Understanding and Using Financial Statements

Understanding and Using Financial Statements

Andrew GrahamQueens University

School of Policy StudiesSPS 827 2014

Structure of the Day

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Double Entry and the Dreaded

Debits and Credits

Accounting Cycle and the

Fundamental Accounting Equation

Financial Statements Architecture

Section 1The Accounting Cycle

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Double-Entry Bookkeeping

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Each financial event is called a transaction• The effect of a transaction is recorded in the

accounts by an entry• Each entry will affect at least two parts of the

accounting record to balance the record – debit and credit

• This does not mean that the financial event is recorded twice – rather it is balanced against either costs, increased or reduced liability, changes in inventory, etc.The Principle of Balance

Double-entry accounting is based on a simple concept: each party in a business transaction will receive something and give something in return. In bookkeeping terms, what is received is a debit and what is given is a credit. The T account is a representation of a scale or balance.

Luca PacioliDeveloper ofDouble-EntryAccounting

Scale or Balance

ReceiveDEBIT

GiveCREDIT

T account

Left SideReceiveDEBIT

Right SideGive

CREDIT

The double-entry system provides checks and balances to ensure that your books are always in balance.

In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits.

Because debits equal credits, double-entry accounting prevents some common bookkeeping errors.

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Double Entry Bookkeeping

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You provide consulting services, on account, to one of your regular customers, Betty Fry, for $1,500. When you write up the invoice, you would make the following bookkeeping entry in your sales journal:

Debit CreditAccounts receivable (Fry) 1,500Consulting revenue 1,500

Upon receipt of the invoice, your customer sends you a cheque for $1,500 in payment of her account. When you receive the check, make the following entry in your cash receipts journal: Debit Credit

Cash 1,500Accounts receivable (Fry) 1,500

Accounting Cycle – within time period

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Financial Event

Source Record

Analyze and

Classify Transactio

n

Record through Journal Entry

Post to Ledge

Accounts

Accounting Cycle – at the end of an accounting period

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Prepare a Trial

Balance

Correct Errors and

Make Adjustment

s

Adjusting Entries

Revised Trial

BalanceFinancial

Statements

Closing Journal Entries

Final Adjustment

s and Restatemen

ts

Steps performed throughout the accounting period:

Identify the transaction or other recognizable event.

Prepare the transaction's source document such as a purchase order or invoice.

Analyze and classify the transaction. Record the transaction by making entries in

the appropriate journal. Such entries are made in chronological order.

Post general journal entries to the ledger accounts.

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The Accounting Cycle

Steps performed at the end of the accounting period:

Prepare the trial balance to make sure that debits equal credits.

Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include:

posting of the wrong amount, omitting a posting, posting in the wrong column, or posting more than once.

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The Accounting Cycle

Prepare adjusting entries to record accrued, deferred, and estimated amounts.

Post adjusting entries to the ledger accounts. Prepare the adjusted trial balance. This step is similar to the

preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found.

Prepare the financial statements. Income statement: prepared from the revenue, expenses, gains,

and losses. Balance sheet: prepared from the assets, liabilities, and equity

accounts. Cash flow statement: derived from the other financial statements

using either the direct or indirect method.

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The Accounting Cycle

Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses.

Post closing entries to the ledger accounts. Prepare the after-closing trial balance to

make sure that debits equal credits. Prepare reversing journal entries (optional).

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The Accounting Cycle

Section 2The Fundamental Accounting Equation

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The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:

Measure how the company has been doing (income statement)

Show where it stands financially at the end of the period (balance sheet)

Summarize transactions with its owners (statement of retained earnings or statement of owners’ equity).

One further extension allows us to summarize balance sheet changes (statement of cash flows).

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The accounting equation as a framework for financial reporting

Assets = Liabilities + Owner’s Equity

The resources owned by a

business

The Accounting Equation

Assets = Liabilities + Owner’s Equity

The rights of the creditors, which

represent debts of the business

The Accounting Equation

Assets = Liabilities + Equity

The residual worth

The Accounting Equation

Assets = Have Economic resources owned by the organization

that are expected to be of benefit to it in the future

Rights owed that have a monetary value e.g. right to collect fees

Cash. Office supplies, inventory, furniture, land and buildings

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The Fundamental Accounting Equation

The Basic Logic of the Equation: What you have minus what you is what you are worth.

Grouping of assets for presentation on Financial Reports:

Very liquid – cash and securities Assets for immediate use - inventory Productive Assets – plant and machinery Accounts receivable Fixed Assets – capital holdings Restricted Assets – non-mission holdings or

assets held subject to highly restrictive conditions.

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The Fundamental Accounting Equation

Liabilities = Owe Outsider claims which are economic

obligations payable to outsiders Outside parties are called creditors

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The Fundamental Accounting Equation

Equity = Value to Owners = Worth = Net Debt Insider claims to the organization’s assets From a public sector perspective, it reflects the public holdings

that remain after transactions – these can be both assets and debts

An owner has a claim to the entity’s assets because he or she has invested in the business

Amount of an entity’s assets that remain after the liabilities are subtracted

Often referred to as net assets Governments will refer to this portion often as Non-Financial

Assets/Debt

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The Fundamental Accounting Equation

Section 3Recording Financial Information

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Recording Financial Information

A financial event is one that affects the fundamental accounting equation by changing any of its components:

Assets = Liabilities + Net Assets

A journal is a chronological listing of every financial event that occurs in an organization.

Every type of asset, liability, revenue, or expense is referred to as an account. Organizations may have as many accounts as they need.

From journal to general ledger

Journal: chronological Ledger: analytical Journal entries are

posted (copied), line by line, to corresponding account in the general ledger

Use a T-account to represent an account

Account nameDebit

Creditxxx

xxx25

Financial events are recorded as a series of debits and credits Increases in assets are recorded by debits and decreases are recorded by credits.

Increases in liabilities and in owner's equity are recorded by credits and decreases are recorded by debits.

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Recording Financial Information – Debits and Credits

Notice that the debit and credit rules are related to an account's location in the balance sheet. If the account appears on the left-hand side of the balance sheet (asset accounts), increases in the account balance are recorded by left-side entries (debits).

If the account appears on the right-hand side of the balance sheet (liability and owner's equity accounts), increases are recorded by right-side entries (credits).

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Recording Financial Information – Debits and Credits

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Debits, Credits and the T-Account

Increases are recorded on one

side of the T-account, and decreases are

recorded on the other side.

Left or

Debit Side

Right or

Credit Side

Title of Account

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Debit Credit

A debit in an increase in an asset item; a decrease in a claim or expense item

A credit is an increase in a claim item; a decrease in an asset or revenue item.

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A = L + NAASSETS

Debit for

Increase

Credit for

Decrease

NET ASSETS

Debit for

Decrease

Credit for

Increase

LIABILITIES

Debit for

Decrease

Credit for

Increase

Debits and credits affect accounts as follows:

Debit and Credit Rules

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A Sample Transaction Suppose an agency buys inventory for $2,000. We could just

add it to assets. But, that puts the Fundamental Equation out of balance.

Assets = Liabilities + Net AssetsSupplies

$2,000 = no change + no change

We have not paid for the supplies. Suppose the seller sent a bill. We would record the full transaction as:

Assets = Liabilities + Net Assets

Supplies Accounts Payable + $2,000 = + $2,000 + no

change To record a financial event, at least two elements of the

fundamental equation must change.

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Supplies Accounts Payable

Debit DebitCredit Credit

$2000 $2000

Asset

Account

Liability

Account

Debits = Credits

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A One-Sided Change Example

Not every financial event (transaction) results in changes to both sides of the fundamental equation. Suppose the agency paid for the inventory in cash. Then the transaction would have been recorded as follows:

Assets = Liabilities + Net Assets

Inventory Cash + $2,000 - $2,000 = no change +

no change The fundamental equation is still in balance. But, all of the

changes occurred on the left side of the equation.

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Supplies Cash

Debit DebitCredit Credit

$2000 $2000

Asset

Account

Asset

Account

Debits = Credits

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Recording Transactions

The first step in recording a transaction is determining what has happened and what accounts will be impacted.

Suppose near the end of the year, the agency buys a one-year insurance policy for $100 and pays for the policy in cash. Two things have happened:

- Cash has gone down by $100.- The agency owns a new $100 asset called "prepaid

insurance." Here's the way the transaction would be recorded:

Assets = Liabilities + Net Assets

P/I Cash + $100 - $100 = no change + no change

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Another Example

The agency mails a cheque to its bedpan supplier for $2,000 to pay part of the $7,000 it owed them at the start of the year. Two things have happened:

- Cash has gone down by $2,000.- The agency’s accounts payable have decreased by $2,000.

Here's the way the transaction would be recorded:

Assets = Liabilities + Net Assets

Cash = Accounts Payable - $2,000 = - $2,000

+ no change

Debit

Credit

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A Non Transaction

A hospital signs a binding contract to buy an X-Ray machine that will cost $50,000.

This event will not give rise to a journal entry because it does not meet its rules for recognition.

- The value of the transaction is known.

- The timing of the transaction is known.

- But, the hospital does not yet own the equipment. There has been no exchange. So the hospital does not owe the money. No liability unless we owe the creditor.

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“A person should not go to sleep atnight until the debits equaled the credits”

Friar Luca dal Bargo, founder of modern accounting, 1450

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“Never call an accountant a credit to his profession; a good accountant is a

debit to his profession.” – Sir Charles Lyell.

Section 4

Financial Statements

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Balance Sheet/ Statement of Financial Position

Income Statement/ Statement of Operations

Statement of Change in Net DebtStatement of Cash Flows

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Core Financial Statements

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Describes where the

organization stands at a

specific date.

Income Statement

Balance Sheet

Statement of Cash Flows

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Depicts the revenue and

expenses for a designated

period of time.

Income Statement

Balance Sheet

Statement of Cash Flows

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Depicts the ways cash has changed during

a designated period of time.

Income Statement

Balance Sheet

Statement of Cash Flows

Statement of Financial Position or The Balance Sheet

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The Balance Sheet reports:

Has Today = Owes today + Worth today

A Snapshot in time

AssetsCash $ 40Accounts receivable 100Land 200

Total assets $340

LiabilitiesAccounts payable $ 50Notes payable 150

$200Owners’ EquityCapital stock $100Retained earnings 40

$140 Total liabilities and owners’ equity $340

Sample Balance Sheet

Must Equal

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Current and Long-Term Assets Assets on the balance sheet are divided into

current or short-term (those that are cash or cash-equivalents or are expected to become cash or will be used up within twelve months) and long-term (those that will not).

Short-Term or Current Assets are listed in order of declining liquidity and normally include:

- cash and cash equivalents,- marketable securities,- accounts receivable,- inventory, and- prepaid expenses (long-term prepaid

expenses are called Deferred Charges)

The ultimate liquid assets Includes all forms of immediately available

funds, including bank deposits Always denominated in Canadian funds even

if foreign currencies being held

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Cash and Cash Equivalents

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Marketable Securities

Marketable securities include equity and debt instruments that can be bought and sold in public and private markets.

The values of marketable securities are reported by governments and not-for-profit organizations at fair market value.

If there is any dispute about fair market value, then cost is used to provide a value.

When an organization produces a product, service or obligation for another entity and it is transferred to the entity, the organization acquires the right to collect the money from that entity – this establishes a receivable account

An accounts receivable entry is made when this occurs but before the entity pays for it

Knowing what the outstanding accounts receivable are for the organization is an important indicator of its anticipated income, the degree to which is it efficiently collecting for its services and the degree to which it is carrying debt that it should collect

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Accounts Receivable

Inventory is both the finished products held by the organization for sale to an outside buyer and the products used to make the finished product

Three kinds of inventory: Raw material inventory Work-in-progress inventory Finished goods inventory

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Inventory

This becomes an accounts

receivable when it is sold and cash

when the customer pays for it.

Financial obligations that the organization has already paid for but not yet received

Examples are: insurance, rent, deposits made with suppliers, salary advances

They are current assets not because they can be turned into cash, but because the organization will have to use cash to pay for them in the near future and they are generally available for consumption within the twelve month period

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Pre-paid expenses

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Long-Term AssetsLong-Term Assets are generally divided into

three categories:1. Fixed Assets, which include:

1. property (land) usually recorded at cost,

2. plant (buildings) recorded at cost and reported at net book value, and

3. equipment recorded at cost and reported at net book value

2. Investments, and3. Intangibles

Productive assets not intended for sale. They will be used over and over again to

produce value to the end product of the organizations

Commonly include land, buildings, machinery, equipment, furniture, vehicles, etc.

Normally reported on Balance Sheet in Net Fixed Asset format: listed at original cost minus an allowance for depreciation

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Fixed Assets

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Net Fixed Asset Determination

Recorded at cost when acquired. Reported net of accumulated depreciation on the

balance sheet.Suppose an organization buys a van for $30,000 and expects to use it for five years and sell it for $5,000. Assuming that the van will be used up evenly over the five years, how would its value appear on the balance sheet at the end of two years?

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A Net Book Value Example

Subtract two years of depreciation[($30,000 - $5,000 salvage)/5 yr. life] x 2 = $10,000

Record the Van at Cost = $30,000

Net Book Value =$30,000 cost - $10,000 Accumulated Depreciation = $20,000

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Fixed Assets on the Balance SheetAll three values - cost, accumulateddepreciation, and net book value are shown.

Museum A Museum B

Are these two museums really similar or different?

Net Fixed Assets orNet Book Value $1,000,000 $ 1,000,000Property, Plant & Equipment at cost $40,000,000

$ 2,000,000

Accumulated Depreciation (39,000,000) (1,000,000)

Net Book Value $ 1,000,000 $ 1,000,000

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Recognizing Asset Transactions Financial events are recorded at the time of Recognition

Asset transactions are recognized when:- they are owned by the organization,- they have a monetary value,- that monetary value can be objectively

determined.

Which of the following should be recognized as assets? the amount due on a bill sent to a

client? an overhead projector? a fundraising mailing list developed in an

organization?

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Recognizing Asset Transactions

Intangibles, intangible assets, knowledge assets and intellectual capital are more or less synonyms. All are widely used – intangibles specifically in the accounting literature, knowledge assets by economists and intellectual capital predominantly in the management literature.

Intangibles create future value. All intangibles are future-oriented.

Rule of quantification – slippery slope of quantification

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Can Intangible Assets Appear on a Balance Sheet?

Good will and knowledge assets………which represents the amount by which the price of an acquired company exceeds the fair value of the related net assets acquired.

This excess is presumed to be the value of the company’s name and reputation and its customer base, intellectual capital, and workforce.

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Can Intangible Assets Appear on a Balance Sheet?

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Liabilities Liabilities are economic obligations of the

organization such as money that it owes to lenders, suppliers, employees, etc.

Like assets, liabilities are categorized as short term and long term depending on when they are due for payment.

Can be categorized and groups for presentation on the balance sheets by:

To whom the debt is owned and Whether the debt is payable within the year

Generally consist of: specific "payables" which are typically due within a

specified period, usually the current fiscal year, e.g. wages or salary payable

Generally have the following groupings: Accounts payable to suppliers Accrued expenses owed to employees and other for

services Current debt owed to lenders Taxes owed

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Short-term or current liabilities

Monetary obligations similar to accounts payable Some flexibility on how these categories are

used Generally accrued expenses involve financial

obligation within the organization Therefore, this often records salary earned but

not yet paid, interest due but not yet paid on bank debt, pension buy-outs, outstanding training costs

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Accrued Expenses – Wage Payable

Obligations to pay, generally to other organization for material sand equipment bought on credit, that must soon be paid

When it receives materials, the organization can either pay for them immediately with case or wait and let what is owed become an account payable

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Accounts Payable

Short-term obligations that are payable in a year or less

Brings in long-term obligations, but only the amount to be spent within the year to discharge it

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Notes Payable/Current Portion of Debt

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Long-Term Liabilities

Long-Term Liabilities included in Liabilities section is the current portion of the long-term liability that would have to be paid in the next 12 months:

- Long-Term Debt,– Capital Leases– Long-Term Unsecured Loans– Mortgages– Bonds Payable

- Pension Liabilities, and- Contingent Liabilities.

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Liability Recognition

Liabilities are recognized when: they are legally owed, have to be paid, and the amount to be paid can be objectively

measured. Which of the following should be recognized as

a liability? a bill received from a vendor? wages that are due to a worker? a $5 million lawsuit filed against an

organization?

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Equity/Net Asset Categories The amount of total assets minus total liabilities equals

equity. Because equity is equal to the net difference between

assets and liabilities, it is also called net assets. The net worth of an organization represents the sum of

the organization's earnings from inception plus any paid-in capital

Retained earnings/ accumulated surplus/deficit: money that is held after all liabilities have been discharged and not used for assets

Net debt is the accumulated debt of a government that it carries forward from one year to the next.

The Income Statement or Statement of Operations

Also called Activity Statement, Statement of Revenues and Expenses

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Reports on all changes in financial position in the organization in a given period

Statement of cash movement for a specific period of time, usually a quarter, month or year – a specified period of time.

Unlike a Balance Sheet which is a snapshot of a specific day Can be the most important in reading into the activities of the

organization, its ability to meet obligations and ability to stay within budget

Key tool in financial control and budgetary management: used to inform of current financial situation, identify surplus/deficits, measure performance

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What is a Statement of Operations?

Basic Income Statement Formula

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Revenues – Expenses = Net Income (Net Loss)

represent inflows that the organization has received or is entitled to receive.

result in an inflow of Assets to the organization and an increase in Net Assets.

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The Income Statement: Revenues and Support

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Recognizing Revenue and Support Revenue is recognized if:

- the goods or services have been provided,- the amount to be collected can be objectively

measured, - there is a reasonable likelihood of collection.

Support is recognized if:- all of the conditions of the gift have been met,- the value of the pledge can be objectively

measured, and- there is a reasonable likelihood of collection.

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Recognizing ExpensesExpense Recognition depends on the type of expense:

- Product costs are those directly connected to providing goods and services. They are recognized based on the matching principle, which holds that expenses should be recorded in the same period as the revenue they were used to generate.

- Period Costs, like rent, are those related to the passage of time. They are recognized in the time period they are incurred.

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Deferred Revenue Deferred or unearned revenues arise when an

organization is paid in advance for goods or services. Deferred usually long term, Unearned usually short term.

- Why is deferred revenue a liability to an organization? A museum sells a five-year membership for $250.

- How much of the $250 should be recorded as deferred

revenue?

- How much of the $250 would the museum recognize as revenue during the first year of the membership?

Has to provide basis of comparison: Compare to previous years Compare to budget

As statement of flow, reflects what actually happened over the year

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Statement of Operations: Key to Understanding Performance

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Increase (Decrease) %

ENROLMENTElementary 34,531.73 34,499.35 -32.38 -0.1%Secondary 18,034.02 18,088.30 54.28 0.3%

Total Enrolment 52,565.75 52,587.65 21.90 0.0%

OPERATING REVENUEGrants for Student Needs 498,520,530$ 498,641,782$ 121,251$ 0.0%Prior Year Grants (66,509) (66,509) Other Grants 4,613,718 6,879,161 2,265,443 49.1%Other Revenues 3,494,858 3,860,856 365,998 10.5%Continuing Education Other 5,366,511 4,577,934 (788,577) -14.7%

OPERATING REVENUE 511,995,617$ 513,893,224$ 1,897,607$ 0.4%

OPERATING EXPENDITURES 517,273,902 517,019,109 (254,793)$ 0.0%

(5,278,285)$ (3,125,885)$ 2,152,400$ -40.8%

EXTRAORDINARY ITEMS:

Extraordinary Items -$ 1,170,365$ 1,170,365$

(5,278,285)$ (1,955,520)$ 3,322,765$ -63.0%

5,278,285$ 1,955,520$ (3,322,765)$ -63.0%

-$ -$ -$

UTILIZATION OF AS-AFC

Balance

Variance2010-11 Revised

Estimates2010-11Actual

Results

(DEFICIT) before Extraordinary Items

SURPLUS (DEFICIT) after Extraordinary Items

2010-11 Financial Operating Results

York Catholic District School Board

2010-11YEAR END FINANCIAL REPORT

Cash Flow Statements

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Links Balance Sheet and Income Statement elements to change in cash position.

Integral part of holy trinity of financial statements

Undoes some accrual accounting adjustments underlying the income statement.

Presents cash flows logically organized by source or type of activity generating the cash flows.

403MSBASOCF.ppt81

Statement of Cash Flows

The Cash Flow Statement shows: Cash on hand at the start of the period Cash received in the period Cash spent in the period Cash on hand at the end of the period

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The Cash Flow Statement

Why does an organization need both an operating statement and a cash flow statement? Cash flow statements provide vital budget to plan information in

purely cash terms Cash flow information gives you information on your budgetary

flexibilities and also on the actual cash performance versus the predicted one for cash/budget management purposes

Why is it important to know the sources and uses of cash flow? This will depend on the nature of the organization – less so with

single source (budget funds) of cash Isn't knowing if cash increased or decreased enough?

No, source and availability are important

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The Cash Flow Statement

The Example OrganizationStatement of Cash Flows

December 31, 2011

Cash Flows From Operating Activities:Receipts 48 Payments (43) 5

Cash Flows From Investing Activities:Receipts 0 Payments (4) (4)

Cash Flows Used By Financing Activities:Receipts 10 Payments (6) 4

Net Cash Flow 5

Notes to the Financial Statements

Four general types of notes:Summary of significant accounting policies:

assumptions and estimates.Additional information about the summary

totals.Disclosure of important information that is

not recognized in the financial statements.Discuss concentrations of risk, commitments

and contingencies, related party transactions, and other significant items

Statements that project likely financial results based on known policies and projections

Projected financial position, operations and cash flows

Unlike financial statements, this is prospective, based on a planned course of action

Common in private sector – emerging in public sector

Requirement for all federal departments 86

Future Oriented Financial Statements

Section 5: Ratios and Financial Analysis

Financial Analysis

Two Objectives• Measure financial condition• Measure financial performance

Financial Analysis

Horizontal Analysis: Looks at trends in performance and strength over time

Vertical Analysis: Looks at within year events rather than over time

Ratio Analysis: Allows for consistent comparison of a single unit over time as well as comparison between units

Five Criteria Being Looked AtLiquiditySolvencyProfitabilityFinancial EfficiencyRepayment Capacity

Liquidity: Ability of an entity to pay current liabilities as they come due

Current Ratio• Current Assets/Current Liabilities• Less than one is bad

Working capital• Current assets minus current

liabilities• Negative number is bad

Solvency: Ability of an entity to repay all of its financial obligations

Debt to Asset Ratio• Total liabilities/total assets• Greater than one bad

Equity to Asset Ratio• Total equity/total assets

Debt to Equity Ratio• Leverage ratio• Less than one better

Profitability

Rate of return on assetsRate of return on equityOperating profit margin ratio

Limited government application, but viable in both government enterprises and not-for-profits

Financial Efficiency: the intensity with which an entity uses its assets to generate results and the effectiveness of production

Asset turnover ratioOperating expense ratioDepreciation ratioInterest expense ratioNet income from operations ratio

Repayment Capacity: Measures the borrower’s ability to repay term debts and capital leases rather than financial position or performance

Term debt and capital lease coverage ratio

Capital replacement and term repayment margin

Cautions

Measures are only as good as the data usedMethods must be consistent between years

and between operations• Example – Asset valuation methods

Measures ask the right questions but do not provide the answers

Federal debt as a % of GDP Revenues as a % of GDP Interest ratio: public debt charges as a % of

revenues

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Key Macro Ratios the Federal Government Now Tracks in its Financial Statements

Source: https://www.fin.gc.ca/afr-rfa/2013/report-rapport-eng.asp

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Are we having fun

yet?