Chapter 3: financial statements Flashcards Preview

FN1 corporate finance > Chapter 3: financial statements > Flashcards

Flashcards in Chapter 3: financial statements Deck (83):

what is accounting

an organized way of summarizing the activities of a business


why do internal and external users of accounting rely on accounting information

to make decisions


why do fiancial managers require a strong understanding of accounting

they use that information to make significant decisions that will affect the firm


why is it important to report financial performance in a consistent manner between firms

it enhances the usefulness of those reports, allowing comparative analysis


what does IFRS stand for

international financial reporting standards


what is IFRS

a new set of accounting principles


who must use IFRS

publicly accountable companies in Canada


does IFRS replace GAAP



How can private companies report?

they can use IFRS or ASPE


What is ASPE

accounting standards for private enterprises


which private companies are more likely to use IFRS

larger private companies


Which private companies are more likely to use ASPE

small to mid-size companies


has USA adopted IFRS

no, they use US GAAP


can any Canadian company use US GAAP

public companies who stock is listed on both Canadian and US stock Exchanges can use IFRS or US GAAP


Why was Sarbane-Oxley act (SOX) passed

due to scandals involving companies like Enron and worldcom
- was passed in an attempt to restore investor's confidence by imposing new requirements for financial disclosure and oversight


What are the main provisions of Sarbanes Oxley (2002)

1. A new public company accounting oversight board
- register and inspect accounting firms
- establish audit standards

2. separation of the audit function from other services provided by auditing firms
4. 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
5. new requirement that annual reports indicate the state of a firm's internal controls and asses their effectiveness
6. the CEO and CFO must certify that the firm's financial statements "fairly present in all material respect the operations and financial conditions of the issuer)


what is bookkeeping

the mechanical act of managing and recording transactions


what is accounting

the application of GAAp and conventions to bookkeeping data to produce financial statements that fairly represent the financial condition and operations of the economic entity


what are the most basic accounting principles

1. the entity concept
2. going concern principle
3. A period of analysis
4. a monetary value
5. matching principle
6. Revenue recognition


what is the entity concept

accounting is for a specific economic entity


what is the going concern principle

statements are prepared on the basis that the entity will continue to operate into the future; therefore liquidation of values are irrelevant


what is a period of analysis

usually a fiscal year
- although quarterly and monthly f.s. are also produced


what is monetary value

historical costs are usually used because of the objectivity inherent in arms length transactions


what is the matching principle

revenue must be matched to expenses in the same period (period they are incurred or earned)


What is revenue recognition

revenue is recognized in the period it is earned, even though the cash may not yet have been received


what should financial information have

1. relevance
2. faith representation


what is relevance

information is relevant if it could potentially affect a user's decisions and has a predictive and/or confirmatory power


what is faithful representation

the information provided should be free from bias and free form error


to enhance relevance and faithful representation information should have the following characteristics

1. comparability
2. verifiability
3. timeliness
4. understandability


what is comparability

consistent comparisons can be made across entities and across time (one year to the next)


what is verifiability

information can be verified by an independent knowledgeable party


what is timeliness

information is presented in a timely manner


what is understandability

the information is clear and concise


what is the balance sheet

a snapshot at one point in time
- usually dated for the last day of the firm's fiscal year
- shows what the firm owns (assets) and what it owes (Liabilities)
- and how those assets were financed (liabilities and onwer's equity)
- items are listed vertically in order of liquidity
- fixed assets like machinery are listed last


what is the income statement also called

profit and loss statement


what is the income statement

income earned over a given period of time (usually a monthly, yearly or quarterly)


what principle is applied ot income statement

matching principle


how is the income statement setup

revenues is the top line and expenses are listed below
- expenses are often reported separately by type (variable/direct, indirect/fixed, interest, amortization, income taxes ect)


GAAP provides flexibility in the accounting treatment of economic events such as

1. when to recognize revenue
2. when to capitalize an expense (as an asset)
3. what rate to use for depreciation


Managers often face considerable pressure to make the firm's financial performance appear as good as possible this causes what

- managers may change accounting policies within the limits allowed by GAAp to suit their needs


if there is a change in the application of GAAP what must happen

it must be disclosed in the audited F.s. and could jeopardize the audit opinion offered by the external auditors if it is not in compliance with GAAP


How do companys report income statements to the government

they report to CRA and remit income taxes in accordance with the income tax act (ITA)


what does cra require business to sue for asset depreciation

capital cost allowance
- specified in the ITA's regulations


firms in Canada tend to produce how many sets of f.s?

1. for shareholders
and one for CRA according to tax rules


what kind of method is CCA for depreciation

accelerated method and assets are often replaced more frequently than they are fully depreciated


actual income tax liabilities based on the ITA and CCA is usually what

less than what is estimated when reporting to shareholders under GAAP


What does CCA create

a difference in tax liability called deferred taxes which is capitalized on balance sheet when reporting to shareholders


what does deferred tax not mean

does not mean the firm has an unpaid tax liability


deferred tax means



What is the cash flow statement show

helps to provide a clearer picture of sources and uses of cash (cash doesn't lie)
- analysts are very interested in cash flow because it indicates a firm's solvency


What are the two methods to prepare the 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


the federal and provincial governments in Canada tax individuals and corporations based on what

income earned


corporations pay income taxes and then use after0tax income for what

to distribute dividends to shareholders


how are dividends taxed?

dividends received by shareholders are taxed again as one form of personal investment income


due to double taxation of dividends what happens to corporations

they get some partial relief through the dividend gross0up tax credit
- dividends received from non-Canadian companies do not qualify for this special tax treatment


how are corporate taxes taxed

paid at a flat or fixed ate on taxable income
- small business are defined as those which earn income of $300,00 or less, and usually pay a lower rate of tax (depending on province)


what does the income statement show

shows the variable costs and period overhead costs can be subtracted to determine earnings before interest and taxes (EBIT)


interest expenses on debt borrowed to earn income is what

generally deductible form taxable income


since CCA affects a firm's net income and its net cash flow, what must be addressed

taxation issues in each financial decision a firm makes and decision makers need to understand CCA


what does CCA give rise to

tax-shield benefit


What is 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


what is the calculation for tax shield benefit

corporate tax rate x dollar amount of claimed CCA


. A firm with a 40% Corporate tax rate and a $2,000 CCA deduction will save how much in taxes

- Because of the ½ year rule
o Only one half of the CCA rate can be applied to net acquisitions to an asset class in the year the asset is acquired
o So, the first year CCA is less than the second year’s CCA


what are the characteristics of CCA

1. similar assets are grouped into pools or classes
2. each asset classes CCA rate is specified in the regulations to the ITA and approximates the economic wastage fo the asset
3. no estimate of useful life or salvage value is necessary
4. 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


what are the characteristics of accounting depreciation

1. firm choose the method that best represents the economic wastage of the asset
2. assets are depreciated individually, not in a group
3. estimates of useful life and salvage values are necessary


what is CCA like

is like a declining balance method and change each year
- the largest benefit occurs in the early years of the asset's life
- residual values always remain in the pool, even after the asset is disposed


when does taxable capital gain occur

if the firm sold a depreciable asset for greater than its original cost


how is capital gain calculated

original cost base - salvage value


what is recapture of depreciation

if salvage value of the asset exceeds the underpeciated capital cost (UCC) of the asset pool, there is a recapture of deprecation which is subject to tax
- an asset pool is closed when the last physical asset in the pool is sold and not replaced


what is 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 of
- terminal losses are non-cash deductions just like CCA


In Canada how is personal income tax taxed

on their worldwide income


what is the personal taxation year

the calendar year


Canada the tax system is ?

progressive in most provinces
- tax rates increase as the amount of a person's income increases


investment income can be earned by investors in one of 3 different forms of which is taxed differently
what are the 3 different forms

1. interest
2. dividends
3. capital gains


Personal 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 what

the amount of income earned in a progressive tax system


the marginal tax rates on interest income are usually

higher than those on dividends and capital gains (depending on a person's circumstances)


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 (eg Canada savings bonds that have not yet been redeemed)


what is the tax treatment for personal tax on dividends

receive a special treatment called the grow-up tax credit


what is the gross -up tax credit

cash dividends form eligible corporations are grossed up by 45% and this total amount is included in taxable income
- federal and provincial tax credits, which vary form province to province are deducted form grossed up amount
federal tax credit: 18.97%
- provincial tax credits vary form a low of 14.55% in alberta to a high of 29.69% in Quebec
- tax credits reduce the marginal tax rate applied to dividend income


personal tax - how are capital gains taxed

only realized capital gains are taxed which means that unrealized capital gains do not trigger tax until investments are sold
- investors can therofre defer capital gains taxes until funds are required
- only 1/2 of the realized capital gain is subject to income tax at the person's marginal tax rate
- capital losses can be used to offset taxable gains
- at higher marginal tax rates, investors prefer to receive investment income in the form of capital gains and dividends because these often taxed at a lower marginal rate than interest income


what is traditional cash flow

net income plus non-cash expenses, such as depreciation and deferred taxes


what is free cash flow

the result of subtracting capital expenditures from cash flow form operations