Laurence Booth Sean Cleary. LEARNING OBJECTIVES Financial Statements 3 3.1Describe international...

Laurence Booth

Sean Cleary

LEARNING OBJECTIVESLEARNING OBJECTIVES

Financial Statements33.1 Describe international financial reporting standards

(IFRS) and state their significance for Canadian firms.

3.2 Organize a firm’s transactions, and explain what are the most important accounting principles related to this task.

3.3 Prepare a firm’s financial statements.

3.4 Analyze a firm’s financial statements.

3.5 Describe the Canadian tax system and explain the differences between how a corporation and an individual are taxed.

3.1 ACCOUNTING PRINCIPLES

• Accounting is an organized way of summarizing the activities of business.

• Internal and external users of accounting information rely on it to make decisions.

• Financial managers require a strong understanding of accounting because they use that information to make significant decisions that will affect the firm.

Booth • Cleary – 3rd Edition 3


• A new set of accounting guidelines, International Financial Reporting Standards (IFRS), have been the primary accounting standards used for publicly accountable enterprises in Canada since January 2011, replacing Canadian generally accepted accounting principles (GAAP).

• Reporting of financial performance in a consistent manner over time and between firms enhances the usefulness of those reports, allowing comparative analysis.


© John Wiley & Sons Canada, Ltd.

• Private companies may report under IFRS or they may choose to report under Accounting Standards for Private Enterprises (ASPE).

• Most small and mid-sized private Canadian companies have chosen to report under ASPE as it is similar to the former Canadian GAAP.

• Larger private companies have opted to adopt IFRS.• The United States has not adopted IFRS; it uses U.S. GAAP.• Since March 2005, Canadian securities laws permit a public

company whose stock is listed on both Canadian and U.S. stock exchanges to prepare its financial statements under U.S. GAAP.



© John Wiley & Sons Canada, Ltd.Booth • Cleary – 3rd Edition 6


Figure 3-1 Accounting Options Available to Various Forms of Organizations

The Impact of Accounting Scandals• The Enron bankruptcy, in addition to other scandals

involving WorldCom, Tyco. and others demonstrate the need for reform.

• Since investors use accounting information to make investing decisions and value firms, recent accounting scandals where financial statements were misleading have caused investors to lose confidence in financial markets.

• The U.S. Congress passed the Sarbanes-Oxley Act (SOX) in 2002 in an attempt to restore investor confidence by imposing new requirements for financial disclosure and oversight.




Main Provisions of Sarbanes-Oxley (2002)• A new Public Company Accounting Oversight Board– Register and inspect public accounting firms– Establish audit standards

• Separation of the audit function from other services provided by auditing firms




Main Provisions of Sarbanes-Oxley (2002) (continued)• Improved standards for corporate governance– Separate board committees for finance and audit– Require external auditors to report to the audit committee– Require audit committee independence and financial

expertise, with membership dominated by external directors• New requirement that annual reports indicate the state of

a firm’s internal controls and assess their effectiveness• The CEO and CFO must certify that the firms financial

statements “fairly present in all material respects the operations and financial condition of the issuer”




3.2 ORGANIZING A FIRM’S TRANSACTIONS• Bookkeeping is the mechanical act of managing and

recording transactions• Accounting is the application of generally accepted

accounting principles (GAAP) and conventions to bookkeeping data to produce financial statements that fairly represent the financial condition and operations of the economic entity



3.2 ORGANIZING A FIRM’S TRANSACTIONS• The most basic accounting principles are:

1. The Entity Concept – accounting is for a specific economic entity

2. The Going Concern Principle – the statements are prepared on the basis that the economic entity will continue to operate into the future; therefore, liquidation values are irrelevant

3. A Period of Analysis – usually a fiscal year, although quarterly and monthly financial statements are also produced



• Basic accounting principles (continued)4. A Monetary Value – historical costs are

traditionally used because of the objectivity inherent in arms-length transactions

5. The Matching Principle – expenses incurred must be matched to the revenue earned in the period of analysis

6. Revenue Recognition – revenue is recognized when it has been earned, even though the cash may not yet have been received


3.2 ORGANIZING A FIRM’S TRANSACTIONS


General Themes of IFRS: Financial information should have:• Relevance: information is relevant if it could potentially affect users’

decisions and has predictive and/or confirmatory power. • Faithful representation: the information provided should be

complete, bias-free, and error-free.To enhance relevance and faithful representation, information should have the following characteristics:– Comparability: consistent comparisons can be made across entities

and across time.– Verifiability: information can be verified by an independent

knowledgeable party.– Timeliness: information is presented in a timely manner.– Understandability: the information presented is clear and concise.


3.2 ORGANIZING A FIRM’S TRANSACTIONS


3.3 PREPARING ACCOUNTING STATEMENTS:The Balance Sheet and Income Statement

• The balance sheet is a financial snapshot at one point in time and is usually dated for the last day of the firm’s fiscal year

• It shows what the firm owns (assets) and how those assets were financed (liabilities and owners’ equity)– Assets (debit accounts) are usually shown on the left side with

liabilities and equity (credit accounts) on the right side– Items are listed vertically in order of liquidity (e.g., cash is the first

asset, while fixed assets like machinery are the last)



• The income statement is also known as the profit and loss statement

• Reports the income earned over a given period of time, usually a year, quarter or month.

• Applies the matching principle by reporting expenses incurred in order to earn the revenue recognized in that period

• Revenue is always reported on the top line, with expenses below

• Expenses are often reported separately by type: variable/direct, indirect/fixed, interest, amortization, income taxes, etc.


3.3 PREPARING ACCOUNTING STATEMENTS:The Balance Sheet and Income Statement


• GAAP provides flexibility in the accounting treatment of economic events, such as:– When to recognize revenue– When to capitalize an expense (as an asset)– What rate to use for depreciation

• Managers often face considerable pressure to make the firm’s financial performance appear as good as possible.

• As a result of this pressure, management may change accounting policies within the limits allowed by GAAP to suit their needs and the current circumstances facing the firm.

• Any change in the application of GAAP must be disclosed in the audited financial statements and could jeopardize the audit opinion offered by the external auditors if it is not in compliance with GAAP.


3.3 PREPARING ACCOUNTING STATEMENTS:Changing Accounting Assumptions


• In Canada, firms must report to Canada Revenue Agency (CRA) and remit income taxes in accordance with the Income Tax Act (ITA).

• CRA requires businesses to use capital cost allowance (CCA) rates for asset depreciation which are specified in the ITA’s Regulations.

• Firms in Canada tend to produce two sets of financial statements: one prepared for shareholders and another for CRA prepared according to tax rules.


3.3 PREPARING ACCOUNTING STATEMENTS:Preparing Tax Statements


• Because capital cost allowance (CCA) is an accelerated method of amortization and assets are often replaced more frequently than they are fully depreciated:– Actual income tax liabilities based on the ITA and CCA is

usually less than what is “estimated” when reporting to shareholders under GAAP

– This creates a difference in tax liability called deferred taxes which is capitalized on balance sheets when reporting to shareholders

– Deferred taxes does not mean the firm has an unpaid tax liability


3.3 PREPARING ACCOUNTING STATEMENTS:Preparing Tax Statements


• Accounting profit may not reflect the firm’s actual cash flow

• The cash flow statement helps to provide a clearer picture of sources and uses of cash

• Analysts are very interested in cash flow because it indicates a firm’s solvency


3.3 PREPARING ACCOUNTING STATEMENTS:Cash Flow Statements


• Two methods to prepare a cash flow statement:1. Examine the changes in the balance sheet

accounts and reconcile them through the cash account

2. Add non-cash items to net income


SOURCES OF CASH USES OF CASH

Asset Decreases Asset Increases

Liability Increases Liability Decreases

Common Stock Increases

Retained Earnings Increases



3.4 TIM HORTONS’ ACCOUNTING STATEMENTS


Figure 3-4 Tim Hortons Inc. Consolidated Balance Sheet



Figure 3-5 Tim Hortons Inc. Income Statement



Figure 3-6 Tim Hortons Inc. Consolidated Statement of Cash Flows


3.5 THE CANADIAN TAX SYSTEM

• Federal and provincial governments in Canada tax individuals and corporations based on income earned

• Corporations pay income taxes and then use after-tax income to distribute dividends to shareholders

• Dividends received by shareholders are taxed again as one form of personal investment income– In recognition of this double-taxation of dividends,

dividends from Canadian corporations are given some partial relief through the “dividend gross-up tax credit”

– Dividends received from non-Canadian companies do not qualify for this special tax treatment



• Corporate tax is paid at a flat or fixed rate on taxable income

• Small businesses are defined as those which earn income of $300,000 or less, and usually pay a lower rate of tax (depending on the province)

• Companies are free to choose their own taxation (fiscal) year but, once established, cannot alter it without justification and approval

• Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income


3.5 THE CANADIAN TAX SYSTEMCorporate Taxes


• The income statement shows that variable costs and period overhead costs can be subtracted to determine earnings before interest and taxes (EBIT)

• For tax purposes the Income Tax Act requires that the capital cost allowance system be used instead of accounting amortization

• Interest expenses on debt borrowed to earn income is generally deductible from taxable income




• Capital cost allowance (CCA) is the method of depreciation or amortization used by taxpayers in Canada when reporting business income to CRA for tax purposes

• Since CCA affects a firm’s net income and its net cash flow, taxation issues must be addressed in each financial decision a firm makes and decision makers need to understand CCA

• CCA gives rise to a tax-shield benefit




• CCA is a non-cash deduction from income that would otherwise be subject to income tax. Taxable income is reduced as a result of the deduction and the result is a savings in tax payable

• Tax shield benefit = corporate tax rate × dollar amount of claimed CCA

• Example: A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes

• Because of the half-year rule, only one-half of the CCA rate can be applied to net acquisitions to an asset class in the year the assets are acquired; so the first year’s CCA is less than the second year’s CCA




• Capital Cost Allowance– Similar assets are grouped into

pools or classes– Each asset class’s CCA rate is

specified in the Regulations to the ITA and approximates the economic wastage of the asset

– No estimate of useful life or salvage value is necessary

– As long as the firm remains a going concern and assets remain in the pool, residual undepreciated capital cost (UCC) values remain in the pool


• Accounting Depreciation– Firms choose the method

that best represents the economic wastage of the asset

– Assets are depreciated individually, not in a group

– Estimates of useful life and salvage value are necessary

3.5 THE CANADIAN TAX SYSTEMCCA versus Accounting Depreciation


• CCA is like a declining balance method and changes each year• The largest benefit occurs in the early years of an asset’s life• Residual values always remain in the pool, even after the asset is

disposed

3.5 THE CANADIAN TAX SYSTEMCCA, Capital Gains, Recapture And Terminal Loss


• A taxable capital gain would occur if the firm sold a depreciable asset for greater than its original cost

• Capital Gain = Original Cost Base – Salvage Value• Recapture of Depreciation: if the salvage value of the asset

exceeds the undepreciated capital cost (UCC) of the asset pool, there is a recapture of depreciation which is subject to tax

• An asset pool is closed when the last physical asset in the pool is sold and not replaced

• Terminal Loss: if there is a positive UCC balance remaining in the pool when it closes, that balance is called a terminal loss and is deductible from taxable income in the year the last asset is disposed; terminal losses are non-cash deductions just like CCA


3.5 THE CANADIAN TAX SYSTEMCCA, Capital Gains, Recapture And Terminal Loss


• Canadians are taxed on their worldwide income• The taxation year is the calendar year: January 1st to

December 31st• The personal tax system is progressive in most

provinces, where tax rates increase as the amount of a person’s income increases

• Investment income can be earned by investors in one of three different forms, each of which is taxed differently: interest, dividends, capital gains


3.5 THE CANADIAN TAX SYSTEMPersonal Tax


• Interest income is taxed at the person’s marginal personal tax rate, which is the same rate at which employment and business income is taxed

• Marginal personal tax rates depend on the amount of income earned in a progressive tax system

• All sources of interest must be claimed in each calendar year, both cash interest payments received and interest that has accrued but not yet been paid (e.g., Canada Savings Bonds that have not yet been redeemed)

• The marginal tax rates on interest income are usually (depending on a person’s circumstances) higher than those on dividends and capital gains


3.5 THE CANADIAN TAX SYSTEMPersonal Tax—Interest


• Dividends from Canadian companies receive a special tax treatment called the “gross-up tax credit”

• Cash dividends from eligible corporations are grossed up by 45% and this total amount is included in taxable income

• Federal and provincial tax credits, which vary from province to province, are deducted from the grossed up amount

• Federal tax credit: 18.97%• Provincial tax credits vary from a low 14.55% in Alberta to a

high of 29.69% in Quebec• The tax credits reduce the marginal tax rate applied to

dividend income


3.5 THE CANADIAN TAX SYSTEMPersonal Tax—Dividends


• Only realized capital gains are taxed which means that unrealized capital gains do not trigger tax until investments are sold. Investors can therefore defer capital gains taxes until funds are required.

• Only one-half (50%) of a realized capital gain is subject to tax at the person’s marginal tax rate

• Capital losses can be used to offset taxable capital gains• At higher marginal tax rates, investors prefer to receive

investment income in the form of capital gains and dividends because these are often taxed at a lower marginal rate than interest income


3.5 THE CANADIAN TAX SYSTEMPersonal Tax—Capital Gains


WEB LINKS

Wiley Weekly Finance Updates site (weekly news updates): http://wileyfinanceupdates.ca/

Textbook Companion Website (resources for students and instructors): www.wiley.com/go/boothcanada


http://wileyfinanceupdates.ca/

http://www.wiley.com/go/boothcanada

Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

COPYRIGHTCopyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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