flags. (b) Should a shareholder read the notes to the financial statements? Explain why or why not. (c) Name a Canadian company that was involved in a corporate scandal.

Interpreting Financial Statements

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Broadening Your Perspective

BYP1-4 Gildan Activewear Inc., headquartered in Montreal, makes T-shirts, sweatshirts, and golf shirts for private label use. The company reports the following selected information (in U.S. thousands) for the years ended October 3, 2004, and October 5, 2003: 2004

2003

Statement of earnings Sales $533,368 $431,195 Cost of sales 378,696 301,341 Net earnings 60,251 53,156 Statement of retained earnings Dividends 0 0 Ending retained earnings 222,496 162,244 Balance sheet Total assets 489,004 429,663 Total liabilities 161,409 165,460 Total shareholders’ equity 327,595 264,203 Cash flow statement Cash flows from operating activities 58,920 63,721 Cash flows from (used in) financing activities (14,350) 411 Cash flows used in investing activities (53,820) (39,458) Cash and cash equivalents, end of year 60,671 69,340 Instructions (a) Why do you think a Canadian company such as Gildan Activewear would present its financial statements in U.S. dollars rather than Canadian dollars? (b) Did the company’s sales improve faster or slower than its net earnings? What do you think is the main reason for this? (c) Why, in your opinion, did Gildan Activewear not pay a dividend to its shareholders in fiscal 2004 or 2003? (d) What proportion of the company’s assets is financed by debt in each fiscal year? By equity? Does this change represent an improvement or a deterioration for the company? (e) Why, in your opinion, did the company’s cash decline by U.S. $8,669 million in fiscal 2004? (f) Why do you think net earnings increased in fiscal 2004 but cash decreased?

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Broadening Your Perspective

A Global Focus BYP1-5 Zachary Wall is thinking about expanding the product offerings in his local store. He would like to include automobile tires. In deciding which product lines to carry, Zachary knows that it is important to consider many factors, including quality, performance rating, price, and warranty. However, he is also interested in investigating the financial health of the tire manufacturers and has obtained recent financial statements for The Goodyear Tire & Rubber Company (“Goodyear”) and Compagnie Générale des Etablissements Michelin (“Michelin”). As it turns out, however, Zachary soon discovers that he is having trouble comparing the two companies’ financial results. Goodyear’s results are reported in US dollars and use US accounting practices. Michelin’s headquarters are located in Clermont-Ferrand, France, and its financial statements use Euro dollars (“Euros”) as the reporting currency. In addition, Michelin used to prepare its financial statements in accordance with French accounting practices. It was only in 2005 that certain things changed and the company was then required to follow International Financial Reporting Standards (IFRS). Zachary is confused: “I had no idea that there were so many sets of accounting practices - or languages of business!! How can this be useful to people outside the company?” Instructions (a) Who are the external users of accounting information? (b) Will Zachary be able to find the information he needs about the quality, performance rating, price, and warranty in the financial statements? If not, where might he find such information? (c) Zachary notes that Michelin explains that there are different alternatives for classifying expenses under IFRS. What are expenses and what are some examples? (d) Zachary understands that the purpose of accounting is to provide information for decisionmaking. He understands that currencies change from country to country (e.g., Canadian dollars, US dollars, Euros, etc.) but he would like to know whether you think that basic decision-making changes from country-to-country. In other words, he wants to know if you think there should be different accounting practices for Goodyear, which is based in the United States, and for Michelin, which is based in France.

Financial Analysis on the Web

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Broadening Your Perspective

BYP1-6 When making decisions, no financial decision-maker should ever rely solely on the financial information reported in a company’s annual report. It is important to keep abreast of financial news. This activity shows you how to search for financial news about Loblaw and Sobeys using Yahoo! Canada Finance. Instructions Specific requirements of this Web case can be found on the Toolkit website.

Critical Thinking Collaborative Learning Activity BYP1-7 In a recent cash flow statement, the Made-in-Canada Corporation reported a $3-million decrease in cash from its operating activities. It also reported increases in cash from investing and financing activities of $2 million and $1 million, respectively. The largest source of cash from investing activities was from the discontinuation and sale of one of the company’s production facilities. The largest source of cash from financing activities was from bank borrowings. Overall, the change in cash for the year was nil, resulting in an ending cash balance of $250,000. Except for this year when the cash balance remained unchanged, cash has declined in each of the past five years. While management believes that there are sufficient financing options to fund the company’s ongoing operations and repay its obligations, the auditors have indicated concerns about the financial position and future viability of the company because of the continually declining cash position. Instructions With the class divided into groups, answer the following questions: (a) If you were a creditor of Made-in-Canada, what reaction might you have to the above information?

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Broadening Your Perspective

(b) If you were an investor in Made-in-Canada, what reaction might you have to the above information? (c) If you were evaluating the company as either a creditor or an investor, what other information would you be interested in seeing?

Communication Activity BYP1-8 You are presented with the following information for two companies: Company A Company B Cash provided (used) by operating activities Cash provided (used) by financing activities Cash used by investing activities Net increase in cash Cash, beginning of period Cash, end of period

$100 (30) (10) 60 15 $75

($90) 160 (10) 60 15 $75

Instructions (a) What is the main purpose of the cash flow statement? (b) What are operating activities, financing activities, and investing activities? (c) Which company is in better shape and why?

Ethics Case

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Broadening Your Perspective

BYP1-9 Chief executive officers (CEOs) and chief financial officers (CFOs) of publicly traded companies are required to personally certify that their companies’ financial statements and other financial information contain no untrue statements and do not leave out any important facts. The certification requirement was introduced after numerous corporate scandals as a way to hold top executives personally responsible for the integrity of their company’s financial information. Khan Corporation just hired a new management team, and its members say they are too new to the company to know whether the most recent financial reports are accurate or not. They refuse to sign the certification. Instructions (a) Who are the stakeholders in this situation? (b) Should the CEO and CFO sign the certification? Explain why or why not. (c) What are the CEO’s and CFO’s alternatives?

Serial Problem BYP1-10 Natalie Koebel spent much of her childhood learning the art of cookie-making from her grandmother. They passed many happy hours mastering every type of cookie imaginable and later devised new recipes that were both healthy and delicious. Now at the start of her second year in college, Natalie is investigating various possibilities for starting her own business as part of the requirements of the Entrepreneurship program she is taking. A long-time friend insists that Natalie has to somehow include cookies in her business plan and, after a series of brainstorming sessions, Natalie settles on the idea of operating a cookiemaking school. She will start on a part-time basis and offer her services in people’s homes. Now that she has started thinking about it, the possibilities seem endless. During the fall, she will concentrate on Christmas cookies. She will offer group sessions (which will probably be more entertainment than education for the participants) and individual lessons. Natalie also decides to include children in her target market. The first difficult decision is coming up with the perfect name for her business. In the end she settles on “Cookie Creations,” and she then moves on to more important issues.

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Broadening Your Perspective

Instructions (a) What form of business organization—proprietorship, partnership, or corporation—do you recommend that Natalie use for her business? Discuss the benefits and weaknesses of each form that Natalie might consider and give your reasons for choosing the form of business organization you are recommending. (b) Will Natalie need accounting information? If yes, what information will she need and why? How often will she need this information? (c) Identify specific asset, liability, and equity accounts that Cookie Creations will likely use to record its business transactions. (d) Should Natalie open a separate bank account for the business? Why or why not? (e) Natalie expects she will have to use her car to drive to people’s homes and to pick up supplies, but she also needs to use her car for personal reasons. She recalls from her firstyear accounting course something about keeping business and personal assets separate. She wonders what she should do for accounting purposes. What do you recommend?

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Glossary

Glossary Accounting The process of identifying, recording, and communicating the economic events of a business to interested users of the information. Accounting equation Assets = liabilities + shareholders’ equity. Annual report A report prepared by management that presents financial and nonfinancial information about the company. Assets The resources owned by a business. Balance sheet A financial statement that reports the assets, liabilities, and shareholders’ equity at a specific date. Cash flow statement A financial statement that provides information about the cash inflows (receipts) and cash out-flows (payments) for a specific period of time. Comparative statements A presentation of the financial statements of a company for two or more years. Corporation A business organized as a separate legal entity having ownership divided into transferable shares. Dividends The distribution of retained earnings from a corporation to its shareholders in the form of cash or other assets. Ethics The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or unfair. Expenses The cost of assets consumed or services used in ongoing operations to generate revenues. Fiscal year An accounting period that is one year long. Liabilities The debts and obligations of a business. Liabilities are claims of creditors on the assets of a business. Net earnings (also known as net income) The amount by which revenues are more than expenses.

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Glossary

Net loss The amount by which expenses are more than revenues. Partnership A business owned by more than one person. Proprietorship A business owned by one person. Retained earnings The amount of accumulated net earnings (less losses, if any), from the prior and current periods, that has been kept in the corporation for future use and not distributed to shareholders as dividends. Revenues The economic resources that result from the operating activities of a business, such as the sale of a product or provision of a service. Share capital Shares representing the ownership interest in a corporation. If only one class of shares exists, it is known as common shares. Shareholders’ equity The shareholders’ claim on total assets, represented by the investments of the shareholders (share capital) and undistributed earnings (retained earnings) generated by the company. Statement of earnings (also known as income state-ment) A financial statement that presents the revenues and expenses and resulting net earnings or net loss of a company for a specific period of time. Statement of retained earnings A financial statement that summarizes the changes in retained earnings for a specific period of time.

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