Cash flow statement and the conceptual framework of accounting

LESSON 10 Cash flow statement and the conceptual framework of accounting Topic outline and required reading 10.1 Cash flows and the cash flow statement (Levels 1 and 2) 10.2 Preparing cash flow statements (Level 1) 10.3 Interpreting financial statements using ratio analysis (Level 2) 10.4 The conceptual framework of accounting (Levels 2 and 3) Chapter 19, pages 964-970 Chapter 19, pages 971-979 Chapter 20, pages 1040-1051 10.5 Summary No required reading Appendix 10-1: CICA Handbook, section 1000, Financial Statement Concepts Overview Lesson 10 concludes this introductory course in financial accounting by focusing on the cash flow statement (CFS), ratios, and a synthesis of basic accounting concepts. The CFS provides relevant financial information about the cash receipts and cash disbursements of a firm during a fiscal year. This information is especially important to shareholders and creditors. As part of their investment return, shareholders often expect to receive dividends, and the ability to pay cash dividends depends on the availability of cash flows. Creditors are concerned about a firm s ability to make interest and principal payments on loans they have made to the firm. Other stakeholders such as employees and suppliers are also concerned about a firm s ability to meet its financial obligations. Ratios derived from financial information help in the assessment of an organization s profitability, efficient use of assets, effective use of debt, and liquidity. Ratios additional to those introduced in earlier lessons are reviewed in Lesson 10. The last topic in this course deals with the conceptual framework of accounting. This framework provides a review of the principles and concepts integrated throughout the Lesson Notes. The conceptual framework enables you to define the essential characteristics of accounting information and to identify the fundamental concepts used in preparing external financial reports. Finally, the elements of financial statements are reviewed. Learning objectives Explain why cash flow information is important to decision making. (Level 1) Distinguish among the types of cash flows resulting from operating, financing, and investing activities. (Level 1) Prepare a cash flow statement using the direct method. (Level 1) Financial Accounting 1 Lesson 10 1

Explain how several ratios are used to evaluate a company s performance. (Level 2) Describe the essential characteristics and fundamental concepts of accounting. (Level 2) TOPIC 10.1 Cash flows and the cash flow statement Required reading LEVEL 1 Chapter 19, pages 964-970 Importance of cash flows Cash flow statement Investors, creditors, and managers use cash flow information to make decisions about a company s ability to meet obligations, or to take advantage of business opportunities. Information about a current period s cash flows provides a basis for predicting the amount, timing, and certainty of future cash flows. Cash flow information is also useful in evaluating the liquidity, solvency, and financial flexibility of a company. Liquidity refers to the ability of a company to pay its current liabilities with existing liquid assets. Solvency is the ability to pay all debts as they come due. A company may wish to raise money by issuing shares, for instance. Financial flexibility relates to the ability of a company to use its resources to adapt to change and take advantage of business opportunities as they arise. A cash flow statement (formerly known as a statement of changes in financial position) is designed to help a user make these evaluations and to answer specific questions such as What accounts for the difference between cash and cash equivalents at the beginning of the year and at the end of the year? What was done with the cash raised from the sale of bonds or shares? How did the business finance its purchases of machinery or other capital assets? How was it possible to pay dividends when the business reported a net loss on its income statement? Does the firm have the ability to pay off the mortgage on its office building? In 1998, the CICA revised section 1540 of the CICA Handbook, changing the statement of changes in financial position to cash flow statement. This does not affect the preparation of the cash flow statement, which is still based on cash and cash equivalents. This applies to all businesses unless a business has relatively simple operations, with few or no significant financing and investing activities, and their effects on cash flows are apparent from the other financial statements or are adequately disclosed in the notes to the financial statements (paragraph 1540.04). For example, the cash flow statement does not apply to pension plans or not-for-profit organizations. Note: The term statement of cash flows is used in the text. However, in these Lesson Notes and all review material and assignments, as well as the CGA Model Financial Statements, the term cash flow statement is used, which conforms to the CICA Handbook. The CFS is similar to an income statement in that it summarizes the activities of a company during a given period. An income statement, however, only reports on operating activities. The CFS not only reports on operating activities, but also on investing and financing 2 Lesson 10 Financial Accounting 1

Direct and indirect methods Cash and cash equivalents activities. Another key difference between the income statement and the CFS is that the income statement is prepared using the accrual basis of accounting, but the CFS includes inflows and outflows of cash or cash equivalents, thus it is prepared on a cash basis. There are two widely used methods to report (or present) cash flows from operating activities: the direct method and the indirect method. The direct method determines net cash provided (used) by operations by directly subtracting major classes of operating cash inflows. One of the changes resulting from section 1540 is that enterprises are encouraged to report cash flows from operating activities using the direct method. The indirect method first presents net income. Net income is then converted to a cash basis by making the following adjustments: adjustments for changes in noncash current assets and current liabilities that relate to operating activities adjustments for items that relate to operating activities but do not provide cash inflows or cash outflows during the period adjustments for gains and losses that do not relate to operating activities Both methods are presently acceptable, but enterprises are encouraged to report operating cash flows using the direct method. The direct method is illustrated in Topic 10.2, while the indirect method will be introduced in FA2. The indirect method is not examinable in FA1. A common definition of cash is necessary so that the CFS can be prepared on a consistent basis. Cash is generally defined to include both cash and cash equivalents. Equity investments are excluded from cash equivalents (Handbook, paragraph 1540.08). The CFS shows the events or transactions that created the difference between beginning and ending balances of cash and cash equivalents. Cash and cash equivalents would normally include cash on hand, demand deposits, short-term borrowing and temporary investments, and may include certain other elements of working capital (current assets less current liabilities) when they are equivalent to cash. Examples include temporary investments in Canadian Treasury bills, commercial paper, and money market funds. Key features of cash equivalents are that they are readily convertible into cash and are relatively insensitive to changes in interest rates because they are so near to maturity. Any liquid investments not held as temporary investments of idle cash should be excluded from the cash equivalent classification. Policies for determining cash equivalents must be consistently followed and disclosed in financial statement footnotes. You may find it helpful to think of cash flows in the context of the balance sheet equation presented in Lesson 1. The balance sheet equation can be expressed as: Cash + Noncash assets = Liabilities + Shareholders equity This equation will also be true for changes made to these accounts. Therefore, using the symbol to represent changes: Cash + Noncash assets = Liabilities + Shareholders equity Solving for Cash: Cash = Liabilities + Shareholders equity Noncash assets Changes in shareholders equity can be expanded to take into account changes in capital shares (CS) plus net income (NI) (or less net loss) less cash dividends (Div.): Cash = Liabilities + CS + NI Div. Noncash assets Financial Accounting 1 Lesson 10 3

Classification of cash transactions A common method of analyzing the change in cash is to start with net income, then add other sources of cash, and deduct other uses of cash. This can be seen by manipulating the previous equation. Let upward-pointing arrows represent increases and downward-pointing arrows represent decreases: Cash = (Sources of cash) (Uses of cash) = (NI + Noncash assets + Liab. + CS) ( Noncash assets + Liab. + CS + Div.) Cash flows result from operating, financing, and investing activities. You must be able to distinguish among these types of cash flows. These activities are explained as follows. Operating activities Cash flows from operating activities include all cash flow transactions that are not classified as investing or financing activities. Operating activities are related to the primary operations of the company in generating revenues and incurring related expenses. Companies expect to generate more cash inflows from selling goods and services than they spend in doing so. As you know, revenues are recorded when they are earned and expenses are recorded when incurred. Revenues and expenses therefore seldom match perfectly with their corresponding cash flows. For example, of $20,000 sales during the current fiscal period, perhaps only $10,000 are collected in the same period as the sales. The income statement also includes noncash expenses such as amortization. Amortization expense reduces income without a corresponding reduction in cash. You should think of operating cash flow activities as those that affect net income as well as current assets and current liabilities (the working capital accounts or operating accounts). Changes in working capital accounts are very much affected by a company s rate of growth. Expanding businesses will usually report significant increases in accounts receivable and inventories. If a business uses suppliers to finance these increases, you will see an upward change in accounts payable. Some changes in current liabilities, however, are not usually classified as operating activities. For instance, changes in dividends payable and interest charged to retained earnings are classified as financing activities. In the previous example, a business may finance increases in accounts receivable and inventory with borrowing or equity financing. However, borrowing and equity financing are not considered to be operating activities. Investing activities In general, investing activities are transactions for purchasing and selling capital assets and other productive assets. Capital assets are acquired in order to increase productive capacity. Cash needed for this expansion may come from the sale of existing assets that are less productive. Usually this section of the CFS shows a net cash outflow because companies typically spend more cash than they receive from the sale of non-current assets. Additional cash, therefore, has to come from operations or other sources to finance capital expansion. Investing activities also include purchasing and selling of long-term investment securities such as bonds or shares of other companies. Financing activities Financing activities affect a business capital structure, its debt and equity. This includes a company s transactions with its owners and creditors but does not include cash payments to settle credit purchases of merchandise, which are operating activities. 4 Lesson 10 Financial Accounting 1

Financing activities include the use of cash to pay dividends to shareholders, the borrowing or payment of debt, and the issue or repurchase of shares. Do not confuse dividends declared and paid with dividends received from investments. Dividends paid are a cash outflow that is a financing activity, but dividends received are a cash inflow reported on the income statement. Dividends received are therefore classified as an operating activity. LEVEL 2 Exhibits 19.1, 19.2, and 19.3 on pages 968 and 969 summarize cash flows from operating, investing, and financing activities respectively. Noncash transactions Many investing and financing transactions do not require the use of cash or cash equivalents. Noncash transactions are excluded from the cash flow statement because these items do not involve cash flows in the current period. According to the CICA Handbook, paragraph 1540.47: Examples of non-cash transactions are: (a) the acquisition of assets by assuming directly related liabilities; (b) the acquisition of assets by means of a capital lease; (c) the acquisition of an enterprise in exchange for shares of the acquirer; and (d) the conversion of debt to equity. LEVEL 1 Illustrative examples of noncash transactions that involve both investing and financing activities are given in Exhibit 19.4 on page 969. Format of the cash flow statement Exhibit 19.5 on page 970 illustrates the format of the cash flow statement. Notice that although noncash transactions are excluded from the statement, they are included in a note to the financial statements. Textbook activities Judgement Call on page 970 Flashback on page 970 Related review and assignment questions Review Question 1 Assignment Question 1 Financial Accounting 1 Lesson 10 5

TOPIC 10.2 Preparing cash flow statements Required reading LEVEL 1 Chapter 19, pages 971-979, up to Mid-Chapter Demonstration Problem Analyzing noncash accounts Analysis of the cash account alone is not practical for purposes of preparing a CFS. The cash account generally contains a large number of cash transactions; it is cumbersome to track each cash inflow and outflow separately and classify them as operating, financing, or investing activities. Cash flows eventually affect the noncash balance sheet accounts. The nature of the cash flows can be determined more simply by examining the noncash accounts. In effect, when a company purchases inventory on account, there is an implicit change in cash. It is as if the supplier had lent the company cash that the company uses to purchase inventory. The increase in the inventory account can be thought of as use of cash, and the increase in the accounts payable account as a source of cash. Remember that cash equivalents are part of the definition of cash and, therefore, are not a noncash asset. Preparing the CFS For the actual preparation of the CFS, refer now to Exhibit 19.7 on page 973. This illustration presents comparative balance sheets for 2003 and 2002, as well as an income statement for the year ended 2003. You can use this information to develop a formal cash flow statement that will classify cash receipts (sources) and cash payments (uses) into operating, investing, and financing activities. Cash flows are presented as inflows and outflows of cash and cash equivalents. As noted in Topic 10.1, two widely-used methods of presenting the operations sections of the CFS are the direct method and the indirect method. You will now take a closer look at the direct method. Direct method of calculating net cash provided (used) by operating activities For firms with simple structures, the CFS can be efficiently constructed by analyzing the changes in comparative balance sheet items and referencing the current income statement and supplementary data. The following refers to the direct method of presenting the CFS. With the direct method you must identify the major classes of cash receipts and gross cash payments. First, compute the cash flows from sales and other revenues. Then, compute cash outflows for expenses such as payments made to suppliers of inventory, salaries, interest payments, and so on. You will now work through some of these calculations. Cash receipts from customers (a source of cash) If all sales are for cash, the amount of cash received from customers is equal to sales. When sales are on account, the amount of cash received from sales equals the sales revenue amount plus the decrease in accounts receivable or less the increase in accounts receivable. To understand why decreases in accounts receivable are added to determine cash received from customers, look at the journal entry that causes that decrease: Cash... XX Accounts receivable... XX 6 Lesson 10 Financial Accounting 1

The debit to cash indicates that cash was received from the customer. Remember, you are calculating actual cash received and not revenue earned. A look at the journal entry that causes accounts receivable to increase will help you understand why increases in accounts receivable are subtracted to determine cash received from customers: Accounts receivable... XX Sales... XX This entry causes Sales (or Revenues) to increase but there has been no cash received from customers. Therefore, in order to determine the actual cash received from customers as a result of sales transactions, increases in Accounts receivable must be subtracted. Using the data in Exhibit 19.7 on page 973, sales for the year was $590,000 and accounts receivable increased from $40,000 to $60,000. Cash collected from customers is calculated as follows: Beginning accounts receivable $ 40,000 Sales 590,000 630,000 Less: Ending accounts receivable (60,000) Cash receipts from customers $ 570,000 Cash payments for merchandise (a use of cash) The following two points are important when recording cash payments for merchandise: If all merchandise purchases are for cash and the ending balance of Merchandise inventory is unchanged from the beginning balance, the total cash outflow is equal to cost of goods sold. When the balances in Merchandise inventory and Accounts payable change, the amount of cash paid for merchandise equals the cost of goods sold amount plus the increase (or less the decrease) in Merchandise inventory plus the decrease (or less the increase) in Accounts payable. Again, an analysis of the journal entries that cause changes in both Merchandise inventory and Accounts payable will help you understand these relationships. The journal entry that causes Accounts payable to increase is: Merchandise inventory... XX Accounts payable... XX Accounts payable increases because of the purchase of Merchandise inventory on credit; no cash was actually used to make the purchase; therefore, increases in Accounts payable are subtracted when determining the cash paid for merchandise. A decrease in Accounts payable would occur with the following entry: Accounts payable... XX Cash... XX Notice that Cash is being used (the credit reflects a decrease); therefore, decreases in Accounts payable are added when determining how much cash was used to acquire Merchandise inventory. Financial Accounting 1 Lesson 10 7

The impact of changes in Merchandise inventory can also be analyzed using journal entries: Merchandise inventory... XX Accounts payable or Cash... XX As you can see, an increase in Merchandise inventory can use Cash; therefore, increases in Merchandise inventory are added when determining how much cash was actually paid for Merchandise inventory. When Merchandise inventory is decreasing, the entry is: Cost of goods sold... Merchandise inventory... XX XX This does not affect Cash, hence decreases in Merchandise inventory are subtracted when determining how much Cash was paid for Merchandise inventory. Using the data in Exhibit 19.7, cost of goods sold is $300,000. Inventories increased by $14,000 and Accounts payable decreased by $5,000 during the year. Cost of goods sold $ 300,000 Inventories 14,000 Accounts payable 5,000 Payments for merchandise $ 319,000 Cash payments for wages and other operating expenses (a use of cash) The amount of cash paid for operating expenses equals the expense account amounts plus the increases (or less the decreases) in Prepaid expenses plus the decreases (or less the increases) in Accrued liabilities. As demonstrated previously, you may find it useful to prepare an analysis of those journal entries causing changes in Prepaids and Accrued liabilities to help you understand the calculations regarding the cash paid for operating expenses. Each expense must be adjusted for unpaid expenses (accrued expenses) and for any expenses that were paid in advance, such as prepaid insurance. For Genesis in Exhibit 19.7, wages and other operating expenses of $216,000 must be adjusted for the increase in prepaid expenses. There are no accrued expenses for wages and other operating expenses in this example. Wages and other operating expenses $ 216,000 Prepaid expenses 2,000 Payments for wages and other operating expenses $ 218,000 Cash payments for interest (a use of cash) The amount of cash paid equals the expense plus the decrease (or less the increase) in the related payable. In more complicated cases, interest expense would have to be adjusted not only for any changes in interest payable but also for changes in prepaid interest and bond discount or premium amortization in order to determine the cash paid for interest. For Genesis, there was no prepaid interest expense account. Interest payable, however, decreased by $1,000. This indicates that the cash payment for interest must be greater than the interest expense amount reported on the income statement. Interest payable $ 1,000 Interest expense 7,000 Interest paid $ 8,000 8 Lesson 10 Financial Accounting 1

Cash payments for income tax (a use of cash) Income taxes must be adjusted for changes in income taxes payable and future income taxes. An increase in future tax expense is an increase equal to the amount by which income tax expense exceeds income tax payable. Income tax expense $ 15,000 Future income tax decrease* Future income tax increase* Income tax payable 10,000 Income taxes paid $ 5,000 *Future income taxes will be covered in FA2 and FA3. Example 10.1 following shows the direct method of computing cash flows. EXAMPLE 10.1 Calculating cash flows The following cases provide information about the operations of a company during the year. How these transactions affect cash flows in each case is then computed. Case A: Computing cash receipts from customers Sales revenue $ 255,000 Accounts receivable, January 1 12,600 Accounts receivable, December 31 17,400 The cash receipts from customers is computed as follows: Sales revenue $ 255,000 Accounts receivable, December 31 $ 17,400 Accounts receivable, January 1 (12,600) Less: Increase in accounts receivable (4,800) Cash receipts from customers $ 250,200 An increase in the balances of accounts receivable from January to December causes a decrease in the company s level of cash at December 31. Case B: Computing cash paid for insurance Insurance expense $ 34,200 Prepaid insurance, January 1 5,700 Prepaid insurance, December 31 8,550 The cash paid for insurance is computed as follows: Insurance expense $ 34,200 Prepaid insurance, December 31 $ 8,550 Prepaid insurance, January 1 (5,700) Add: Increase in prepaid insurance 2,850 Payments for insurance $ 37,050 An increase in the balance of prepaid insurance over the fiscal year causes a decrease in the company s level of cash at December 31. Financial Accounting 1 Lesson 10 9

Case C: Computing cash paid for salaries Salaries expense $ 102,000 Salaries payable, January 1 6,300 Salaries payable, December 31 7,500 The cash paid for salaries is computed as follows: Salaries expense $ 102,000 Salaries payable, December 31 $ 7,500 Salaries payable, January 1 (6,300) Less: Increase in salaries payable (1,200) Payments for salaries $ 100,800 An increase in balance of salaries payable causes an increase in the company s level of cash at December 31. Source: Text, Exercise 19-3, page 1006. Adjustments for other operating items that do not provide or use cash Some income statement items do not provide or use cash. Examples are amortization and bad debt expense. Using the direct method, these items are not included in net cash provided (or used) by operating activities. Investing activities Financing activities Investing activities usually refer to transactions that affect long-term assets. Cash used for purchases and cash provided by sales (or disposals) of such assets can be determined by reconstructing the applicable accounts. Financing activities usually relate to a company s long-term debt and shareholders equity accounts. Cash used for payment of debt, cash dividends, as well as cash provided from issuance of shares can be determined by reconstructing the applicable accounts. Exhibit 19.8 on page 974 is a CFS for Genesis using the direct method. Note that the section relating to operating activities differs from the format illustrated in Exhibit 19-13 on page 981, which shows the indirect method. Note also that the noncash portion of the plant acquisition ($60,000 from item b on page 972) is not shown on the CFS. The CICA Handbook provides the following guidance to classify transactions as either operating, financing, or investing activities. Dividends and interest paid and charged to retained earnings should be presented separately as cash flows used in financing activities. (paragraph 1540.35) The cash flows associated with extraordinary items should be classified as arising from operating, investing or financing activities as appropriate and presented separately on a before-tax basis. (paragraph 1540.32) The aggregate cash flows arising from each of business combinations and disposals of business units should be presented separately and classified as cash flows from investing activities. (paragraph 1540.42) Example 10.2 illustrates how to compute the cash flows from operating activities using the direct method. 10 Lesson 10 Financial Accounting 1

EXAMPLE 10.2 Cash flows from operating activities Alama Data Company s income statement for 2002 is presented as follows: ALAMA DATA COMPANY Income Statement year ended December 31, 2002 Sales $ 606,000 Cost of goods sold 297,000 Gross profit from sales 309,000 Operating expenses: Salaries expense $ 82,845 Amortization expense 14,400 Rent expense 16,200 Amortization expense, patents 1,800 Utilities expense 6,375 121,620 Total 187,380 Gain on sale of equipment 2,400 Net income $ 189,780 In addition, the following are changes in current asset and current liability accounts during the year, all of which related to operating activities: Accounts receivable $ 13,500 increase Merchandise inventory 9,000 increase Accounts payable 4,500 decrease Salaries payable 1,500 decrease Cash flows from operating activities by the direct method: Cash receipts from customers 1 $ 592,500 Cash payments for merchandise 2 (310,500) Cash payments for salaries 3 (84,345) Cash payments for other operating expenses 4 (22,575) Net cash provided by operating activities $ 175,080 1 $606,000 $13,500 = $592,500 2 (297,000) + ($4,500) + ($9,000) = ($310,500) 3 ($82,845) + ($1,500) = ($84,345) 4 ($16,200) + ($6,375) = ($22,575) Source: Text, Exercise 19-5, page 1007. Using a spreadsheet Textbook activities Appendix 19A on pages 997 to 1000 demonstrates a spreadsheet (or working paper) approach to preparing a CFS. This approach is not examinable. However, you may find it helpful to read this section to enhance your understanding of the CFS. Flashback on page 979 Mid-Chapter Demonstration Problem on pages 979-980 Judgement Call on page 990 Demonstration Problem and solution on pages 993-996 or the online Animated Solution Self-study tools in the OLC for Chapter 19 Financial Accounting 1 Lesson 10 11

Review and assignment questions TOPIC 10.3 Review Questions 2, 3, and 4 Assignment Questions 2 and 3 Interpreting financial statements using ratio analysis Required reading LEVEL 2 Chapter 20, pages 1040-1051 Ratios are a widely used tool to help us interpret financial information. You have already been introduced to several ratios in previous lessons: current ratio (Topic 3.11) gross margin ratio (Topic 4.8) merchandise turnover and days sales in inventory (Topic 5.6) acid-test ratio (Topic 6.7) accounts receivable turnover and days sales outstanding (Topic 6.14) total asset turnover and return on total assets (Topic 7.8) book value per share (Topic 9.9) earnings per share (Topic 9.12) Return on common equity You will now explore several additional ratios. One way to measure a firm s financial performance is to compare the firm s return on common equity with the returns offered by other investments. The formula for this ratio is: Net income Preferred dividends Return on common equity = 100 Average common shareholders' equity To have meaning, these ratios must have some standard of comparison or benchmark. Three standards of comparison are: other enterprises in the same industry results of previous accounting periods budgeted or expected results Example 10.3 illustrates the calculation and use of the return on common equity ratio. EXAMPLE 10.3 Return on common equity The following information was extracted from the financial statements of CGA Model Ltd.: Year 2 Year 1 Net income $ 3,877 $ 20,626 Owner s equity $ 46,607 $ 44,830 12 Lesson 10 Financial Accounting 1

The return on common equity for year 2 is calculated as follows: Net income Preferred dividends Return on common equity = 100 Average common shareholders' equity Information collected is as follows: $3,877 0 $46,607 + $44,830 2 = 100 8.48% ( ) CGA Model Ltd. Industry average Major competitor Return on equity 8.48% 6.52 % 6.95 % The data suggest that CGA Model Ltd. is outperforming both the industry average and its major competitor. = Debt ratio Companies usually finance assets using both debt and equity. The debt ratio is used to assess the risk of a company not being able to pay debts on time. It is calculated as follows: Total liabilities Debt ratio = Total assets The extent to which a company is financed by debt is known as the degree of financial leverage. It is sometimes called trading on the equity. A more highly leveraged firm is considered riskier because it is obligated to repay larger amounts of loans as well as interest. A firm s debt ratio should be evaluated in the context of the nature of the firm s activities, its ability to generate cash to repay debt, current economic conditions, and the general level of debt held by other firms in the same industry. Many factors such as a company s age, stability, profitability, and cash flow should be taken into account when assessing whether a particular company s debt ratio is high or low. For example, an older company may be able to tolerate a higher debt ratio than a new company because the market value of the older company s assets may be much higher than the historical cost figures reported on the balance sheet. If the market value of assets is significantly higher than book value, the firm will have substantial unrecorded equity and will therefore be able to support a higher debt ratio. Financial Accounting 1 Lesson 10 13

Example 10.4 illustrates how to calculate and use debt ratios to assess a company s risk of not being able to pay debts on time. EXAMPLE 10.4 Calculating and using debt ratios The following accounts were extracted from CGA Model Ltd. s balance sheet. The industry average for the debt ratio is 45%. Year 2 Year 1 Accounts payable and accruals $ 38,980 $ 38,519 Dividends payable 4,500 5,000 Income taxes payable 1,689 10,500 Current portion of long-term debt 12,500 12,000 Long-term debt 25,500 38,000 Due to related company 13,500 25,000 Due to shareholders 6,505 12,000 $ 103,174 $ 141,019 Total assets $ 149,781 $ 185,849 The debt ratio for CGA Model Ltd. in year 2 is calculated as follows: Total liabilities $103,174 Debt ratio = = = 68.9% Total assets $149,781 $141,019 In year 1, the debt ratio is = 75.9%. $185,849 CGA Model s debt ratio for year 2 is less than year 1 but higher than the industry average of 45%. The high debt ratio as compared to that of the industry indicates that the company should continue to reduce the amount of debt in its financial structure. Caution is appropriate in this type of interpretation because historical costs of assets may not reflect the market values of the company s assets. Profit margin It is important to ensure that accounts are brought to their proper balances and financial statements are kept up-to-date because readers make use of such information to assess a company s performance. One method of evaluating success in generating profits is by calculating a company s profit margin. The profit margin, sometimes called return on sales, measures how much a company is able to keep as profits for each dollar of sales it makes. The profit margin is calculated with the formula: Profit margin = Net income Revenues An interesting question is whether a company s profit margin is consistent with its competitive strategy. You might expect a company with a relatively high profit margin to want to differentiate itself from companies such as Wal-Mart, which compete on the basis of lower prices and high turnover. Example 10.5 shows an application of the profit margin ratio. 14 Lesson 10 Financial Accounting 1

EXAMPLE 10.5 Profit margin CGA Model Ltd. reports net income for the year of $3,877 on sales of $125,291. Last year the company reported a net profit margin of 19.07%. The company s profit margin for this year is calculated as follows: Net income Profit margin = sales = $3,877 $125,291 = 3.09% The company s profit margin for this year has decreased compared to last year. This decrease could be attributed to many factors: competition may have forced CGA Model Ltd. to decrease its prices; the company may be paying more for its inputs; or it may not be managing its overhead and administrative costs efficiently. Times interest earned Times interest earned, also called times fixed interest charges earned, can be calculated as a measure of risk to the long-term creditor. This ratio indicates the dollars of earnings available for each dollar of interest payments to be made. Times interest earned is calculated as follows: Income Times interest earned = before interest and income taxes Interest expense Pledged assets to secured liabilities The numerator is income before interest and taxes. Income before taxes is used because interest expense is deducted before income taxes are calculated. For many companies, interest expense is relatively fixed. It is useful to look at the long-term trend in earnings when assessing the times interest earned ratio. Because of the fixed nature of interest, a company may be vulnerable to cyclical changes in the economic environment. Investors in secured debt obligations need to estimate whether the pledged assets of the debtor or borrower provide adequate security. Pledged assets are those that the lender(s) of the secured liability(s) would receive if the borrower fails to pay in accordance with the terms of the debt agreement. Both secured and unsecured creditors are concerned with the relationship between assets owned by the debtor and the amount of secured liabilities. This is shown by the pledged assets to secured liabilities ratio, and is calculated as follows: Pledged assets to secured liabilities ratio = Book value of pledged assets Book value of secured liabilities When this ratio is high, secured creditors are better protected, but unsecured creditors face greater risk. If market values differ significantly from book values, this ratio can be quite misleading. Creditors may request market value appraisals to supplement this ratio. Dividend yield Shares that pay regular dividends are called income shares. If the shares do not pay regular dividends but are held by investors who expect the market value of these shares to increase, they are known as growth shares. Financial Accounting 1 Lesson 10 15

The dividend yield shows the dividend paid per share as a proportion of the market price per share, and is calculated as follows: Annual cash dividend per share Dividend yield = 100 Market price per share This is generally expressed as a percent. Example 10.6 shows how to calculate a dividend yield. EXAMPLE 10.6 Calculating dividend yield The following information is extracted from CGA Model Ltd: Year 2 Year 1 Share capital $ 100 $ 100 Retained earnings 46,507 44,730 Dividends 2,100 18,000 CGA Model Ltd. has 100 shares outstanding and the market price on its shares was reported at $15.90 per share at the end of year 2. The dividend yield in year 2 is determined as follows: Dividends $2,100 Dividends per share = = = $21.00 Number of shares 100 Dividend per share $21.00 Dividend yield = 100 = 100 = 132% Market price per share $15.90 Price-earnings ratio The dividend yield is a useful measure for income shares, but growth shares are more appropriately measured by the capital gains yield, calculated as follows: Capital gains Change in market yield = Original market price for the year price 100 Then, total return on a share would be the dividend yield plus the capital gains yield. This will be dealt with in more detail in your finance courses. The price-earnings ratio (P/E ratio) is widely used by investors to analyze a firm s share value. The ratio indicates the price that investors are willing to pay for each dollar of a company s earnings. For this reason, a higher P/E ratio is generally equated with a more risky investment, because investors are willing to invest more money in current earnings in the hope of significantly higher earnings in the future. High P/E ratios are typically afforded to companies that investors believe have high growth prospects, such as young, developing organizations. Companies in mature or established industries tend to have lower P/E ratios, because their growth outlook is lower and more stable. The ratio is calculated as: Market price per share Price -earnings ratio = Earnings per share 16 Lesson 10 Financial Accounting 1

Example 10.7 demonstrates how to compute the P/E ratio. EXAMPLE 10.7 Computing the price-earnings ratio The following information was extracted from the annual reports of two steel manufacturing companies. The industry average of the P/E ratio for the steel manufacturing industry is 13.8. Earnings per share Market value per share Telco Inc. $ 4.50 $ 43.00 Nco Inc. $ 0.75 $ 18.00 The price-earnings ratios for the two companies are: Telco Inc.: $43.00 $4.50 = 9.6 Nco Inc.: $18.00 $0.75 = 24.0 The P/E ratio for Nco Inc. suggests that the investors believe that the company has better growth prospects than Telco Inc. and the average company in the steel industry. Cash flow per share Financial analysts sometimes calculate cash flow per share based on the CFS. The cash flow per share ratio is calculated as: Net income after adjusting for noncash items Cash flow per share = Number of shares outstanding Noncash items include bad debt expense, amortization, and other adjustments such as those that are required to prepare a CFS using the indirect method. As you are not responsible for the indirect method in FA1, you will not be asked to calculate net income after adjusting for noncash items. This figure will be provided where required. Creditors and investors evaluate a company s ability to generate cash flows before lending money or investing in the company. Normally, this ratio is compared with the historical trend for the same company because the number of shares outstanding varies greatly between companies, thus making comparisons between them difficult on a per share basis. Although relevant information can be extracted from cash flows from the investing and financing sections of the CFS, particular attention is often paid to cash flow from operations, which help predict recurring cash flows. Despite the fact that analysts find cash-flow-per-share information useful, the CICA Handbook disallows it from being included in the financial statements. Paragraph 1540.54 explains: Per share or per unit amounts of net cash flow, cash flow from operating activities or other cash flow amounts are not an alternative to earnings per share as an indicator of an enterprise's performance. Those cash flow amounts do not accrue directly to the benefit of the owners of an enterprise's residual equity, as would be implied if they were reported on a per share or per unit basis. Accordingly, such per share or per unit amounts are not presented in the financial statements. Financial Accounting 1 Lesson 10 17

Related review and assignment questions TOPIC 10.4 Review Question 6 Assignment Questions 4 and 7 The conceptual framework of accounting Required reading LEVEL 2 Appendix 10-1 (Level 3) In this introductory course to financial accounting, you have obtained an overview of the principles and concepts that will now be integrated with the conceptual framework. In this topic, you will review the essential characteristics of accounting information and look at section 1000 of the CICA Handbook on financial statement concepts (see Appendix 10-1). In Lesson 1 you learned that accounting is a service activity whose function is to provide quantitative information, primarily financial in nature, about economic entities. Accounting involves identifying economic events and then measuring, recording, summarizing, and reporting information to users. The aim of accounting is to provide useful information for making economic decisions. In the United States, the Financial Accounting Standards Board (FASB) set out to create a coherent system of interrelated accounting objectives and fundamentals that can lead to consistent standards. The FASB has released Statements of Financial Accounting Concepts (SFAC) that are essentially pronouncements intended to provide a framework to serve as a basis for the future development of financial reporting standards. CICA Handbook section 1000 draws heavily from this project. The conceptual framework of accounting includes two major areas: defining the essential characteristics of accounting information identifying the fundamental concepts of accounting used in preparing external financial reports Essential characteristics of accounting information Accountants must determine the purpose and ultimate use for the financial reports they prepare. The reports assist users in making financial decisions by disclosing information. Financial reports should be presented in a manner that will be understood by users who have a reasonable level of knowledge of business and economics. In other words, financial statements are not designed for the naïve investor. Read paragraphs.01 to.15 of Appendix 10-1, which expand on the characteristics that make accounting information useful. Paragraph.18 of Appendix 10-1 identifies four qualitative characteristics or qualities that make accounting information useful: understandability, relevance, reliability, and comparability. Of these, relevance and reliability are considered the primary qualities that must be present for accounting information to be useful. Each of these four qualitative characteristics is tied up with the ethical foundations of accounting, providing useful information to financial users. They set ethical parameters or limits on acceptable accounting information. All of them require good judgment and expertise. 18 Lesson 10 Financial Accounting 1

Following is a description of the four qualities. Understandability (paragraph.19 of Appendix 10-1) The primary criterion for selecting accounting reporting methods is decision usefulness. That is, the information should be helpful to users in making investment, financing, and operating decisions. For the information to be useful, it must be understandable by users. Information is understandable if a user can perceive the significance of the information. In some cases, however, when a user doesn t understand the information, it does not mean that the information is not relevant. It may mean that the particular user does not have sufficient accounting knowledge to be able to interpret the information. Remember that accounting reports are prepared for informed users who have a reasonable understanding of business and are willing to study the information. Relevance (paragraph.20 of Appendix 10-1) Accounting information must be relevant to, or useful for, the decision-making needs of users. Information is relevant if it has the capacity to make a difference in the decision-making process. Relevance is enhanced by Predictive value: the quality of financial information that enhances the users ability to forecast an entity s future income and cash flows. Feedback value: the quality of financial information that confirms or corrects prior expectations relating to past decisions and events. Timeliness: the availability of information in time to influence users decisions. Financial statements issued late lose the quality of timeliness. Reliability (Paragraph.21 of Appendix 10-1) Accounting information must be reliable (free from error and bias) in order to reduce the level of risk to those who base decisions on it. Reliability is improved if information possesses the following qualities: Representational faithfulness: the degree to which the information accurately measures or describes the real-world situation it represents. The information says what it appears to say. This quality of representational faithfulness is sometimes referred to as validity. Amounts reported on financial statements should be a faithful representation of the economic resources of an organization, the claims to these resources, and the residual equity of the enterprise. Verifiability: the measurement methods allow others to arrive at the same quantitative result without error or bias. Information is considered verifiable if there is a high degree of consensus on the measurement of financial statement items when the same measurement methods are being used. Neutrality: freedom from bias and attempts to influence decisions on the part of preparers of financial reports. Conservatism: when two or more valid alternatives exist, select the least optimistic outcome. Conservatism is a form of bias that contradicts the desired quality of neutrality. Therefore, it should never be used to justify an alternative estimate that is extremely pessimistic. When there is risk or uncertainty, the preference for possible accounting measurement errors should be in the direction of understatement rather than overstatement of assets and income. You should bear in mind, however, that over the life of an entity, income equals cash inflows less cash outflows involving transactions with non-owners. Although conservatism does reduce net income in earlier periods, it actually increases net earnings of later periods. For example, assume that a firm uses the double-declining-balance method of amortization. During the early years of a capital asset s life, relatively high amortization charges will Financial Accounting 1 Lesson 10 19

Tradeoff of qualitative characteristics reduce income by more than the amortization of the later years. In the later years the tendency will therefore be to report higher net incomes unless new capital asset acquisitions are made. Comparability (paragraphs.22 and.23 of Appendix 10-1) Comparability and consistency are interrelated. There are two dimensions of comparability. One dimension is the user s ability to make comparisons between different entities, such as between different companies in the same industry. For example, investors frequently evaluate and compare the performance of competitors by analyzing the results found in their financial reports. Accounting standards facilitate comparability by requiring specific treatments of certain transactions. For example, all companies must value their inventory at the lower of cost or market. The second dimension is the user s ability to compare the results of a specific entity from year to year. Use of the same accounting procedures and policies over time, demonstrating consistency, allows users to identify significant trends. Without consistency, there is a chance that changes in reported results of operations are simply due to changes in accounting procedures rather than actual changes in performance. To date, accountants have had only limited success in achieving comparability between firms; however, consistency within a firm is generally observed. A problem is that the conceptual framework does not give clear guidance when alternative methods to account for various events exist. As you have seen, there are alternative acceptable methods of inventory valuation LIFO, FIFO, weighted-average; alternative methods of amortization straight-line, declining-balance; and considerable discretion in the recording of various expenses bad debt expense and warranty expense. The essential characteristics of accounting information understandability, relevance, reliability, and comparability do not always support each other; nor are all four always present. For example, relevant information may not always be reliable. What users especially want are data about the future, but such data generally cannot be considered reliable (because data cannot be verified until the future event has occurred). Accountants must therefore make tradeoffs or compromises between these essential characteristics; compromises are a natural factor in the accounting process. That compromises have to be made may give rise to a disquieting question: Is there any principled way of making such compromises, or is this simply a free-for-all where anything goes? There is a good answer to this question that brings out some of the basic principles of ethics in accounting. First, the overall objective in accounting is to provide useful financial information for stakeholders (users of the financial information). Therefore, if a particular compromise can t be justified in terms of its usefulness, then it is highly suspect. Second, it is important to make compromises between one objective (such as relevance) and another (such as reliability) as transparent to all stakeholders as possible. Such transparency treats users of financial information fairly by disclosing important limitations on the accounting information provided to them. Third, accounting has developed conventional modes of providing financial information as reflected in generally accepted accounting principles and the Handbook standards. These provide guidance as to acceptable compromises. Accountants generally consider two constraints when implementing accounting procedures and reporting information. These constraints are practical application guidelines related to the usefulness of accounting information and should be assessed on an individual basis. 20 Lesson 10 Financial Accounting 1