Understanding and Using Financial Statements
Andrew GrahamQueens University
School of Policy StudiesSPS 827 2014
Structure of the Day
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Double Entry and the Dreaded
Debits and Credits
Accounting Cycle and the
Fundamental Accounting Equation
Financial Statements Architecture
Section 1The Accounting Cycle
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Double-Entry Bookkeeping
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Each financial event is called a transaction• The effect of a transaction is recorded in the
accounts by an entry• Each entry will affect at least two parts of the
accounting record to balance the record – debit and credit
• This does not mean that the financial event is recorded twice – rather it is balanced against either costs, increased or reduced liability, changes in inventory, etc.The Principle of Balance
Double-entry accounting is based on a simple concept: each party in a business transaction will receive something and give something in return. In bookkeeping terms, what is received is a debit and what is given is a credit. The T account is a representation of a scale or balance.
Luca PacioliDeveloper ofDouble-EntryAccounting
Scale or Balance
ReceiveDEBIT
GiveCREDIT
T account
Left SideReceiveDEBIT
Right SideGive
CREDIT
The double-entry system provides checks and balances to ensure that your books are always in balance.
In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits.
Because debits equal credits, double-entry accounting prevents some common bookkeeping errors.
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Double Entry Bookkeeping
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You provide consulting services, on account, to one of your regular customers, Betty Fry, for $1,500. When you write up the invoice, you would make the following bookkeeping entry in your sales journal:
Debit CreditAccounts receivable (Fry) 1,500Consulting revenue 1,500
Upon receipt of the invoice, your customer sends you a cheque for $1,500 in payment of her account. When you receive the check, make the following entry in your cash receipts journal: Debit Credit
Cash 1,500Accounts receivable (Fry) 1,500
Accounting Cycle – within time period
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Financial Event
Source Record
Analyze and
Classify Transactio
n
Record through Journal Entry
Post to Ledge
Accounts
Accounting Cycle – at the end of an accounting period
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Prepare a Trial
Balance
Correct Errors and
Make Adjustment
s
Adjusting Entries
Revised Trial
BalanceFinancial
Statements
Closing Journal Entries
Final Adjustment
s and Restatemen
ts
Steps performed throughout the accounting period:
Identify the transaction or other recognizable event.
Prepare the transaction's source document such as a purchase order or invoice.
Analyze and classify the transaction. Record the transaction by making entries in
the appropriate journal. Such entries are made in chronological order.
Post general journal entries to the ledger accounts.
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The Accounting Cycle
Steps performed at the end of the accounting period:
Prepare the trial balance to make sure that debits equal credits.
Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include:
posting of the wrong amount, omitting a posting, posting in the wrong column, or posting more than once.
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The Accounting Cycle
Prepare adjusting entries to record accrued, deferred, and estimated amounts.
Post adjusting entries to the ledger accounts. Prepare the adjusted trial balance. This step is similar to the
preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found.
Prepare the financial statements. Income statement: prepared from the revenue, expenses, gains,
and losses. Balance sheet: prepared from the assets, liabilities, and equity
accounts. Cash flow statement: derived from the other financial statements
using either the direct or indirect method.
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The Accounting Cycle
Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses.
Post closing entries to the ledger accounts. Prepare the after-closing trial balance to
make sure that debits equal credits. Prepare reversing journal entries (optional).
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The Accounting Cycle
Section 2The Fundamental Accounting Equation
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The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:
Measure how the company has been doing (income statement)
Show where it stands financially at the end of the period (balance sheet)
Summarize transactions with its owners (statement of retained earnings or statement of owners’ equity).
One further extension allows us to summarize balance sheet changes (statement of cash flows).
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The accounting equation as a framework for financial reporting
Assets = Liabilities + Owner’s Equity
The resources owned by a
business
The Accounting Equation
Assets = Liabilities + Owner’s Equity
The rights of the creditors, which
represent debts of the business
The Accounting Equation
Assets = Liabilities + Equity
The residual worth
The Accounting Equation
Assets = Have Economic resources owned by the organization
that are expected to be of benefit to it in the future
Rights owed that have a monetary value e.g. right to collect fees
Cash. Office supplies, inventory, furniture, land and buildings
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The Fundamental Accounting Equation
The Basic Logic of the Equation: What you have minus what you is what you are worth.
Grouping of assets for presentation on Financial Reports:
Very liquid – cash and securities Assets for immediate use - inventory Productive Assets – plant and machinery Accounts receivable Fixed Assets – capital holdings Restricted Assets – non-mission holdings or
assets held subject to highly restrictive conditions.
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The Fundamental Accounting Equation
Liabilities = Owe Outsider claims which are economic
obligations payable to outsiders Outside parties are called creditors
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The Fundamental Accounting Equation
Equity = Value to Owners = Worth = Net Debt Insider claims to the organization’s assets From a public sector perspective, it reflects the public holdings
that remain after transactions – these can be both assets and debts
An owner has a claim to the entity’s assets because he or she has invested in the business
Amount of an entity’s assets that remain after the liabilities are subtracted
Often referred to as net assets Governments will refer to this portion often as Non-Financial
Assets/Debt
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The Fundamental Accounting Equation
Section 3Recording Financial Information
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Recording Financial Information
A financial event is one that affects the fundamental accounting equation by changing any of its components:
Assets = Liabilities + Net Assets
A journal is a chronological listing of every financial event that occurs in an organization.
Every type of asset, liability, revenue, or expense is referred to as an account. Organizations may have as many accounts as they need.
From journal to general ledger
Journal: chronological Ledger: analytical Journal entries are
posted (copied), line by line, to corresponding account in the general ledger
Use a T-account to represent an account
Account nameDebit
Creditxxx
xxx25
Financial events are recorded as a series of debits and credits Increases in assets are recorded by debits and decreases are recorded by credits.
Increases in liabilities and in owner's equity are recorded by credits and decreases are recorded by debits.
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Recording Financial Information – Debits and Credits
Notice that the debit and credit rules are related to an account's location in the balance sheet. If the account appears on the left-hand side of the balance sheet (asset accounts), increases in the account balance are recorded by left-side entries (debits).
If the account appears on the right-hand side of the balance sheet (liability and owner's equity accounts), increases are recorded by right-side entries (credits).
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Recording Financial Information – Debits and Credits
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Debits, Credits and the T-Account
Increases are recorded on one
side of the T-account, and decreases are
recorded on the other side.
Left or
Debit Side
Right or
Credit Side
Title of Account
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Debit Credit
A debit in an increase in an asset item; a decrease in a claim or expense item
A credit is an increase in a claim item; a decrease in an asset or revenue item.
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A = L + NAASSETS
Debit for
Increase
Credit for
Decrease
NET ASSETS
Debit for
Decrease
Credit for
Increase
LIABILITIES
Debit for
Decrease
Credit for
Increase
Debits and credits affect accounts as follows:
Debit and Credit Rules
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A Sample Transaction Suppose an agency buys inventory for $2,000. We could just
add it to assets. But, that puts the Fundamental Equation out of balance.
Assets = Liabilities + Net AssetsSupplies
$2,000 = no change + no change
We have not paid for the supplies. Suppose the seller sent a bill. We would record the full transaction as:
Assets = Liabilities + Net Assets
Supplies Accounts Payable + $2,000 = + $2,000 + no
change To record a financial event, at least two elements of the
fundamental equation must change.
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Supplies Accounts Payable
Debit DebitCredit Credit
$2000 $2000
Asset
Account
Liability
Account
Debits = Credits
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A One-Sided Change Example
Not every financial event (transaction) results in changes to both sides of the fundamental equation. Suppose the agency paid for the inventory in cash. Then the transaction would have been recorded as follows:
Assets = Liabilities + Net Assets
Inventory Cash + $2,000 - $2,000 = no change +
no change The fundamental equation is still in balance. But, all of the
changes occurred on the left side of the equation.
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Supplies Cash
Debit DebitCredit Credit
$2000 $2000
Asset
Account
Asset
Account
Debits = Credits
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Recording Transactions
The first step in recording a transaction is determining what has happened and what accounts will be impacted.
Suppose near the end of the year, the agency buys a one-year insurance policy for $100 and pays for the policy in cash. Two things have happened:
- Cash has gone down by $100.- The agency owns a new $100 asset called "prepaid
insurance." Here's the way the transaction would be recorded:
Assets = Liabilities + Net Assets
P/I Cash + $100 - $100 = no change + no change
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Another Example
The agency mails a cheque to its bedpan supplier for $2,000 to pay part of the $7,000 it owed them at the start of the year. Two things have happened:
- Cash has gone down by $2,000.- The agency’s accounts payable have decreased by $2,000.
Here's the way the transaction would be recorded:
Assets = Liabilities + Net Assets
Cash = Accounts Payable - $2,000 = - $2,000
+ no change
Debit
Credit
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A Non Transaction
A hospital signs a binding contract to buy an X-Ray machine that will cost $50,000.
This event will not give rise to a journal entry because it does not meet its rules for recognition.
- The value of the transaction is known.
- The timing of the transaction is known.
- But, the hospital does not yet own the equipment. There has been no exchange. So the hospital does not owe the money. No liability unless we owe the creditor.
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“A person should not go to sleep atnight until the debits equaled the credits”
Friar Luca dal Bargo, founder of modern accounting, 1450
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“Never call an accountant a credit to his profession; a good accountant is a
debit to his profession.” – Sir Charles Lyell.
Section 4
Financial Statements
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Balance Sheet/ Statement of Financial Position
Income Statement/ Statement of Operations
Statement of Change in Net DebtStatement of Cash Flows
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Core Financial Statements
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Describes where the
organization stands at a
specific date.
Income Statement
Balance Sheet
Statement of Cash Flows
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Depicts the revenue and
expenses for a designated
period of time.
Income Statement
Balance Sheet
Statement of Cash Flows
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Depicts the ways cash has changed during
a designated period of time.
Income Statement
Balance Sheet
Statement of Cash Flows
Statement of Financial Position or The Balance Sheet
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The Balance Sheet reports:
Has Today = Owes today + Worth today
A Snapshot in time
AssetsCash $ 40Accounts receivable 100Land 200
Total assets $340
LiabilitiesAccounts payable $ 50Notes payable 150
$200Owners’ EquityCapital stock $100Retained earnings 40
$140 Total liabilities and owners’ equity $340
Sample Balance Sheet
Must Equal
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Current and Long-Term Assets Assets on the balance sheet are divided into
current or short-term (those that are cash or cash-equivalents or are expected to become cash or will be used up within twelve months) and long-term (those that will not).
Short-Term or Current Assets are listed in order of declining liquidity and normally include:
- cash and cash equivalents,- marketable securities,- accounts receivable,- inventory, and- prepaid expenses (long-term prepaid
expenses are called Deferred Charges)
The ultimate liquid assets Includes all forms of immediately available
funds, including bank deposits Always denominated in Canadian funds even
if foreign currencies being held
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Cash and Cash Equivalents
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Marketable Securities
Marketable securities include equity and debt instruments that can be bought and sold in public and private markets.
The values of marketable securities are reported by governments and not-for-profit organizations at fair market value.
If there is any dispute about fair market value, then cost is used to provide a value.
When an organization produces a product, service or obligation for another entity and it is transferred to the entity, the organization acquires the right to collect the money from that entity – this establishes a receivable account
An accounts receivable entry is made when this occurs but before the entity pays for it
Knowing what the outstanding accounts receivable are for the organization is an important indicator of its anticipated income, the degree to which is it efficiently collecting for its services and the degree to which it is carrying debt that it should collect
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Accounts Receivable
Inventory is both the finished products held by the organization for sale to an outside buyer and the products used to make the finished product
Three kinds of inventory: Raw material inventory Work-in-progress inventory Finished goods inventory
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Inventory
This becomes an accounts
receivable when it is sold and cash
when the customer pays for it.
Financial obligations that the organization has already paid for but not yet received
Examples are: insurance, rent, deposits made with suppliers, salary advances
They are current assets not because they can be turned into cash, but because the organization will have to use cash to pay for them in the near future and they are generally available for consumption within the twelve month period
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Pre-paid expenses
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Long-Term AssetsLong-Term Assets are generally divided into
three categories:1. Fixed Assets, which include:
1. property (land) usually recorded at cost,
2. plant (buildings) recorded at cost and reported at net book value, and
3. equipment recorded at cost and reported at net book value
2. Investments, and3. Intangibles
Productive assets not intended for sale. They will be used over and over again to
produce value to the end product of the organizations
Commonly include land, buildings, machinery, equipment, furniture, vehicles, etc.
Normally reported on Balance Sheet in Net Fixed Asset format: listed at original cost minus an allowance for depreciation
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Fixed Assets
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Net Fixed Asset Determination
Recorded at cost when acquired. Reported net of accumulated depreciation on the
balance sheet.Suppose an organization buys a van for $30,000 and expects to use it for five years and sell it for $5,000. Assuming that the van will be used up evenly over the five years, how would its value appear on the balance sheet at the end of two years?
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A Net Book Value Example
Subtract two years of depreciation[($30,000 - $5,000 salvage)/5 yr. life] x 2 = $10,000
Record the Van at Cost = $30,000
Net Book Value =$30,000 cost - $10,000 Accumulated Depreciation = $20,000
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Fixed Assets on the Balance SheetAll three values - cost, accumulateddepreciation, and net book value are shown.
Museum A Museum B
Are these two museums really similar or different?
Net Fixed Assets orNet Book Value $1,000,000 $ 1,000,000Property, Plant & Equipment at cost $40,000,000
$ 2,000,000
Accumulated Depreciation (39,000,000) (1,000,000)
Net Book Value $ 1,000,000 $ 1,000,000
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Recognizing Asset Transactions Financial events are recorded at the time of Recognition
Asset transactions are recognized when:- they are owned by the organization,- they have a monetary value,- that monetary value can be objectively
determined.
Which of the following should be recognized as assets? the amount due on a bill sent to a
client? an overhead projector? a fundraising mailing list developed in an
organization?
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Recognizing Asset Transactions
Intangibles, intangible assets, knowledge assets and intellectual capital are more or less synonyms. All are widely used – intangibles specifically in the accounting literature, knowledge assets by economists and intellectual capital predominantly in the management literature.
Intangibles create future value. All intangibles are future-oriented.
Rule of quantification – slippery slope of quantification
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Can Intangible Assets Appear on a Balance Sheet?
Good will and knowledge assets………which represents the amount by which the price of an acquired company exceeds the fair value of the related net assets acquired.
This excess is presumed to be the value of the company’s name and reputation and its customer base, intellectual capital, and workforce.
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Can Intangible Assets Appear on a Balance Sheet?
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Liabilities Liabilities are economic obligations of the
organization such as money that it owes to lenders, suppliers, employees, etc.
Like assets, liabilities are categorized as short term and long term depending on when they are due for payment.
Can be categorized and groups for presentation on the balance sheets by:
To whom the debt is owned and Whether the debt is payable within the year
Generally consist of: specific "payables" which are typically due within a
specified period, usually the current fiscal year, e.g. wages or salary payable
Generally have the following groupings: Accounts payable to suppliers Accrued expenses owed to employees and other for
services Current debt owed to lenders Taxes owed
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Short-term or current liabilities
Monetary obligations similar to accounts payable Some flexibility on how these categories are
used Generally accrued expenses involve financial
obligation within the organization Therefore, this often records salary earned but
not yet paid, interest due but not yet paid on bank debt, pension buy-outs, outstanding training costs
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Accrued Expenses – Wage Payable
Obligations to pay, generally to other organization for material sand equipment bought on credit, that must soon be paid
When it receives materials, the organization can either pay for them immediately with case or wait and let what is owed become an account payable
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Accounts Payable
Short-term obligations that are payable in a year or less
Brings in long-term obligations, but only the amount to be spent within the year to discharge it
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Notes Payable/Current Portion of Debt
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Long-Term Liabilities
Long-Term Liabilities included in Liabilities section is the current portion of the long-term liability that would have to be paid in the next 12 months:
- Long-Term Debt,– Capital Leases– Long-Term Unsecured Loans– Mortgages– Bonds Payable
- Pension Liabilities, and- Contingent Liabilities.
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Liability Recognition
Liabilities are recognized when: they are legally owed, have to be paid, and the amount to be paid can be objectively
measured. Which of the following should be recognized as
a liability? a bill received from a vendor? wages that are due to a worker? a $5 million lawsuit filed against an
organization?
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Equity/Net Asset Categories The amount of total assets minus total liabilities equals
equity. Because equity is equal to the net difference between
assets and liabilities, it is also called net assets. The net worth of an organization represents the sum of
the organization's earnings from inception plus any paid-in capital
Retained earnings/ accumulated surplus/deficit: money that is held after all liabilities have been discharged and not used for assets
Net debt is the accumulated debt of a government that it carries forward from one year to the next.
The Income Statement or Statement of Operations
Also called Activity Statement, Statement of Revenues and Expenses
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Reports on all changes in financial position in the organization in a given period
Statement of cash movement for a specific period of time, usually a quarter, month or year – a specified period of time.
Unlike a Balance Sheet which is a snapshot of a specific day Can be the most important in reading into the activities of the
organization, its ability to meet obligations and ability to stay within budget
Key tool in financial control and budgetary management: used to inform of current financial situation, identify surplus/deficits, measure performance
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What is a Statement of Operations?
Basic Income Statement Formula
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Revenues – Expenses = Net Income (Net Loss)
represent inflows that the organization has received or is entitled to receive.
result in an inflow of Assets to the organization and an increase in Net Assets.
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The Income Statement: Revenues and Support
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Recognizing Revenue and Support Revenue is recognized if:
- the goods or services have been provided,- the amount to be collected can be objectively
measured, - there is a reasonable likelihood of collection.
Support is recognized if:- all of the conditions of the gift have been met,- the value of the pledge can be objectively
measured, and- there is a reasonable likelihood of collection.
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Recognizing ExpensesExpense Recognition depends on the type of expense:
- Product costs are those directly connected to providing goods and services. They are recognized based on the matching principle, which holds that expenses should be recorded in the same period as the revenue they were used to generate.
- Period Costs, like rent, are those related to the passage of time. They are recognized in the time period they are incurred.
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Deferred Revenue Deferred or unearned revenues arise when an
organization is paid in advance for goods or services. Deferred usually long term, Unearned usually short term.
- Why is deferred revenue a liability to an organization? A museum sells a five-year membership for $250.
- How much of the $250 should be recorded as deferred
revenue?
- How much of the $250 would the museum recognize as revenue during the first year of the membership?
Has to provide basis of comparison: Compare to previous years Compare to budget
As statement of flow, reflects what actually happened over the year
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Statement of Operations: Key to Understanding Performance
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Increase (Decrease) %
ENROLMENTElementary 34,531.73 34,499.35 -32.38 -0.1%Secondary 18,034.02 18,088.30 54.28 0.3%
Total Enrolment 52,565.75 52,587.65 21.90 0.0%
OPERATING REVENUEGrants for Student Needs 498,520,530$ 498,641,782$ 121,251$ 0.0%Prior Year Grants (66,509) (66,509) Other Grants 4,613,718 6,879,161 2,265,443 49.1%Other Revenues 3,494,858 3,860,856 365,998 10.5%Continuing Education Other 5,366,511 4,577,934 (788,577) -14.7%
OPERATING REVENUE 511,995,617$ 513,893,224$ 1,897,607$ 0.4%
OPERATING EXPENDITURES 517,273,902 517,019,109 (254,793)$ 0.0%
(5,278,285)$ (3,125,885)$ 2,152,400$ -40.8%
EXTRAORDINARY ITEMS:
Extraordinary Items -$ 1,170,365$ 1,170,365$
(5,278,285)$ (1,955,520)$ 3,322,765$ -63.0%
5,278,285$ 1,955,520$ (3,322,765)$ -63.0%
-$ -$ -$
UTILIZATION OF AS-AFC
Balance
Variance2010-11 Revised
Estimates2010-11Actual
Results
(DEFICIT) before Extraordinary Items
SURPLUS (DEFICIT) after Extraordinary Items
2010-11 Financial Operating Results
York Catholic District School Board
2010-11YEAR END FINANCIAL REPORT
Cash Flow Statements
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Links Balance Sheet and Income Statement elements to change in cash position.
Integral part of holy trinity of financial statements
Undoes some accrual accounting adjustments underlying the income statement.
Presents cash flows logically organized by source or type of activity generating the cash flows.
403MSBASOCF.ppt81
Statement of Cash Flows
The Cash Flow Statement shows: Cash on hand at the start of the period Cash received in the period Cash spent in the period Cash on hand at the end of the period
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The Cash Flow Statement
Why does an organization need both an operating statement and a cash flow statement? Cash flow statements provide vital budget to plan information in
purely cash terms Cash flow information gives you information on your budgetary
flexibilities and also on the actual cash performance versus the predicted one for cash/budget management purposes
Why is it important to know the sources and uses of cash flow? This will depend on the nature of the organization – less so with
single source (budget funds) of cash Isn't knowing if cash increased or decreased enough?
No, source and availability are important
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The Cash Flow Statement
The Example OrganizationStatement of Cash Flows
December 31, 2011
Cash Flows From Operating Activities:Receipts 48 Payments (43) 5
Cash Flows From Investing Activities:Receipts 0 Payments (4) (4)
Cash Flows Used By Financing Activities:Receipts 10 Payments (6) 4
Net Cash Flow 5
Notes to the Financial Statements
Four general types of notes:Summary of significant accounting policies:
assumptions and estimates.Additional information about the summary
totals.Disclosure of important information that is
not recognized in the financial statements.Discuss concentrations of risk, commitments
and contingencies, related party transactions, and other significant items
Statements that project likely financial results based on known policies and projections
Projected financial position, operations and cash flows
Unlike financial statements, this is prospective, based on a planned course of action
Common in private sector – emerging in public sector
Requirement for all federal departments 86
Future Oriented Financial Statements
Section 5: Ratios and Financial Analysis
Financial Analysis
Two Objectives• Measure financial condition• Measure financial performance
Financial Analysis
Horizontal Analysis: Looks at trends in performance and strength over time
Vertical Analysis: Looks at within year events rather than over time
Ratio Analysis: Allows for consistent comparison of a single unit over time as well as comparison between units
Five Criteria Being Looked AtLiquiditySolvencyProfitabilityFinancial EfficiencyRepayment Capacity
Liquidity: Ability of an entity to pay current liabilities as they come due
Current Ratio• Current Assets/Current Liabilities• Less than one is bad
Working capital• Current assets minus current
liabilities• Negative number is bad
Solvency: Ability of an entity to repay all of its financial obligations
Debt to Asset Ratio• Total liabilities/total assets• Greater than one bad
Equity to Asset Ratio• Total equity/total assets
Debt to Equity Ratio• Leverage ratio• Less than one better
Profitability
Rate of return on assetsRate of return on equityOperating profit margin ratio
Limited government application, but viable in both government enterprises and not-for-profits
Financial Efficiency: the intensity with which an entity uses its assets to generate results and the effectiveness of production
Asset turnover ratioOperating expense ratioDepreciation ratioInterest expense ratioNet income from operations ratio
Repayment Capacity: Measures the borrower’s ability to repay term debts and capital leases rather than financial position or performance
Term debt and capital lease coverage ratio
Capital replacement and term repayment margin
Cautions
Measures are only as good as the data usedMethods must be consistent between years
and between operations• Example – Asset valuation methods
Measures ask the right questions but do not provide the answers
Federal debt as a % of GDP Revenues as a % of GDP Interest ratio: public debt charges as a % of
revenues
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Key Macro Ratios the Federal Government Now Tracks in its Financial Statements
Source: https://www.fin.gc.ca/afr-rfa/2013/report-rapport-eng.asp
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Are we having fun
yet?