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Whether investors are interested in individual securities or mutual funds, it is impor-tant that they understand the factors that affect the securities (or underlying securi-ties) in which they are investing. Intelligent investors comprehend how a company is

formed and financed. They must be able to read a company’s financial statements, know whatinformation to look for and what it tells them about their investment.

The first part of this chapter will focus on the corporation and how it raises investment capitalthrough the issuing of debt and equity. It will demonstrate why equity markets exist, and howindividuals can invest in the share capital of these organizations.

The second part of the chapter will illustrate and explain the four key financial statements foundin all corporate annual reports: the balance sheet, the earnings statement, the retained earningsstatement and the cash flow statement.

A. TYPES OF BUSINESS STRUCTURESThere are three forms of business organization: sole proprietorships, partnerships and corpora-tions. A sole proprietorship involves one person running his or her own business and the indi-vidual is taxed on earnings at their personal income tax rate. While the individual profits if theventure is successful, he or she is also personally liable for all debts, losses, and obligations aris-ing from the business activity beyond the assets held in the business. While the sole proprietor-ship is not regulated to the extent of other forms of business organization and the proprietor isfree to make decisions, resources are limited for acquiring capital and expertise.

A second form of organization is the partnership, which involves two or more persons con-tributing to the business, whether it be capital or expertise required to run the enterprise. Thisform of business organization is legislated under the Partnership Act. There are two forms ofpartnership agreements: general partnership and limited partnership. While the general part-ners are involved in the day-to-day operations and are personally liable for all debts and obliga-tions incurred in the course of business, a limited partner cannot participate in the daily businessactivity and liability is limited to the partner’s investment.

In both the sole proprietorship and the partnership there is unlimited personal risk to the pro-prietor or general partner(s): these owners are personally liable to the creditors of the businessfor all the debts of the business.

Proprietorships and partnerships have limited ability to grow and expand. For example, while apartnership might have been able to operate a stagecoach to transport goods and people betweenlocal towns many years ago, it would not have been able to fund the construction of ships tocross oceans or the building of railways to cross continents. The need for capital helped lead tothe development of the third type of business organization, the corporation.

A corporation is unique in that it is a distinct legal entity separate from the people who own itsshares. Corporations pay taxes and can sue or be sued in a court of law. Property acquired by thecorporation does not belong to the shareholders of the corporation, but to the corporation itself.The shareholders have no liability for the debts of the corporation and there can be no addition-

Chapter 4

Corporations and their Financial Statements

© CSI Global Education Inc. (2005)

PRE-TEST

al levy on shareholders if the debts of a bankrupt corporation exceed the value of itsrealizable assets. In addition, corporations are able to raise funds by issuing equity ordebt, and are thus more suitable for large business ventures than proprietorships or part-nerships.

B. INCORPORATED BUSINESSES1. Government Approval

Although corporations form a small percentage of the total number of businesses, theyattract a large proportion of the total capital invested. The basic procedure for incorpo-ration is for one or more persons to file documents with the appropriate department ofeither the federal or a provincial government and pay the required fees. The governmentwill issue a charter, the document under which the corporation comes into existence, inthe form of letters patent, memorandum of association, or articles of incorporation. Thecharter usually includes such information as the corporate name, date of incorporation,the location of the registered office, any maximum authorized capital, the characteristicsof the shares, the restrictions, if any, in the business the corporation may carry on, thetransfer of shares, etc.

A corporation’s name must include the words limited, corporation, or incorporated (orabbreviations thereof or French equivalents). Certain enterprises must be incorporatedunder a specific statute dealing only with that type of business. For example, charteredbanks can only be incorporated under the federal Bank Act. Some specific enterprisesmay require a special act of incorporation to be passed by the federal or provincial gov-ernment for each individual enterprise. A corporation formed by a special act might nothave the word limited (or equivalents) included in its name.

2. Choice of Jurisdiction

Once a decision has been made to incorporate, the jurisdiction of incorporation mustbe selected. In most cases the choice will be whether to incorporate under the laws ofthe province where the corporation’s chief place of business will be located or to incor-porate federally under the Canada Business Corporations Act (CBCA).

One factor in this decision is how the differences in the law governing a provincial anda federal corporation will affect the affairs of the particular business. Depending uponthe province, some of these differences may be the method of incorporation, provincialtax rates, corporate names available, requirement of directors to be Canadian residents,minimum age of the applicants, necessity of holding formal meetings, number of direc-tors and filing of financial statements.

A provincially incorporated corporation can carry on business in the province of incor-poration, but may need a further license or registration to carry on business in otherprovinces.

A federally incorporated corporation is subject to the laws of general application in aprovince and may have to register there, but no provincial law may discriminate againsta federal corporation so as to deprive it of the powers conferred on it by the federal gov-ernment.

Generally, unless the law of one jurisdiction gives some particular benefit, solicitors usu-ally recommend that corporations that will carry on business within one province beincorporated provincially and corporations that will operate across the country be incor-porated federally.


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3. Public and Private Corporations

Historically, corporations have been divided into two types:

• Private Corporations which have in their charters a restriction on the right ofshareholders to transfer shares, a limitation on the number of shareholders to notmore than 50, and a prohibition on inviting members of the public to subscribe fortheir securities; and

• Public Corporations which are incorporated without such restrictions.

The Canada Business Corporations Act (CBCA) and many provincial acts no longermake this distinction. However, the distinction is still relevant for the purposes ofthe securities statutes, which provide exemptions for private corporations. All corpo-rations whose shares are listed on a stock exchange or traded over-the-counter arepublic corporations.

4. The By-laws

A corporation is regulated by:

• The federal or provincial act under which its charter is issued;

• Its own charter; and

• Its by-laws.

A general by-law is prepared at the time of incorporation and contains rules that governthe conduct of the corporation. By-laws are passed by the directors and approved by theshareholders. Provisions in the by-laws usually deal with items such as:

• Shareholders’ meetings – the time, place and method of notifying shareholders, thedate as of which the list of shareholders eligible to vote shall be made up, the num-ber constituting a quorum, and the procedures for proxy votes;

• Directors’ meetings – the time, place and method of notifying directors and thequorum;

• Qualification, election and removal of directors;

• Appointment, duties and remuneration of officers;

• Declaration and payment of dividends;

• Date of fiscal year-end; and

• Signing authority for documents.

5. Voting and Control

Through the right to vote at the annual meeting and at special or general meetings,shareholders exercise their rights as owners to control the destiny of the corporation.They elect the directors who guide and control the business operations of the corpora-tion through its officers. Many matters of an unusual, non-recurring nature, such as thesale, merger or liquidation of the business and the amendment of the charter mustreceive shareholder approval before action is taken. To vote, an individual must haveshares registered in his or her own name or be in possession of a completed proxy form.

Usually each common shareholder has one vote for each share owned. If there were ninedirectors being elected, each shareholder may cast a ballot for each of the nine personsto be elected, with a vote equal to the number of shares the shareholder owns. Underthis system, one or more shareholders controlling more than half of the total number ofvoting shares can determine every question and elect all the directors. The result is con-trol by those holding a majority of the voting shares and not necessarily by the majority

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in number of shareholders. If the voting shares are widely held (i.e., held by manyshareholders), a corporation may be controlled by a shareholder or a group of share-holders owning substantially less than 50% of the voting shares.

A corporation’s charter may provide that different classes of shares may vote separatelyfor a certain number of directors. Some classes of shares have no voting rights. Otherclasses of shares have multiple voting rights. The use of non-voting and multiple votingshares by control groups to retain control has increased steadily over the last 20 years.

6. Shareholders’ Meetings

All shareholders must be given the opportunity to receive materials relating to meetingsof shareholders, including proxies and audited (or unaudited) annual financial state-ments, and to attend and to vote at the meetings. Shares may not be voted by interme-diaries (including investment dealers) unless instructions have been given by the share-holder to do so.

Shareholders ordinarily take action as a group only at corporate meetings after propernotice has been given and in accordance with the by-laws. In the case of a regular meet-ing, the list of eligible shareholders is prepared as of a certain date prior to the meetingand shareholders are notified of the meeting within a specified time period. At theannual meeting, they elect the directors, appoint independent auditors (or accountants),receive the financial statements and the auditor’s (or accountant’s) report for the preced-ing year and consider other matters regarding the company’s affairs. Special meetingsmay be called for any matter that requires attention prior to the next annual meeting.

7. Voting by Proxy

As we learned in Chapter 3, a proxy is a power of attorney given by a shareholder thatgives a designated person the authority to vote the shareholder’s stock at a shareholders’meeting. Under the federal act and many provincial acts, the proxy holder need not be ashareholder of the company. A proxy is given for one meeting and all adjournmentsthereof. A wider power of attorney may give authority to vote at all meetings for a stat-ed period. Proxies are always revocable.

Sending proxies to company shareholders is compulsory. A proxy form and an informa-tion circular must accompany the notice of a shareholders’ meeting which is sent to allshareholders. The information circular sent with the notice of the annual meeting mustcontain details about proposed directors, directors’ and officers’ remuneration, interestof directors and officers in material transactions, the appointment of auditors and par-ticulars of other matters to be acted upon at the meeting.

At the annual shareholders’ meeting of a public corporation, enough shareholders haveusually signed proxy forms appointing the management nominees as their proxy thatthe management is able to carry any resolution it wishes. Most resolutions are passed asa matter of course with or without significant prior discussion. Even in these circum-stances, where individual shareholders have no real chance to defeat a management pro-posal, the meeting can be a valuable opportunity for shareholders to question manage-ment and to make their views known.

In many public corporations the management group itself does not own a large percent-age of the issued shares and may be dependent upon the support of the shareholders atlarge. In such circumstances there is always the possibility of a contest for control of thecorporation, with both the management group and the challengers actively seekingproxy support from the shareholders at large before the meeting. Although such ‘proxyfights’ are rare, they can lead to the removal of the existing management if enoughshareholders lend support to the challengers.



8. Voting Trusts

A corporation that is undergoing a restructuring due to financial difficulties may beplaced under the control of a few individuals through a voting trust. The voting trust isusually put into effect for specific periods of time, or until certain results have beenachieved. It is used because financiers may be willing to inject new capital only if theycan be assured of control to protect their investment until there is a recovery in the for-tunes of the corporation.

To transfer voting control, shareholders are asked to deposit their shares with a trustee,usually a trust company, under the terms of a voting trust agreement. The trustee issuesa voting trust certificate, which returns to the shareholder the same rights, possessed bythe original shares, with the exception of the voting privileges, which remain with thetrustee.

9. Directors

To qualify as a director, an individual must be of the age of majority, of sound mindand not an undischarged bankrupt. The legal age of majority is 19 in BC, Nova Scotia,Newfoundland New Brunswick the Yukon, the Northwest Territories and Nunavut. Allother provinces are 18. In Quebec, the Civil Code creates a specialty status of “emanci-pated minor” who is under 18, who by marriage or court order, is emancipated to per-form certain acts if he had attained his majority. Most corporations acts require that acertain number or proportion of the directors of a public corporation not be officers oremployees of the corporation or any of its affiliates.

The directors exercise their functions at periodic meetings largely by setting policies andsupervising the work of the officers. Directors act by passing resolutions, which areapproved at directors’ meetings or, in some jurisdictions, by the signatures of all direc-tors. They are normally responsible for:

• The appointment and supervision of officers;

• The appointment of signing authorities for banking;

• The authorization of important contracts; the approval of budgets, financing andplans for expansion;

• The decision to issue shares; and

• The declaration of dividends and other disposition of profits.

Directors may be liable for illegal acts of the corporation done with their knowledge andconsent. They may be responsible for dividends that are improperly declared, as well asup to six months of wages of the employees of the corporation. Directors are also liablefor unremitted Goods and Services Tax (GST), Provincial Retail Sales Taxes (RST) andEmployee Payroll Deductions at Source (ETD). They must be aware of potential con-flicts of interest and may not profit from transactions entered into with the corporationwithout the appropriate disclosure. Directors must act honestly, in good faith and in thebest interests of the corporation. Many corporations’ statutes require that directors mustalso exercise the care, diligence and skill that a reasonably prudent person would exercisein comparable circumstances. Recent court decisions also indicate that directors areexpected to be actively involved in the proper conduct of their duties.

In addition to liability in private law and under corporations’ statutes, directors and offi-cers may be subject to regulatory sanctions, quasi-criminal prosecution under securitieslegislation, or prosecution under the criminal law. Directors and officers may be liableunder securities statutes for misrepresentations contained in prospectuses and other statu-tory filings such as takeover bid circulars or issuer bid circulars. Insider trading provisions

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in securities statutes also expose directors and officers to possible regulatory and quasi-criminal liability. Securities commissions may order that directors and officers of a com-pany comply or cease contravening securities legislation or administrative orders.Additionally, securities commissions may remove statutory exemptions to prevent certainpersons from trading in securities. Securities commissions in some jurisdictions areempowered to order that a director or officer resign his position and may prohibit suchpersons from becoming a director or officer of a company for a stated period.

10. Officers

Corporations acts authorize the directors to designate the offices of a corporation and toappoint officers and specify their duties, subject to the by-laws. In contrast to the direc-tors, the officers are corporate employees responsible for the day-to-day operation of thebusiness. Through them, the lines of authority descend until they reach the lowestranks.

There are no legal restrictions which require the corporation to group its operationalactivities in any special way. Size, nature of the industry and geographic concentrationof the corporation’s plants are all factors that influence the organizational structure.

Officers hold office until the annual meeting following their appointment or untilremoved by the directors. Although the by-laws of individual corporations usuallyspecifically set forth the responsibility and authority of the officers, most public corpo-rations use the following structure.

a) Chairman of the Board

The chairman of the board is elected by the board of directors and may have all or anyof the duties of the president or any other officer of the corporation. Depending on thedivision of duties and authority, either the chairman of the board or the president maybe the chief executive officer. The chairman of the board presides over meetings of theboard and generally exerts great influence on the management of the affairs of the cor-poration. Chart 4.1 provides an example of a typical corporate structure.

b) President

The president is appointed by and responsible to the board of directors. The presidentexercises authority through the other officers and through the heads of departments ordivisions. If the job of president is not combined with that of the chairman, the presi-dent may act as chairman in the latter’s absence.

c) Executive Vice-President

The “second in command” is often an executive vice-president who may be the chiefoperating officer.

d) Vice-Presidents

Vice-presidents are appointed to head specific areas of the corporation’s operations suchas sales or finance. Some corporations appoint both senior vice-presidents and vice-pres-idents. The number of vice-presidents varies widely according to each corporation’s sizeand requirements.



CHART 4.1

Simplified Organization Chart of a Hypothetical Corporation

*Many Boards of Directors elect Executive Committees, Finance Committees and Audit Committees

11. Financing the Corporation

a) Equity Financing

The money to start a corporation is often raised by issuing common shares for cash topersons who thus become the initial shareholders of the corporation. The commonshares usually carry the right to vote at shareholders’ meetings.

In many cases, charters also authorize another class of shares, sometimes called preferredor special shares, which may be non-voting but have a special status compared to thecommon shares in terms of dividends, distribution of assets in liquidation, etc. In largercorporations there may be several classes of preferred shares with different features.

Both common shares and preferred shares form the company’s capital stock or equitycapital.

Authorized, Issued and Outstanding Shares

Authorized shares refer to the maximum number of common (or preferred) shares thatthe corporation may issue under the terms of its charter. Usually more shares areauthorized than issued to shareholders so that the corporation may raise additionalfunds in the future by issuing more shares. A corporation may amend its charter toincrease or decrease the number of authorized shares. In recent years, corporations’ actshave made it possible to provide for an unlimited number of shares which may beissued for an unlimited amount of money.

Example: The charter of ABC Inc. indicates that it has 1,000,000 commons sharesauthorized. The company’s balance sheet would show the following:

Common Shares – Authorized 1,000,000 shares of no par value

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Issued shares refer to that part of the authorized shares that have been issued by the cor-poration. A corporation is not required to issue all of its authorized shares. In a relatedway, outstanding shares refer to that part of the issued shares which remain outstandingand owned by the shareholders of the company. Issued and outstanding shares are oftenused interchangeably.

The capital stock section of the balance sheet shows the number of shares a companycurrently has issued and outstanding. From time to time a corporation may redeem orpurchase some or all of various classes of its issued shares, which in normal circum-stances would then reduce the number of shares outstanding. If no redemptions orrepurchases of shares are made by the corporation, the total number of shares issued willbe the same as the total number outstanding.

Example: ABC Inc. has 850,000 common shares issued and outstanding. The company’sbalance sheet would show the following:

Common Shares – Authorized 1,000,000 shares of no par value – Issued and outstanding 850,000 shares

The total of a company’s outstanding shares is used to determine its market capitaliza-tion, which is the total dollar value of the company based on the current market priceof its issued and outstanding shares. For ABC Inc., if the shares are currently trading ata price of $10 a share, its market capitalization is $8,500,000.

Public float refers to that part of the issued shares that are outstanding and available fortrading by the public and not held by company officers, directors, or institutions thathold a controlling interest in the company. Public float is different from outstandingshares as it excludes those shares owned in large blocks by institutions (e.g., mutualfunds or pension funds). Investor should be interested in the size of a company’s publicfloat. The smaller the float, the more volatile the price of the stock will be because largebuy or sell orders on the stock can influence its price dramatically. A larger float meansthat the stock’s price would be less volatile.

Example: ABC Inc. has 200,000 common shares held by the company’s officers anddirectors and by large institutions. Its public float is then 650,000 shares (850,000issued and outstanding shares less the 200,000 non-public shares).

Par Value

Some corporations acts provide that shares of a corporation may be designated in thecorporation’s charter as either par value or no par value. However, under the federal andsome provincial corporations acts, shares must be without par value.

The par value of a share is its stated face value most commonly expressed in terms of somany dollars such as $5, $10, $25, $50 or $100 per share. Conversely, no par value(n.p.v.) shares have no such stated face value.

The use of par value shares can be misleading because there is no fixed amount of assetsto which the shares are entitled. There is also no fixed relationship between the parvalue of a share and its current market value. Novice investors can be confused when astock with a par value of, say, $50 is selling at $40 or $60 in the marketplace. Therefore,shares are most often issued without par value, although the shares still have a statedvalue assigned by the company’s board of directors for accounting purposes. In somejurisdictions, shares with a par value (excluding shares of mining corporations) cannotbe issued at a discount from their par value. Thus, a corporation which has issued partof its authorized capital, and wishes to sell some of its remaining authorized but unis-sued shares to raise funds, will find this difficult if the shares are selling in the market at



less than the par value. There is no such set price at which no par value shares must besold. A corporation simply issues them at a price which is attractive to investors, andwill assist in their distribution to the public.

b) Debt Financing

A corporation with a large need for new capital may also undertake debt financing.Unlike equity financing, funds raised by issuing debt securities really represent a loanfrom investors and must be repaid. The two main types of securities used in long-termdebt financing are mortgage bonds and debentures. Other financing methods includebank loans, medium term notes, callable bonds, and convertible bonds. Mortgage bondsare backed by a specific pledge of assets such as land or properties similar to the waythat a mortgage loan on a house is secured by the house itself to protect the lender.Debentures are backed only by the general credit of the corporation. The corporation’sability to repay its obligations is considered sufficient without a specific pledge of itsassets.

c) Other Types of Financing

In practice a corporation also has many other financing alternatives including bankloans, money market borrowing, commercial paper, bankers’ acceptances, leasing, gov-ernment grants and export financing assistance.

12. Advantages of Incorporation

a) Limited Liability of Shareholders

The principle that shareholders of a corporation risk only the amount of money theyhave invested in the corporation’s common shares is an outstanding advantage of thecorporate form of organization. For example, a shareholder who has invested $1,000 ina corporation’s common shares is not liable for additional contributions even if the cor-poration was to go bankrupt and its obligations to creditors far exceeded the value of itsrealizable assets.

b) Continuity of Existence

A sole proprietorship ends when the proprietor dies, and, subject to an agreement to thecontrary, a partnership terminates upon the death or withdrawal of one partner. A cor-poration’s continued existence is not affected by the death of any or all of its sharehold-ers. The shares are simply part of the shareholder’s estate, eventually going to the share-holder’s heirs.

The existence of a corporation is terminated only by imposed acts such as the windingup or the bankruptcy of the corporation itself.

c) Transfer of Ownership

Shareholders of a public corporation can usually transfer their shares to other investorswith relative ease. This liquidity is an attractive feature of share ownership. And,although the ownership of shares may change, the assets of the corporation continue tobe owned by the corporate entity itself.

d) Ability to Finance

The raising of capital by a corporation, through the issue of different classes of sharesand debt instruments, is much easier than for sole proprietorships or partnerships. Thelimited liability feature permits investors to contribute capital with a chance of returnand without further liability. Anyone contributing capital as a general partner can beliable for all the debts of the partnership. A contribution of capital to a proprietorship

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by an outsider may inadvertently cause a partnership to be formed. Of course, it isalways possible to contribute funds to a business organization via a loan, without anyrisk of liability.

e) Taxation

Incorporation may result in tax benefits, in the form of tax deferrals and legitimate taxavoidance. However, corporate taxation is a complex matter and careful analysis by taxprofessionals would be required to establish possible tax benefits.

f) Growth

The corporate form is well suited to handle easily the large amounts of capital needed tooperate large and growing businesses. Also, it is flexible enough to accommodate diverseactivities within a corporate group.

g) Legal Entity

A corporation or a partnership can sue or be sued. A shareholder of a corporation cansue the corporation or the corporation can sue the shareholder. However, a partnershipcannot sue a partner, nor can a partner sue the partnership.

h) Professional Management

Although the shareholders are the ultimate owners of the corporation, they play a verysmall part in the management of the corporation. They elect, through their votingrights, a board of directors who manage the affairs of the corporation. If the directors donot manage the corporation to their satisfaction, the shareholders may elect differentdirectors.

13. Disadvantages of Incorporation

a) Loss of Flexibility

A corporation is subject to many rules imposed by various statutes and the trend istowards an increase in the degree of regulation. Partnerships and sole proprietorshipsoperate almost free of any special statutory regulation. For a corporation to arrange forits earnings to be transferred to its shareholders, formal dividends must be declared andpaid. Changes in the charter and by-laws of the corporation can be complicated andsometimes require formal approval of the government of the incorporating jurisdictionas well as of the directors and shareholders. In a partnership, major changes can usuallybe accomplished with comparative ease.

b) Taxation

The possibility of double taxation arises when the after-tax profits of a corporation aredistributed in the form of dividends to shareholders, who themselves pay tax on theirdividend income. There is no possibility of double taxation in the cases of partnershipsor sole proprietorships.

c) Expense

After the initial cost of incorporation, there are annual costs additional to those incurredin proprietorships or partnerships. Annual returns, audits, preparation of federal andprovincial corporate tax returns, the holding of shareholders’ meetings and, for manycorporations, the requirements of securities laws can result in substantial additionaladministrative costs.



d) Capital Withdrawal

For partnerships and proprietorships, the withdrawal of unneeded capital from the busi-ness is simple. For a corporation, the statutory procedures for the redemption of sharesand purchase of shares by the corporation, when permitted by the applicable statutemust be very carefully followed. Practically, a small investor in a public corporation canwithdraw his or her capital, only by selling the shares.

C. UNDERSTANDING THE BALANCE SHEETFinancial statements are like a scorecard of a company’s operations; they show what thecompany owns and how it was financed, as well as how profitable it was (or the losses itincurred) over a given period, usually a year. The ability to understand and analyze thesestatements effectively is important for anyone who is considering investing in a compa-ny’s stocks or bonds, as it can reveal a great deal about a company’s financial health.

The success or failure of investing in a company’s securities depends on how the compa-ny fares in the future. Future prospects are difficult to forecast with a high degree ofaccuracy, but the past often provides a clue. Thus, if an investor has some knowledge ofa company’s present financial position and its past earnings record, he or she is morelikely to select securities that will stand the test of time. The investor will, of course,need to combine this information with an understanding of the industry in which thecompany operates, the economy in general, and the specific plans and prospects for thecompany in question to make a sound selection from investment alternatives.

1. General Form of the Balance Sheet

The balance sheet shows a company’s financial position at a specific date. In annualreports, that date is the last day of the company’s fiscal year. While many companieshave a fiscal year end that corresponds with the calendar year end, i.e., December 31,this is not always the case. For example, many broadcasting and media companies havean August 31 fiscal year end, while banks and trust companies traditionally end theirfiscal year on October 31. In this instance, October 2003 would be the last month ofthe bank’s “fiscal 2003” while November 2003 would represent the first month of “fiscal2004.”

One side of the balance sheet (often the left side) shows what the company owns andwhat is owing to it. These items are called assets. The other side of the balance sheetshows (1) what the company owes (called liabilities) and (2) the shareholders’ equity ornet worth of the company which represents the shareholders’ interest in the company.Shareholders’ equity represents the excess of the company’s assets over its liabilities.Accordingly, the company’s total assets are equal to the sum of the company’s liabilitiesplus the shareholders’ equity.

Assets = Liabilities + Shareholders’ Equity

Balance sheets are prepared and presented in more or less the same way whether forsmall businesses or large nationally known corporations. One might contain nine itemsand the other forty-nine, but basically they tell the same financial story.

Using the Trans-Canada Retail Stores Ltd. financial statements shown at the end of thischapter as an example, the relationship between items on the balance sheet is shown inTable 4.1

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TABLE 4.1

Simple Balance Sheet

Assets . . . . . . . . . . . . . . . . . .$19,761,000 Liabilities . . . . . . . . . . . . . . . .$ 6,402,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ Equity . . . . . . .$13,359,000

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities and Total Assets . . . . . . . . . . . . . .$19,761,000 Shareholders’ Equity . . . . . . .$19,761,000

The above equation between balance sheet items may alternatively be expressed as:

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$19,761,000

Less: Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6,402,000

Equals: Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$13,359,000

Often shareholders’ equity is referred to as the book value of the company and this rep-resents the total value of the company’s assets that shareholders would theoreticallyreceive if the company were liquidated. However, this item does not necessarily indicatethe amount shareholders will receive for their ownership interest in the event of sale.The market value of the shareholders’ interest may be worth a lot more or less thanbook value, largely depending upon the company’s earning power and prospects.

2. Classification of Assets

Taking each class of asset one by one and in the order in which they are shown in theTrans-Canada Retail balance sheet, we will see what they are and what they tell us aboutthe company.

a) Current Assets (items 1 to 6)

Current assets are cash and assets which can be turned into cash right away or which, inthe normal course of business, will be turned into cash in the near future, i.e., normallywithin one year. Current assets are the most important group of assets because theylargely determine a firm’s ability to pay its day-to-day operating expenses. On the bal-ance sheet, current assets are usually listed in order of liquidity, i.e., those which can beconverted into cash most quickly are listed first, followed by the others.

There are five broad groups of current assets:

• Cash on hand or in the bank;

• Temporary investments – bonds and stocks that can be readily sold for cash;

• Accounts Receivables – money owing to the company for goods or services it hassold. Because some customers fail to pay their bills, an item called allowance fordoubtful accounts is often subtracted from receivables. This allowance is manage-ment’s estimate of the amount that will not be collected. This item is generally notshown separately on the balance sheet but it is assumed that an adequate allowancehas been made.

• Inventories – consists of the goods and supplies that a company keeps in stock. Forexample, a furniture manufacturer that sells chairs to Trans-Canada Retail wouldhave inventories of raw materials (e.g. the fabric and wood used to build the chairs),work-in-progress (assembled chair frames) and finished goods (completed chairsready for shipping).

Inventories are changed by successive steps into cash. Raw materials are processedinto finished goods. Finished goods are sold on 30, 60 or 90 days or longer creditterms and give rise to receivables. These receivables become due and are paid off incash. This process goes on day after day, providing the funds to enable the company



to pay for wages, raw materials, taxes and other expenses and ultimately to providethe profits out of which dividends may be paid to shareholders.

Inventories are valued at original cost or current market value – whichever is lower.If the original cost is used, there are three commonly used methods of determiningthe cost of inventories:

– Average cost of all items in inventory;

– FIFO (first-in-first-out) – items acquired earliest are assumed to be used orsold first (most commonly used method in Canada); or

– LIFO (last-in-first-out) – items acquired most recently are assumed to be usedor sold first (acceptable for accounting but not for income tax purposes inCanada).

Example: A computer company manufactured 1,000 hard drives last month at acost of $125 each and an additional 1,000 units this month at a cost of $150 each.The higher costs are due to rising raw materials prices. The company sells 1,000hard drives today.

Under the FIFO method, the cost of the goods sold is $125 per hard drive becausethat was the cost of each of the first hard drives into inventory. The remaining harddrives would be valued at the more recent and higher cost of $150 each, whichworks out to an inventory value of $150,000 (1,000 hard drives × $150).

Under the LIFO method, the cost of the goods sold is $150 per hard drive becausethat was the cost of the last hard drives into inventory. The remaining hard drivesare valued at the older and lower cost of $125 each, or an inventory value of$125,000 (1,000 hard drives × $125).

As its name suggests, the average cost method uses the average of the total cost ofthe goods purchased over the period on a per unit basis. The total cost of the harddrives is $275,000 [(1,000 × $125) + (1,000 × $150)]. The average cost of theinventory is $137.50 ($275,000 ÷ 2,000 units). The cost of the goods sold is$137.50 and the inventory value on the balance sheet would be reported as$137,500.

As the above example shows, if prices are changing, each of these methods producesa different inventory value on the balance sheet and, consequently, a different profitbased on the costs of the goods sold. As you will learn in the section on the earn-ings statement, the lower cost of goods sold under the FIFO method produces ahigher profit level for the company. On the contrary, the LIFO method reports ahigher cost of the goods sold and this translates into a lower profit for the companyduring a period of rising prices.

• Prepaid expenses – payment made by the company for services to be received in thenear future. Since these prepaid expenses eliminate the need to pay cash for goodsor services in the immediate future, they are the equivalent of cash. Rents, insurancepremiums and taxes, for example, are sometimes paid in advance. For accountingpurposes, their cost is generally spread over the periods during which the companybenefits from this expenditure.

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b) Miscellaneous Assets

Miscellaneous Assets are assets that are neither current nor fixed. The most common are:

• Cash surrender value of life insurance;

• Amounts due from directors, officers and employees of the company;

• Investments of a long-term nature, e.g. investment in, or money lent to, a supplier;and

• Investments in, and advances to, subsidiary and affiliated companies.

c) Property, Plant and Equipment (item 8)

Property, Plant and Equipment (also called capital assets) consist of land, buildings,machinery, tools and equipment of all kinds, trucks, furnishings and so on used in theday-to-day operations of a business. Unlike current assets, which are converted by suc-cessive steps into cash, the value of capital assets to a company lies in their use in pro-ducing goods and services for sale, rather than in their sale value. They are not intendedto be sold.

The proportion of capital assets to total assets of a company varies widely in differenttypes of businesses. The capital assets of a public utility, railway, or pulp and paper com-pany, form a very large part of total assets, while those of an insurance or finance com-pany may be a relatively small proportion of total assets.

Capital assets are shown on the balance sheet at original cost, including installation andother acquisition expenses. Except for land, capital assets are amortized (or depreciated)each year and the total accumulated amortization is deducted from the original cost.The value of capital assets recorded on the balance sheet after the deduction of amorti-zation is called the net carrying amount (net book value) of the assets. If a capital assetis sold, its original cost and related amortization are removed from the balance sheet.The difference between the sale price of the capital asset and that asset’s net carryingamount is a profit (or loss) which is treated as non-operating income (or expense) of thecompany.

Amortization

With the exception of land, capital assets wear out in time or otherwise lose their useful-ness. Between the time when a given asset is acquired and when it is no longer econom-ically useful, a decrease in its value takes place. This loss in value over a period of yearsis known as amortization. With respect to capital assets such as buildings or machinery,some companies use the term depreciation rather than amortization. Likewise, amorti-zation is also used to describe the writing off of intangible assets such as patents ortrademarks.

To spread the cost of capital assets over their years of useful service, companies recordamortization expenses against each year’s earnings. This is done on the grounds that thecapital assets are used in the process of producing goods or services and amortization is,therefore, a cost of doing business, just like wages and other operating expenses.

Amortization applies to the ordinary wearing out of plant and equipment. The amountrecorded as amortization each year is based upon the original cost of each asset, itsexpected life and the probable salvage or scrap value, if any, when it is withdrawn fromservice.

There are several methods by which these amounts can be allocated to each accountingperiod. The method used most frequently in Canada by public companies is thestraight-line method, whereby an equal amount is charged to each period. The declin-ing-balance method is also frequently used. This method applies a fixed percentage (usu-



ally double the straight-line rate), rather than a fixed dollar amount, to the outstandingbalance to determine the expense to be charged in each period. This amount is deduct-ed from the capital asset balance to determine the amount against which the percentagewill be applied in the subsequent period – thus the term declining balance. This methodis used frequently by smaller companies, as it usually agrees with the method of com-puting “capital cost allowance” for income tax purposes. Other methods are available,but are used less frequently.

The example in Table 4.2 shows the calculation of amortization by the straight-line anddeclining-balance methods in a typical case.

TABLE 4.2

Methods of Calculating Amortization

Suppose a piece of equipment bought by XYZ Co. Ltd. at $100,000 is expected to have a useful life ofeight years and a salvage value of $10,000. The annual amortization for this asset utilizing the straight-

line method is:

$100,000 – $10,000 = $11,250—————————

8

and the amortization rate is 12.5% (100% / 8) per year for each of the eight years of expected usefulness.

The amortization rate under the declining-balance method would be 25% (which is double thestraight-line rate) on each year’s remaining balance. Thus, in Year 1: $100,000 amortized at 25% =

$25,000. In Year 2: $75,000 ($100,000 – $25,000) amortized at 25% = $18,750. By the end of eightyears, using the declining-balance method of calculating amortization, there is an unamortized balance

of $10,011 as the following table shows:

Amortization: Straight-Line versus Declining-Balance

Cost of Asset: $100,000 Salvage Value: $10,000 Useful Life: 8 Years

Straight-Line Declining-Balance

Fiscal Amortization Carrying Amount on Amortization Carrying Amount onYear-End Charge Balance Sheet Charge Balance Sheet1st $11,250 $88,750 $25,000 $75,000

2nd 11,250 77,500 18,750 56,250

3rd 11,250 66,250 14,063 42,188

4th 11,250 55,000 10,547 31,641

5th 11,250 43,750 7,910 23,730

6th 11,250 32,500 5,933 17,798

7th 11,250 21,250 4,449 13,348

8th 11,250 10,000 3,337 10,011

Amortization is intended to allocate the cost (net of salvage value) of the company’s cap-ital assets over their useful lives, and to provide a realistic matching of earnings toexpenses in a fiscal period, in order to determine the net income of a company on anannual basis.

Depletion

Depletion is similar to amortization and is usually used by mining, oil, natural gas, tim-ber companies and other extractive industries. The assets of these industries consistlargely of natural wealth such as minerals in the ground or standing timber. As these

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assets are developed and sold, the company loses part of its assets with each sale. Suchassets are known as wasting assets and the decrease in value is referred to as depletion.An allowance for depletion is made in recognition of the fact that as companies selltheir natural assets they must recover not only the cost of extraction, but also the origi-nal cost of acquiring such natural resources before a profit can be recognized.

Annual allowances for amortization and depletion appear as non-cash charges againstearnings in the earnings statement. They not only reflect the using-up of assets but alsoproperly match expenses with related income. Thus, it is quite possible for a companyto add considerably to its cash resources for the year yet show little or no net earnings, ifsubstantial amortization charges were made. These effects will be reflected in the cashflow statement, where the cash from operations is reported.

The accumulated allowances for amortization and depletion usually appear on the assetside of the balance sheet as a direct deduction from the capital assets to which theyapply. Usually only one figure for accumulated amortization is shown for all assets. Thebreakdown of amortization by each class of capital asset is relegated to the notes to thefinancial statements.

d) Capitalization

Capitalizing refers to the recording of an expenditure as an asset rather than as anexpense. This is done to allow for the spreading of an expense over more than oneaccounting period. For example, a company will record the cost to purchase a buildingor piece of machinery as an expense on its income statement in the year incurred. Thus,the purchase of a $10 million piece of machinery will likely have a substantial impacton a company’s net income for the year. When a company decides to capitalize an asset,net income in the year of acquisition is impacted in a much smaller way. The expense isinstead recorded as an asset on the balance sheet which is then amortized over a certainnumber of periods.

Two of the most common types of capitalized items are leases and interest.

Capitalized Leases

Companies generally acquire property, plant and equipment by outright purchase, eitherwith internally generated cash or by borrowed funds. Alternatively, they can enter into alease arrangement with another party for the asset for a specified period of time.

Normally, only assets that are legally owned by a company are recorded as capital assetsin their financial statements. Certain leases, however, are considered to be merely anoth-er means of financing the acquisition of an asset. In these cases, the lessee carries sub-stantially all of the risks and benefits associated with property ownership. Consequently,leases of this type (referred to as capitalized leases or capital leases) are recorded as if thelessee had actually acquired the asset and assumed a liability.

It should be noted that the item (e.g., building, equipment, etc.) that is leased is shownon the asset side of the balance sheet and is recorded at its net carrying amount (acquisi-tion cost less accumulated amortization), and is treated like any other capital asset thatthe company “owns.”

Similarly, the amount owed (e.g., capital lease) to acquire the asset is shown on the lia-bility side of the balance sheet and is recorded as the present value of future lease pay-ments. This obligation is treated in the same manner as a long-term debt.



Capitalized Interest

Some companies, such as oil and gas companies active in exploration, capitalize much oftheir interest costs on funds used instead of expensing them when incurred. The argu-ment for doing so is that no revenue is being generated during the exploration phase,and deferring this interest cost to a later period provides for a better matching of rev-enues and expenses.

While this argument has some merit, the capitalization of interest could be used artifi-cially to smooth out income during periods when earnings are actually quite volatile. Aswith other accounting policies, once adopted, the policy should not be changed unlesswarranted by unusual circumstances. This practice will reduce the potential for abuse.

The practice of capitalizing interest is also followed by utilities during periods ofconstruction. The interest cost is added to the cost of the assets constructed and affectsthe base used to calculate the utility rates charged to customers.

Sometimes capitalized interest is not added to the cost of the related asset, but recordedas a deferred charge (discussed next).

e) Deferred Charges (item 9)

Deferred charges are another type of asset frequently shown on the balance sheet. Thesecharges represent payments made by the company for which the benefit will extend tothe company over a period of years. In this way, it is similar to prepaid expenses(described earlier) except that the benefits received extend for a longer period of time.For accounting purposes, the cost of such items is spread out over several years by annu-al write-offs. This gradual writing off of deferred charges is the equivalent of amortiza-tion of capital assets. At the date of the balance sheet, the balance of amounts paid forbenefits, which have not been totally used, is shown as an asset. Deferred charges mayrepresent expenses incurred in issuing bonds, commission paid on the sale of capitalstock, organizational expenses or research expenses.

f) Goodwill and other Intangible Assets (item 10)

Intangible Assets are assets that cannot be touched, weighed or measured. They are notavailable for the payment of debts of a going business and they usually decline greatly invalue in the event of liquidation. Some common examples are goodwill, patents, copy-rights, franchises and trademarks. Intangible assets, which may be grouped on the bal-ance sheet under the headings “miscellaneous assets” or “other assets”, comprise valuablelegal rights essential to the operations of the company.

Since the realizable value in cash of intangible assets is uncertain, most companies showthem on the balance sheet at a nominal value. This practice indicates that managementis being quite conservative in its accounting policy because the intangible assets listedmay be quite valuable to the company.

Goodwill deserves special mention. It is often defined as the probability that a regularcustomer will continue to return to do business. If people get into the habit of doingbusiness with a firm because of its location or reputation for fair dealing and good prod-ucts, they will probably continue that habit, at least to some extent, even though thefirm changes hands.

The buyer of a business is often willing to pay for its “good name” in addition to thevalue of its assets. Goodwill may also signify the amount that a purchaser of a companywill pay for the good management of the company. It will appear on consolidated (orcombined) balance sheets as the excess of the amount paid for the shares over their netasset value.

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Intangible assets with finite useful lives are amortized over this useful life (usuallystraight-line). Goodwill and intangible assets with infinite useful lives are tested at leastannually, to verify that the amount recorded is still the fair value. When the carryingamount of goodwill or an intangible asset exceeds its fair value, an impairment lossshould be recognized in an amount equal to the excess.

In general, the values given to intangible assets on the balance sheet should be viewedwith caution. The value of such an asset is connected more to its contribution to earn-ing power than to its saleability as an asset. For example, a trademark may mean muchto a company from the point of view of brand recognition, yet it may be difficult toassess the trademark’s dollar value if it were to be sold.

3. Classification of Liabilities

We now turn our attention to the right-hand side of the balance sheet, where liabilitiesand shareholders’ equity are found. First we will examine the various categories of liabil-ities.

a) Current Liabilities (items 12 to 17)

For the most part, current liabilities are debts incurred by a company in the ordinarycourse of its business which have to be paid within a short time – a year at the most.The Trans-Canada Retail balance sheet shows five common types of current liabilities:

• Bank advances – consist of short-term loans from financial institutions;

• Accounts payable – includes unpaid bills for raw materials, supplies and the like;

• Dividends payable – are funds that have been set aside after the company declares adividend;

• Income taxes payable – consist of taxes to be paid to the government in the nearterm;

• First mortgage bonds due within one-year are the current portion of the company’slong-term debt.

In addition, all other kinds of obligations that must be met within a year are includedin current liabilities. Some of these are: outstanding wages and salaries, bank and bondinterest, legal fees, pension payments and property and excise taxes. In every case, theliability is a very definite one and has to be met. Quite often, the values given to assetsmay shrink, but liabilities, particularly current ones, never do.

It is important to distinguish between debts (i.e., where the company has borrowedmoney through methods such as bank advances or bonds) and other types of liabilitiessuch as accounts payable or taxes owed. This is an important point to remember whencalculating debt ratios for companies. Only debts incurred by borrowing are included inratios involving debt.

b) Future Income Taxes (item 18)

Public companies must report to their shareholders through financial statements and toappropriate levels of government through their tax returns. Future income tax (previous-ly called deferred income taxes) occurs when taxes reported on a company’s earningsstatement are different from taxes reported on its tax return. This difference arisesbecause taxes on earnings statements are calculated according to strict CanadianInstitute of Chartered Accountants (CICA) guidelines, and taxes paid are based on taxreturns filed under federal and provincial Income Tax Acts and Regulations. These twosets of rules are not always identical.



What shareholders and users of financial statements must keep in mind is that manage-ment has a great deal of flexibility in selecting revenue and expense recognition meth-ods. On the earnings statement, the company may have a strong incentive to report ahigher level of accounting income for the year, perhaps for the purpose of managementcompensation or the overall perception of successful financial performance. On its taxreturn, however, management will likely choose an accounting method that minimizesthe amount of tax payable for the year.

Differences between tax and accounting procedures occur in many areas. These differ-ences may be permanent or they may be “temporary” differences. Permanent differencesare ones that will never reverse and do not result in future income taxes. For example,Canadian dividend income received by a company is considered income for accountingpurposes. However, under the Income Tax Act these same dividends are generally nottaxable. Accordingly, there will be no tax expense reported on the financial statements,or on the company’s tax form, since the dividends are permanently “tax-free”. There areother examples of permanent differences, such as interest and penalties on taxes, whichare not deductible for tax purposes but are considered expenses for accounting purposes.

Future income taxes result from temporary differences. The most common temporarydifferences arise from the differences between book or financial amortization of capitalassets (calculated according to CICA guidelines), as already discussed, and capital costallowances prescribed in the income tax regulations for tax purposes. Capital costallowance is the income tax equivalent of amortization, and allows for larger deductionsduring the early years of an asset’s life. Tax in the financial statements is calculated onbook or accounting income (CICA rules) whereas the actual amount of income taxpayable in the year is calculated on income for tax purposes after deducting capital costallowances. When financial tax provisions exceed taxes currently payable to the CanadaRevenue Agency (CRA), the difference is a future income tax liability on the company’sbalance sheet.

At some point in the future, the company may have to pay its tax liability to the CRA.When taxes currently payable exceed financial tax provisions, this amount shows up onthe asset side of the balance sheet. Many accountants and users of financial statementsdisagree over whether these amounts should be considered actual assets and liabilities.There is some question as to whether or not a future income tax liability will everreverse itself. A company that is continually growing will likely continue to experience agrowing future income tax liability.

Many other permanent and temporary differences exist, including those related toinventory valuation, revenue recognition, leases, capital gains, allowable expenses, losscarryovers, warranties and business combinations. In each case, future income taxes onthe balance sheet reflect the cumulative amount of these differences over the life of thecompany. The current year’s amount appears in the earnings statement, and shows thefuture income taxes for that period, usually a year.

c) Non-controlling Interest in Subsidiary Companies (item 19)

This item appears in some balance sheets that are consolidated. (Consolidated meansthat the parent company’s figures are combined with those of its subsidiaries into a sin-gle joint statement.) Even if the parent company owns less than 100% of a subsidiary’sstock, all of the assets and liabilities are combined in the consolidated financial state-ment. To compensate, the part not owned is shown in the consolidated balance sheet asnon-controlling or minority interest. From the viewpoint of the consolidated statement,minority interest is considered to be the interest or ownership outsiders have in the sub-sidiary company. Accordingly, it is regarded as a quasi-liability, which must be deductedin arriving at the consolidated shareholders’ equity of the parent company.

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d) Other Liabilities

Some companies use a section of the balance sheet between liabilities and shareholders’equity to set up provisions for estimated losses they expect to incur (e.g., from a lawsuitin progress against the company at balance sheet date or as a result of investments inpolitically unstable countries.) If such a contingency is based solely on conservativethinking and refers to remote contingencies and not to a specific loss in prospect, theamount is more properly included as a note to the financial statements.

e) Deferred Revenue

Deferred revenue results when a company receives payment for goods or services that ithas not yet provided. Since the company has an obligation to deliver the goods or serv-ices in the future, the unearned portion of the revenue represents a liability to the com-pany and is therefore shown as such. Deferred revenue is somewhat the opposite of adeferred charge.

One common type of deferred revenue is a prepaid subscription to a magazine, whichcovers future issues still unpublished at date of the payment. These payments representdeferred revenue to the publisher of the magazine. The amount would be shown as cur-rent or long-term, depending on the circumstances. The deferred revenue liabilitywould, in theory, be reduced whenever the obligation was fulfilled; in practice, becauseof the work involved in tracking many such transactions, the liability is usually reducedon an annual basis.

f) Long-term Debt (item 20)

This group of items can normally be thought of as financing the capital assets on theother side of the balance sheet. As distinct from current debts, which have to be paidwithin a year, the long-term debt of a company is usually due in monthly or annualinstalments over a period of years or in a lump sum in a future year. Any portion oflong-term debt that is due in the next year is shown as a current item. The most com-mon of these debts are mortgages, bonds and debentures, though promissory notes andsimilar types of debt instruments are often found. Frequently, capital assets have beenpledged as security for such borrowings.

It is customary to describe these debt items directly on the balance sheet or in a noteattached to it. There must be sufficient detail to tell the reader what kind of security isprovided on the loan, the interest rate carried, when the debt becomes repayable andwhat sinking fund provision, if any, is made for repayment. The sinking fund is theamount set aside each year for repayment of the debt. The money is usually given to atrustee who may either call in some of the debt securities for repayment, purchase themon the open market for cancellation or invest the funds in government securities forrepayment of the debt at maturity as provided in the terms of the issue.

4. Shareholders’ Equity

The items in this section of the balance sheet represent the amount that shareholdershave at risk in the business. The money that is paid in by the shareholders is designatedas capital and the profits that have been earned over a period of years and not paid outas dividends make up the retained earnings. Another item called contributed surplussometimes appears in this section. It, too, belongs to the shareholders but originatesfrom sources other than earnings. Thus, the shareholders’ equity section of the balancesheet is made up of the following items:



a) Share Capital (items 21 and 22)

This item is the amount received by the company for its shares at the time they wereissued. Thus, the share capital shown on the balance sheet is not related in any way tothe current market price of the outstanding shares. Share capital would not change fromyear to year unless the company issued new shares or bought back outstanding ones.Any excess received (when the shares were issued) over par or stated value is shown incontributed surplus.

b) Contributed Surplus (item 23)

Contributed surplus originates from sources other than earnings. It may originate whena company sells its stock for more than the stock’s par value or, in the case of no parvalue shares, its stated value. Thus, if a company’s stock has a par value of $100 pershare and is sold for $125 per share, the $100 is applied against the capital stockaccount, while the difference of $25 is put into the contributed surplus account.

c) Retained Earnings (item 24)

Retained earnings is the portion of annual earnings retained by the company after pay-ment of all expenses and the distribution of dividends. The earnings retained each yearare reinvested in the business. The reinvestment of accumulated earnings may be held incash or reinvested in inventories, property, or any other of the company’s assets.

Retained earnings also serve as a cushion to absorb losses incurred in bad years. If acompany suffers a loss in any year, the loss is deducted from the retained earnings. Inthis event, each shareholder’s ownership interest in the company is reduced becausethere are less retained earnings from which dividend distributions can be made. If morelosses than earnings accumulate, the resulting figure is designated a deficit.

d) Foreign Currency Translation Adjustment (item 25)

This item may appear in consolidated financial statements of companies that havesubsidiaries in foreign countries. The assets of these subsidiaries are valued in the cur-rency of the country in which they are resident. If, due to a significant change in theexchange rate, the foreign assets are worth more (or less) at the time the consolidatedbalance sheet is prepared, this difference is included as an adjustment to shareholders’equity.

Example: Suppose a Canadian company owned a subsidiary in the United States, andthe US dollar had risen dramatically since the subsidiary was purchased. The Americancompany would be more valuable to the Canadian parent after the rise in the US dollar,and the Canadian parent would show this increase as an addition to Foreign CurrencyTranslation Adjustments under shareholders’ equity.

D. UNDERSTANDING THE EARNINGS STATEMENT1. What It Shows

This statement – sometimes called the Income Statement or Profit and Loss Statementor Statement of Revenue and Expense – shows how much revenue a company receivedduring the year from the sale of its products or services and the expenses the companyincurred for wages, materials, operating costs, taxes and other expense items. The differ-ence between the two is the company’s profit or loss for the year. The amount left over,after payment of income taxes, is net earnings, out of which dividends may be paid tothe shareholders.

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POST-TEST

PRE-TEST

Thus, the earnings statement reveals the following information about a company:

• Where the income comes from and how it is spent; and

• The adequacy of earnings both to assure the successful operation of the companyand to provide income for the holders of its securities.

It should be emphasized that, in analyzing the financial condition of a company, itsearning power and cash flow are of primary interest. The proof of a company’s financialstrength and its security lies in its ability to generate earnings and cash flow throughthose earnings. Evidence of this is provided by both the earnings statement and the cashflow statement.

2. Structure of the Earnings Statement

Although earnings statements all provide the same kind of financial information, theirmake-up varies widely, not only among companies in different industries but alsoamong companies in the same industry. A condensed statement that consists of onlythree, four or five items is inadequate; an elaborate and more revealing statement mayconsist of twenty or thirty items. In most statements, about ten to twenty items arefound but no matter how many items there are, they may be readily grouped into oneof four broad sections:

1. The operating section;

2. The non-operating section;

3. The creditors’ section (relates to interest on items in creditors’ section of the balance sheet); and

4. The owners’ section (relates to shareholders’ equity in the balance sheet).

(The section headings would not normally appear as such in the earnings statement butare included in the sample statement as a learning aid.)

Sections 1 and 2 show origin of income, sections 3 and 4 its distribution.

Generally, a company has two main sources of income. First, there is income from oper-ations, i.e., the income from selling its main products or services. For example, if thecompany is a public utility, it derives its main income from the sale of gas or electricity.Such income is termed operating income, the income from its main operations.

The second source of income is not directly related to a company’s normal operatingactivities. Such income would include dividends and interest from investments, rents,royalties from processes or patents it owns and sometimes profits from the sale of capitalassets. Since income from these sources is not directly related to a company’s main oper-ations, it is called non-operating income.

If operating and non-operating income are combined in one figure in the earnings state-ment, it is impossible to gain a true picture of the company’s real earning power. Forexample, a company might in one year realize a substantial profit from the sale of secu-rities or some other asset. A profit of this kind is not likely to be repeated the next year.Yet if it were combined with operating income it would be impossible to obtain anaccurate indication of the company’s true earning power based upon its main opera-tions. For this reason, good accounting practice requires that operating income andnon-operating income be shown separately in the earnings statement, especially if non-operating income is substantial.



3. The Operating Section (items 28-34)

The operating section of the earnings statement may be divided into three parts:

• The operating income received by source;

• The expense incurred to obtain that income; and

• The balance or net amount of that income (operating profit or loss).

The terminology used in describing income in the operating section is not always thesame. Railroads and public utilities generally use the term operating revenue. In the caseof an industrial concern, the comparable term is sales.

a) Net Sales (item 28)

The earnings statement of a commercial, mercantile or industrial company should startwith the amount of net sales (net revenue for other types of company).

Net sales consists of gross sales less:

• Excise tax – applies to the oil, beverage and tobacco industries;

• Returns and allowances – adjustments made as the result of delivery to customers ofunsatisfactory goods and returns of reusable containers;

• Discounts – rebates of a percentage of the sale price to customers for prompt pay-ment.

Net sales or net revenue is a key figure in the earnings statement. It is the figure neededto calculate various ratios useful in determining the basic soundness of a company’sfinancial position. For example, net sales must be known in order to calculate net andgross profit margins and turnover ratio. These ratios are used by credit managers,bankers and security analysts in making a detailed investigation of a company’s financialaffairs.

b) Cost of Goods Sold (item 29)

From the net sales figure, various operating expenses are deducted. These expenses arisein producing the income received from the sale of the company’s products or services.The first such deduction, in the case of a manufacturing or merchandising concern, istermed cost of goods sold. This item includes costs of labour, raw materials, fuel andpower, supplies and services and other kinds of expenses which go directly into the costof manufacturing or in the case of a merchandising concern, the cost of goods pur-chased for resale.

c) Gross Operating Profit (item 30)

Deducting the cost of goods sold from the amount of net sales produces another signifi-cant figure, which is termed gross operating profit. This figure is significant because itmeasures the margin of profit or spread between the cost of goods produced for sale andthe net sales. When the percentage of gross operating profit to net sales is calculated andcompared with those of other companies engaged in the same line of business, it pro-vides an indication of whether the company’s merchandising operations are more or lesssuccessful in producing profits than its competitors. Between different companies in thesame business, differences in the margin of gross operating profit generally reflect differ-ences in managerial ability, although they can also be caused by the inclusion of someexpense items in the cost of goods sold of one company and not in another.

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d) Operating Expenses (items 31 to 33)

After gross operating profit has been determined, a number of other operating expenseitems are then deducted. The first is selling, general and administrative expenses. Thisitem includes such expenses as office expenses, the cost of maintaining a sales organiza-tion and accounting staff, advertising expenses and similar types of costs necessary tooperate a business. Sometimes this item is combined with the cost of sales item andonly one figure is shown to cover all these direct operating expenses. This practice isbecoming less common as reporting standards improve.

The next item deducted is amortization. As explained, amortization represents a cost ofdoing business and as such is deducted from operations. Amortization reduces taxableincome for the year, but, as a non-cash expense, does not reduce cash on hand.

In actual practice, it is impossible to trace the final use of any given dollar coming intoa company. The earnings statement shows that a certain amount of cash comes into acompany each year from the sale of its products and that a certain amount is spent foroperating expenses and income taxes. What is left over represents an inflow of cashavailable to the company for the purchase of assets, debt repayment, the payment ofdividends and other purposes. The net income may be less than this net inflow of cashbecause amortization has been deducted to arrive at net income for the year.

Adequate amortization is of great importance to investors and, therefore, one of the fig-ures the Canadian Institute of Chartered Accountants (CICA) requires to be disclosed.The amortization charge is included as part of the cost of goods sold if the related assetsare used in the manufacturing process, and, if so, a note would be appended to thestatement indicating the treatment.

It is highly significant to the investor if the annual provision for amortization is insuffi-cient. In this event, the earnings of the company would be overstated and securitiesholders might find that the company was living off its capital or, in other words, notreinvesting sufficiently in plant and equipment to maintain operations. For this reason,the annual allowance and method of calculating amortization should be carefullyassessed. Even if accounting amortization is adequate, however, the company may stillbe living off its capital.

In addition to expense items already mentioned, various other items properly regardedas operating expenses, such as pension expense, are deducted in the operating section.Directors’ fees, remuneration of officers and legal fees may also be charged as separateexpense items.

e) The Net Operating Profit (or Loss) (item 34)

After deducting the total of all these operating expenses from the gross profit figure, onereaches the net operating profit of the company for the period under review. This is animportant figure as it excludes non-operating income. It provides a truer picture of thecompany’s earning power as non-operating income items may not be repeated from yearto year. Combining them with operating income could unrealistically inflate (or deflate)income in that year.



4. Non-Operating Section (item 35)

As previously noted, the non-operating section of the earnings statement reveals theincome received from various sources not directly related to the main operations of thecompany. These include interest and dividends on securities held, rents from no-longer-required properties, royalties on patents, finance charges earned, etc.

With the exception of rental or financial income, there are few expenses associated withnon-operating income. Such income is often included in sales and, therefore, distortsthe sales figure for comparative purposes. Consequently, non-operating income must beexcluded from sales before calculating ratios for comparison with other companies inthe same industry.

The total of operating profit and non-operating income is known as earnings beforeinterest and taxes (EBIT) (item 36). This figure is used in many ratio calculations.

5. The Creditors’ Section (items 37and 38)

How a company distributes its income is shown in the Creditors’ section and theOwners’ section of the earnings statement. Debtholders receive interest payments ontheir securities or loans to the company and the Government gets its share as tax.

The distribution of income to creditors is usually made in the form of fixed interestcharges to banks and other debtholders who have lent money to the company. Theseinterest charges are paid out of income before taxes and are fixed in the sense that theamount of interest that has to be paid on borrowed money is definite. If the companyhas $1,000,000 worth of bonds outstanding in the hands of investors, and these bondsbear interest at the rate of 9% per annum, there is exactly $90,000 interest to be paideach year.

Interest charges are also fixed in the sense that they must be paid. Non-payment wouldresult in default and give creditors the right to place the company in receivership. In theevent of bankruptcy, the assets may be offered for sale and the proceeds used to pay offthe claims of the creditors. Consequently, if receivership is to be avoided, the fixedcharges incurred by the company must be paid before any of the income may be distrib-uted to the shareholders. (Bank interest and debt interest, even taxes, may also be con-sidered operating expenses on the basis that they are necessary costs of doing business.)

Subtracting the amount of fixed charges from total net income results in a figure thatbrings us to the owners’ section of the statement. This figure (item 39) is known as netincome before taxes (NIBT).

6. The Owners’ Section (items 40 to 45)

a) Taxes and Non-controlling Interest (items 40 to 41)

The shareholders of a company are its owners and are entitled to their share of the netearnings of the company. The net earnings (item 45) are total net income less creditors’charges and income taxes. Most companies today show two types of income taxes: cur-rent and future. The current portion represents the money that must be remitted toCRA in that year. The future portion represents the accounting or temporary differencesin that year (as already explained under the balance sheet item – future income taxes).

In consolidated statements of companies with non-controlling interests, a deduction ismade for the non-controlling interest portion of the earnings of the subsidiary since thisdoes not belong to the shareholders of the parent company. (As explained earlier, thisitem is also referred to as minority interest.) For example, a company owns 80% of theshares of a subsidiary, which earned $1,000,000 last year. The $1,000,000 will be

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included in the earnings of the parent company but a corresponding deduction of$200,000 will show as non-controlling interest to represent the 20% that is not ownedby the parent company.

b) Equity Income (item 42)

Equity income is derived using the equity method, and usually arises when significantinfluence exists without control (traditionally when 20% to 50% of the voting sharesare owned). A third method, called the cost method, is primarily used for ownershipholdings that do not result in significant influence existing (traditionally ownership ofless than 20%).

Equity income is earned when a company reports its share of an entity subject to signif-icant influence earnings. For example, Trans-Canada Retail Stores Ltd. owns 25% ofAlberta Retail Stores Ltd., and Alberta Retail Stores earned $20,000 (after tax) in a par-ticular fiscal year. Trans-Canada Retail Stores, in its earnings statement, reports $5,000(25%) of this as equity income. This item might alternatively be called equity earnings,earnings from an entity subject to significant influence, earnings from long-term investments,or something similar.

Certain earnings calculations must be adjusted for equity income because, while thecompany reports this income, it does not actually receive it in cash. Thus, equityincome is a non-cash source of funds, just as amortization and depletion are non-cashuses of funds. Company earnings need to be reduced by the amount of equity incomewhen calculating ratios when a true picture of the company’s cash earnings is required.

If an entity subject to significant influence experiences a loss, the company will reportits share of the loss on its earnings statement. This entry, called Equity Loss or somethingsimilar, would reduce earnings on the company’s earnings statement. But, as with equityincome, an equity loss is also a non-cash item. The amount of the equity loss wouldtherefore have to be added back to the company’s earnings when calculating ratios whena true picture of the company’s cash earnings is required.

A related item – dividends from an entity subject to significant influence – is worthy ofnote. Under the equity accounting method, dividends received by a company from itsentity subject to significant influence are not recorded in the company’s income state-ment. Instead, they are recorded in the cash flow statement, perhaps as “Dividends fromentities subject to significant influence.” Here, cash is actually received by the companybut is not included in the company’s earnings as they appear on the earnings statement.Therefore, earnings calculations that are adjusted for equity income are sometimes alsoincreased by the amount of dividends received from the entity subject to significantinfluence. Not all corporations pay dividends, which means that equity income mayappear on an income statement without a corresponding dividend entry on the cashflow statement. Those corporations that do pay dividends do not always pay a signifi-cant amount per share.

When calculating cash flow, equity income from an entity subject to significant influ-ence must be subtracted, because it was not actually paid. Conversely, dividends froman entity subject to significant influence, do not show up in the earnings statement, yetthe company actually receives the money. The dividends must be added when calculat-ing cash flow.



c) Extraordinary Gains or Losses (item 44)

In any given year, a company may experience a gain or loss that is not expected to occurfrequently, is not typical of normal business activity, and is not dependent primarily ondecisions by management or owners. A company may receive a “windfall-type” capitalgain through an expropriation, or a loss resulting from a flood, earthquake or revolu-tion, etc. The amount of this special gain or loss is usually stated as an extraordinaryitem on the earnings statement, after all other revenues and expenses have beenaccounted for. (Another category – unusual items – results from occurrences that aretypical of the normal business activity of the company even though caused by unusualcircumstances, e.g. unusual bad debt or inventory losses.)

If extraordinary items were included in the company’s income, the results for the yearwould be distorted. Accordingly, companies report earnings both before and after theinclusion of extraordinary items. To make year-to-year comparisons meaningful, any cal-culations of a company’s net earnings for a year should always be made before extraordi-nary items.

d) Net Earnings after Extraordinary Items (item 45)

The earnings statement finishes with net earnings (or deficit), the amount of profit fromthe year’s operations that may be available for distribution to shareholders. This mayalso be referred to as net income.

At this point net earnings are transferred to the retained earnings statement. This iswhere you will find any dividends paid to shareholders that year.

E. UNDERSTANDING THE RETAINED EARNINGS STATEMENT

The profit or loss in a company’s most recent year is determined in the earnings state-ment and then transferred to the Retained Earnings Statement. Retained earnings areprofits earned over the years that have not been paid out to shareholders as dividends.These retained profits accrue to the shareholders, but the directors have decided for thepresent time to reinvest them in the business.

The retained earnings statement provides a record of the profits kept in the businessyear after year. Profit for the current year is added to, or the loss is subtracted from, thebalance of retained earnings shown in the statement from the previous year. Dividendsdeclared during the year are subtracted in this statement.

In addition to showing earnings and dividends, the retained earnings statement is usedto record adjustments relating to the earnings of prior periods. From time to time,amounts may be set aside from retained earnings as a reserve against possible eventssuch as a decline in the value of raw materials inventory purchased at a time of highcommodity prices.

The use of a reserve in the retained earnings statement does not mean that a fund ofcash has been set aside for the purpose described. It merely means that a portion of theretained earnings has been earmarked as unavailable for distribution to shareholders.The provision of a fund to meet some future contingency or event would require sepa-rate action on the part of the board of directors. The establishment of a reserve, in itself,has limited usefulness, except to inform readers or investors of possible plans or contin-gencies of the company.

A new final retained earnings figure is determined and carried to the balance sheetwhere it appears in the shareholders’ equity section (item 24). Thus, the retained earn-ings statement provides a link between the earnings statement and the balance sheet.

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F. UNDERSTANDING THE CASH FLOW STATEMENT 1. Introduction

While the balance sheet shows a company’s financial position at a specific point in timeand the earnings statement summarizes the company’s operating activities for the year,neither statement shows how the company’s financial position changed from one periodto the next. The cash flow statement fills this gap between the balance sheet and theincome statement by providing information about how the company generated andspent its cash during the year.

The cash flow statement assists users of financial statements in evaluating the liquidityand solvency of a company. In assessing the quality of a company, the user needs todetermine if the company will be able to:

• Pay its creditors, especially in business downturns;

• Fund its needs internally if necessary; and

• Reinvest and continue to pay dividends to shareholders.

Financial statements are prepared based on Generally Accepted Accounting Principles(GAAP). Under this system, and because of differences in operating environments forcompanies in different industries, GAAP does allow for some flexibility for companiesto choose among accounting standards. This flexibility gives the management of a com-pany the ability or discretion to select accounting standards that best reflects its opera-tions. These decisions can substantially affect the income figures reported by the compa-ny. A change to a different accounting practice can alter the revenue and net income ofa company without an actual change in the operating performance of the companyoccurring.

A review of the cash flow statements over a number of years may illustrate trends thatmight otherwise go unnoticed. The cash flow statement often provides a clearer pictureof the viability of a company than does the income statement as the cash flow statementmeasures actual cash generated from the business. As a consequence, the cash flow state-ment has gained in importance and prominence over the last few years as it focuses onwhat shareholders should be most concerned with – the cash available for operationsand investments.

For purposes of the cash flow statement, “cash” normally includes cash held in bankaccounts, net of short-term borrowings, and temporary investments. In some cases,other elements of working capital might be included when they are equivalent to cash.This financial statement details the changes in cash, and the reasons for them.

A cash flow statement shows the company’s cash flows for the period under the follow-ing three headings:

• Operating Activities;

• Financing Activities; and

• Investing Activities.

The cash flow statement may be shown using the direct method or the indirect method.Since the indirect method is used more often in practice, the following discussion isbased on the indirect method.



2. Operating Activities

The cash flow statement begins by looking at those accounts that directly reflect thebusiness activities of the company – those activities requiring an inflow of cash or out-flow of cash, which generate sales and expenses during the year.

It begins with income before extraordinary items (item 43). As previously explained,extraordinary items are excluded from the income figure in order to make useful year-to-year comparisons, as well as comparisons with other companies. Added back toincome are all items not involving cash (item 32) such as amortization. Future incometaxes (item 49) and non-controlling interest (item 41) are added back and equityincome (item 42) is subtracted, as none are actual cash transactions for the company.

The ‘net change in operating working capital items’ (item 50) are changes in the variousasset and liabilities accounts that appear on the balance sheet. The dollar amounts ofthese accounts in the current year are compared to the dollar amounts of the accountsin the previous year. The change in each account is recorded in the cash flow statement.Operating working capital items include accounts such as:

• Accounts receivables;

• Inventories;

• Accounts payable;

• Accrued liabilities;

• Interest payable;

• Taxes payable; and

• Advances from customers.

For example, the receivables account records invoices that have been sent to customers,but have not yet been paid. The company includes the sale in revenue but has not yetreceived the money. When the invoice is paid, the receivables account declines, as thecash account increases.

Why are changes in these accounts considered important? For example, if accountsreceivable increases substantially in the current year, the company’s sales revenue will bemuch higher than the amount of cash collected over the period. This may require fur-ther investigation on the part of the analyst. It could be an indication that the companyhas a poorly managed receivables department or that it is extending credit to customersthat are unable to pay. More importantly, a company needs a regular stream of cashflowing into the business to maintain its operations. If credit sales go uncollected for anextended period of time, it might be difficult for the company to pay its bills or meetinterest charges. While the company may look good on paper because its revenues areup, as demonstrated by the earnings statement, the company may shortly be in seriousfinancial difficulty if it cannot generate enough cash to pay its creditors.

3. Financing Activities (items 51 to 54)

Cash flows from financing activities involve transactions used to finance the company. Ifthe company has issued new shares (item 51) or debt (item 53), cash flows into thecompany. If the company repays debt (item 52) or pays dividends to the shareholders(item 54), cash flows out of the company. This section is of particular interest to theshareholders of the company as it highlights changes to a company’s capital structure –the overall use of debt and equity financing. A substantial increase in debt, or issuanceof new shares, may negatively affect the shareholders’ equity in the company.

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4. Investing Activities (items 55 to 57)

Investing activities highlight what the company did with any money not used in thedirect operation of the company. It includes any investments that the company made initself, such as the purchase of new capital assets (item 55) or disposal of such assets(item 56). As well, in this section you will find any dividends actually received from aninvestment in another company (item 57) or the initial purchase of an interest in anoth-er company.

5. Change in Cash Flow (items 58 to 60)

The final section of the cash flow statement sums up the cash flows from operating,investing and financing activities to arrive at the increase (decrease) in cash (item 58) forthe current fiscal year. As a final check, the statement compares the cash and temporaryinvestments at the beginning of the year (item 59) to the cash and temporary invest-ments at the end of the year (item 60). Since the cash flow statement looks at the actualchange in the cash position for the year, the final balance in cash and temporary invest-ments (item 60) is comprised of cash (item 1) and temporary investments (item 2)found in the year-end balance sheet for Trans-Canada Retail. This figure should beidentical to the net increase (decrease) found in item 58. Ideally the company shouldalways have a positive net cash flow. If it does not, it is important to find out why.

6. Supplemental information (items 61 to 62)

Information relating to both interest paid and income taxes paid are required to be dis-closed in the cash flow statement. Since these items are not specifically identified whenthe indirect method is used, these items are shown as supplementary information.

G. OTHER INFORMATION IN THE ANNUAL REPORT1. Footnotes to the Financial Statements

There is a considerable amount of detailed information which, in the shareholders’interest, needs to be disclosed. If shown directly in the financial statements themselves,it would result in their becoming so cluttered as to be unreadable. This information isusually shown in a series of footnotes to the financial statements. It is essential for aninvestor to have an understanding of the footnotes as they provide important detailsabout the company’s financial condition. Items that are often included in a company’sfootnotes include accounting policies, descriptions of fixed assets, share capital andlong-term debt, and commitments and contingencies. It is also here that a potentialinvestor should look to ascertain whether the company uses derivatives for hedging orother purposes.

The footnotes usually also disclose information about the various segments of the com-pany’s operations first by industry and second by geographical area. The information foreach segment should include revenue, profit and loss data, capital expenditures andamortization charges for the year and identifiable assets at year-end. Table 4.3 shows anexample of segmented data.



TABLE 4.3

PQR Corporation Limited – Segmented Resultsthousands of dollars

ConsolidatedRetailing Manufacturing PQR Results

———————— ———————— ————————Year 2 Year 1 Year 2 Year 1 Year 2 Year 1

Sales $418,859 $395,515 $81,198 $67,921 $500,057 $463,436

Operating earnings 25,557 23,917 5,124 6,108 30,681 30,025

Interest (net) - - - - 3,418 8,708

Corporate charges - - - - 3,821 2,480

Earnings before income tax - - - - 23,442 18,837

Assets at year end 121,090 115,341 43,271 33,801 164,361 149,142

Capital expenditures and assets undercapital leases for the period 12,421 8,149 1,885 1,184 14,306 9,333

Amortization 8,714 8,285 1,318 921 10,032 9,206

2. The Auditor’s Report

Canadian corporate law requires that every limited company appoint an auditor to rep-resent shareholders and report to them annually on the company’s financial statements,expressing an opinion in writing as to their fairness. The only exception is for privatelyheld corporations where all shareholders have agreed that an audit is not necessary. Inthis case, the accountant (not an auditor) prepares a “Review Engagement Report” or a“Notice to Reader”. The auditor is appointed at the company’s annual meeting by a res-olution of the shareholders and may be dismissed by them. A member of the Instituteof Chartered Accountants (CA) in the province in which he or she carries on businessmay act as auditor if they posses a “Public Accounting License”. In some provinces, inaddition to CAs, CGAs (Certified General Accountants) and CMAs (CertifiedManagement Accountants) may also act as company auditors. In the United States, theCPA (Certified Public Accountant) fills the auditor’s role.

In Canada the auditor’s report conventionally has three paragraphs. The introductoryparagraph identifies the financial statements covered by the auditor’s report and distin-guishes between the responsibilities of management and the responsibilities of the auditor.

The second paragraph, known as the scope paragraph, states how the audit was con-ducted. The purpose of the second paragraph is for the auditor to inform the readerthat the audit was planned and conducted in accordance with Canadian generallyaccepted auditing standards, and that the auditor has made judgments in applying thesestandards. It explains to the reader the nature and extent of an audit and the degree ofassurance it provides.

The third paragraph gives the auditor’s opinion on the financial statements of the com-pany being audited. This paragraph states that the financial statements present fairly thefinancial position of the company, the results of the operations and the cash flows forthe period, in accordance with generally accepted accounting principles.

Generally accepted accounting principles (GAAP) refer to the principles and practices tobe used for recording and reporting business transactions issued by the CanadianInstitute of Chartered Accountants. Where the CICA has not issued a pronouncementregarding the accounting treatment of a particular matter, practice that has been gener-

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ally accepted by the accounting profession and is in current use is considered to beappropriate. If there is any inconsistency in the application of GAAP in a company’sfinancial statements, reference is made in the auditor’s report, in a fourth paragraph, tothe inconsistency and to a note describing it in more detail.

In some cases, the auditor may find that generally accepted accounting principles havenot been used or may be unable to form an opinion on one or more of the financialstatements submitted to the shareholders. In such cases the auditor would state that heor she was unable to give any opinion whatsoever, or else include in the report his orher qualifications regarding the dubious items. A qualified report should be regarded asa signal that the financial statements may not present fairly the financial position orresults of operations of the company in question. In some provinces, qualified reportsare not allowed. Accordingly, shareholders and investors should exercise caution inappraising the company’s financial status.

Events surrounding the technology boom and bust in the late 1990s and more recentevents concerning the reliability of financial statements heightened investor awareness ofthe importance of analyzing financial statements. The public also questioned the objec-tivity of accounting firms and the auditing process of that audit a company’s books andprovide consulting services to that company at the same time.

In response to the public’s concern about the validity of financial statements, the CSA,the CICA and OFSI joined forces to create the Canadian Public Accountability Board(CPAB). The primary role of the CPAB is to strengthen confidence in capital marketsand the credibility of financial statements in general. Major accounting firms in Canada(who already conduct 85% of the public company audits) will be reviewed annually andbe subject to a more comprehensive examination of their quality control policies andprocedures. This new body will ensure increased independence of auditors and increasedtransparency of the auditing process.

The Securities and Exchange Commission in the U.S. also instituted new rules requir-ing chief executives and financial officers of large publicly-traded companies to personal-ly vouch and file sworn statements attesting to the accuracy of their companies’ finan-cial statements. As with the creation of the CPAB in Canada, the SEC rules were creat-ed with a goal of improving public confidence in the financial markets. To achieve this,the Public Company Accounting Oversight Board was created by the Sarbanes-OxleyAct of 2002. The Board is a private-sector, non-profit corporation created to oversee theauditors of public companies in order to protect the interests of investors and furtherthe public interest in the preparation of audited financial reports. The Board will direct-ly perform quality reviews of audit procedures and practices, and will have the power todiscipline accounting firms as well as individual accountants.

H. SPECIMEN FINANCIAL STATEMENTSThe financial statements on the following pages should be referred to when reviewingthis chapter. To make them easier to understand, these financial statements differ fromreal financial statements in the following ways:

1. Comparative (previous year’s) figures are not shown.

2. No Notes to Financial Statements are included.

3. The consecutive numbers on the left-hand side of the statements, which are used inexplaining ratio calculations, do not appear in real reports.

Note: It is assumed that Trans-Canada Retail Stores Ltd. is a non-food retail chain.



POST-TEST

Trans-Canada Retail Stores Ltd.CONSOLIDATED BALANCE SHEETas at December 31, 2004

ASSETSCURRENT ASSETS

1. Cash and bank balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 129,0002. Temporary investments – at cost, which approximates market value . . . . . . . . . . . . . . . . . . . . . . . 2,040,0003. Accounts receivable (less allowances for doubtful accounts – $9,000) . . . . . . . . . . . . . . . . . . . . . 975,0004. Inventories of merchandise – valued at the lower cost or net realizable value . . . . . . . . . . . . . . . 9,035,0005. Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,000

—————6. Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,238,0007. Investment in affiliated company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 917,0008. CAPITAL ASSETS, at cost

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,370,000Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,460,000Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,750,000

—————10,580,000

Accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,260,000) 6,320, 000—————

9. DEFERRED CHARGES (unamortized expenses and discount on bond issue) . . . . . . . . . . . . . . . . 136,000INTANGIBLE ASSET

10. Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000—————

11. TOTAL ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,761,000========

LIABILITIESCURRENT LIABILITIES

12. Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,630,00013. Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,165,00014. Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,00015. Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398,00016. First mortgage bonds due within one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

—————17. Total Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,410,00018. FUTURE INCOME TAXES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485,00019. NON-CONTROLLING INTEREST IN SUBSIDIARY COMPANIES . . . . . . . . . . . . . . . . . . . . . . . . 157,000

FUNDED DEBT (due after one year)20. 11% First Mortgage Sinking Fund Bonds due Dec. 30, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,350,000

—————6,402,000

SHAREHOLDERS’ EQUITYCAPITAL STOCK

21. $ 2.50 Cumulative Redeemable Preferred – Authorized 20,000 shares, $50 par value – issued and outstanding 15,000 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000

22. Common – Authorized 500,000 shares of no par value – issued and outstanding 350,000 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,564,000

23. CONTRIBUTED SURPLUS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,00024. RETAINED EARNINGS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,835,00025. FOREIGN EXCHANGE ADJUSTMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,00026. Total Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,359,00027. Total Liabilities & Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,761,000

========

Approved on behalf of the Board:

“Signature”, Director

“Signature”, Director

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Trans-Canada Retail Stores Ltd.CONSOLIDATED EARNINGS STATEMENTas at December 31, 2004

OPERATING SECTION28. Net Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $43,800,00029. Less: Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,250,000

—————30. Gross Operating Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,550,00031. Less: Selling, administrative and general expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $12,752,00032. Less: Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556,00033. Less: Directors’ remuneration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 13,418,000

————— —————34. Net Operating Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,132,000

NON-OPERATING SECTION35. Income from investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000

—————36. TOTAL OPERATING AND NON-OPERATING SECTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,262,000

CREDITORS’ SECTION37. Less: Bank interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 120,70038. Less: Bond interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,300 289,000

————— —————

OWNERS’ SECTION39. Earnings before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,973,00040. Less: Income Taxes:

Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 830,000Future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 880,000

————— —————41. Less: Non-controlling Interest in earnings of subsidiary companies . . . . . . . . . . . . 12,00042. Equity Income – affiliated company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,00043. Earnings before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,086,000

—————44. Extraordinary gain on sale of capital assets (net of taxes) . . . . . . . . . . . . . . . . . . . 200,000

—————45. Net earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,286,000

========

Trans-Canada Retail Stores Ltd.CONSOLIDATED RETAINED EARNINGS STATEMENTas at December 31, 2004

46. Balance at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,936,500========

45. Net earnings for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,286,000—————

11,222,500Deduct Dividends –

47. on preferred shares ($2.50 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 37,50048. on common shares ($1.00 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 387,500

————— —————24. Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,835,000



Trans-Canada Retail Stores Ltd.CONSOLIDATED CASH FLOWS STATEMENTas at December 31, 2004

OPERATING ACTIVITIES43. Earnings before extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,086,00032. Add items not involving cash – Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556,00049. Future Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,00041. Non-controlling interest in income of subsidiary companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,00042. Equity income – affiliated company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . *(5,000)50. Net change in operating working capital items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (401,000)

—————CASH FLOWS FROM OPERATING ACTIVITIES 1,298,000

FINANCING ACTIVITIES51. Proceeds from share issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,00052. Repayment of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (400,000)53. Borrowing of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,00054. Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (387,500)

—————CASH FLOWS FROM FINANCING ACTIVITIES 12,500

INVESTING ACTIVITIES55. Acquisitions of capital assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (900,000)56. Proceeds from disposal of capital assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,00057. Dividends received from affiliated company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

—————CASH FLOWS FROM INVESTING ACTIVITIES (823,000)

58. INCREASE IN CASH AND TEMPORARY INVESTMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487,500

59. CASH AND TEMPORARY INVESTMENTS – BEGINNING OF YEAR . . . . . . . . . . . . . . . . . . . . . . 1,681,500

60. CASH AND TEMPORARY INVESTMENTS – END OF YEAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,169,000

SUPPLEMENTAL INFORMATION

61. INTEREST PAID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289,000

62. INCOME TAXES PAID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432,000

*( ) = deduction

AUDITORS’ REPORT

To the Shareholders of Trans-Canada Retail Stores Ltd.

We have audited the balance sheet of Trans-Canada Retail Stores Ltd. as at December 31, 2004 and the statements ofearnings, retained earnings and cash flows for the year then ended. These financial statements are the responsibility of thecompany’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require thatwe plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material mis-statement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used and significant estimates made by management,as well as evaluating the overall financial statement presentation.

In our opinion, these financial statements present fairly, in all material respects, the financial position of the company as atDecember 31, 2004 and the results of its operations and the cash flows for the year then ended in accordance withCanadian generally accepted accounting principles.

Toronto, Ontario

February 8, 2005 Signature of Auditors

CSC CHAPTER 4

VOLUME 1


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