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Page 1
After studying this chapter, you should be able to do the following:
1 LEARNING !"E#$I%E&
1 L1 Recogni'e the infor(ation con)eyed in each of the four basic financial state(ents and how it is used by
different decision (a*ers +in)estors, creditors, and (anagers-p- .
1 L. Identify the role of International /inancial Reporting &tandards +I/R& in deter(ining the content of
financial state(ents-p- 10
L2 Identify the roles of (anagers and auditors in the accounting co((unication process-p- .1
L3 Appreciate the i(portance of ethics, reputation, and legal liability in accounting-p- .3
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/#4& #5PAN6:Nestl7 &-A-
%AL4ING AN IN%E&$5EN$ 4&ING /INAN#IAL &$A$E5EN$ IN/R5A$IN
N
estl7 &-A-, based in %e)ey, &wit'erland, is the world8s leading nutrition, health, and wellness co(pany- It was
founded in 1099 by enri Nestl7, a phar(acist who de)eloped a baby for(ula that offered a safe and (ore
nutritious alternati)e to e;isting breast (il* substitutes for (others who were unable to pro)ide breast (il*-
People
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$he Players
$he success story of Nestl7 began in 1099 when the #o(pany8s founder, enri Nestl7, by in)esting a (aDor
portion of his sa)ings, beca(e the sole owner of the co(pany- As is co((on in new businesses, the founder also
functioned as (anager of the business +he wasowner?(anager-
hen he started the co(pany, enri Nestl7 needed additional (oney to build (anufacturing facilities and to
de)elop the business- &o he borrowed (oney fro( a local ban* and other lenders, or creditors, and used the fundsto e;pand the business- enri Nestl78s leadership in de)eloping the baby for(ula and then e;panding into other
(il* products and baby foods helped Nestl7 beco(e the leading international nutrition, health, and wellness
co(pany-
Page .
In)estorsFindi)iduals who buy s(all percentages of large corporationsF(a*e their purchases hoping to gain in
two ways- $hey hope to recei)e a portion of what the co(pany earns in the for( of cash pay(ents called
di)idends, and they hope to e)entually sell their share of the co(pany at a higher price than they paid-
#reditors lend (oney to a co(pany for a specific length of ti(e- $hey gain by charging interest on the (oney
they lend- hen Nestl7 e;changes (oney with its lenders and owners, these are called financing acti)ities- hen
Nestl7 buys or sells property, such as roasting e
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accounting syste(- Internal (anagers typically re
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E;hibit 1-1$he Accounting &yste( and Cecision 5a*ers
Page 2
$o understand the way that in)estors and creditors use Nestl78s financial state(ents in their decisions, we (ust
first understand what specific infor(ation is presented in the four basic financial state(ents for a co(pany suchas Nestl7-
e present (any new business and financial state(ent ter(s in this chapter- Instead of trying to (e(ori'e the
definitions of e)ery ter( used in this chapter, focus your attention on learning the general structure and content of
the state(ents- &pecifically, you should focus on these
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reports and at the end of the year +*nown as annual reports-
$he &tate(ent of /inancial Position1
$he purpose of the state(ent of financial position is to report the financial position +a(ount of assets, liabilities,
and shareholders8 e
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specific date of the state(entFAt Cece(ber 21, .==>
unit of (easureF+in (illions of &wiss francs
Page
$he organi'ation for which
financial data are to be collected
and reported is called an
accounting entity- $he accounting
entity (ust be precisely defined
and is often called the business or the corporation- n the state(ent of financial position, the accounting entity
itself, not the business owners, is )iewed as owning the resources it uses and as owing its debts-
An A##4N$ING EN$I$6is the organi'ation for which financial data are to be collected-
$he heading of the state(ent indicates the ti(e di(ension of the report- $he state(ent of financial position is li*e
a financial snapshot clearly stating the entity8s financial position at a specific point in ti(eFin this case,
Cece(ber 21, .==>Fwhich is stated clearly on the state(ent- /inancial reports are nor(ally deno(inated in the
currency of the country in which they are legally re
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$he basic accounting e
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Liabilities are the entity8s legal obligations that result fro( past business e)ents- $hey arise pri(arily fro( the
purchase of goods or ser)ices on credit and through cash borrowings to finance the business-
$here are se)en types of liabilities listed on Nestl78s state(ent of financial position- $he trade payables arise fro(
the purchase of goods and ser)ices fro( suppliers on credit, without a for(al written contract +or note- &hort?
ter( borrowings represent a(ounts borrowed fro( ban*s and other creditors, to be repaid in the near future- $he
inco(e ta;es payablerepresent an a(ount due to the go)ern(ent8s ta; authorities as a result of the co(pany8sprofitable operations- $he accrued liabilities are a(ounts owed to suppliers of )arious types of ser)ices, such as
rent and utilities-
Long?ter( borrowings result fro( cash borrowings based on for(al written debt contracts with lending
institutions such as ban*s- $he pro)isions are esti(ated a(ounts payable in the future, but the e;act a(ount and
ti(ing of the pay(ent depends on actual future e)ents- Nestl7 is a )ery large global co(pany that incurs (any
other liabilities, which are identified and described in future chapters-
&hareholders8 e
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A Note on /or(atA few additional for(atting con)entions are worth noting here- Assets (ay be listed on the
state(ent of financial position in either increasing or decreasing order of their con)ertibility to cash- &o(e
international co(panies, li*e Nestl7, list their assets beginning with the (ost li
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$he first part reports the accountant8s pri(ary (easure of a co(pany8s perfor(ance: re)enues generated less
e;penses incurred during the accounting period- Accountants label this (easure of perfor(ance Oprofit- $he
second part reports other co(prehensi)e inco(e, which co(prises inco(e and e;pense ite(s that are not
recogni'ed in the inco(e state(ent in accordance with International /inancial Reporting &tandards-
#o(panies can present all ite(s of inco(e and e;penses either in one state(ent of co(prehensi)e inco(e or in
two related state(entsFan inco(e state(ent reporting the re)enues and e;penses that ha)e already affectedprofit, and a state(ent of co(prehensi)e inco(e reporting inco(e and e;pense ite(s that will affect profit in the
future- e discuss the inco(e state(ent in this chapter and the state(ent of co(prehensi)e inco(e in #hapters 9
and 1.-
Nestl7 uses the two?state(ent
approach- A - $he
ti(e period co)ered by the financial state(ents +one year in this case is called an accounting period-
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E;hibit 1-2Inco(e &tate(ent
Page 1=
$heA##4N$ING
PERIC is the
ti(e period co)ered by the financial state(ents-
Notice that Nestl78s inco(e state(ent has three (aDor captions: re)enues, e;penses, and profit- $he inco(e
state(ent e
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wholesale distributors, it recei)es a pro(ise of future pay(ent called a trade recei)able, which is collected in cash
at a later date- In either case, the business recogni'es the total of cash and credit sales (ade during a specific
accounting period as re)enue for that period- %arious ter(s are used in financial state(ents to describe different
sources of re)enue +e-g-, pro)ision of ser)ices, sale of goods, rental of property- Nestl7 lists two sources: sales
re)enue, fro( selling nutrition and health products, and other inco(e fro( its in)est(ents as well as profit fro(
selling property, plant, and e, because during Cece(ber .==> the salespeople e;erted the
efforts resulting in co((issions for successfully selling the co(pany8s )arious products-
Page 11
Profit +also called net inco(e or net earnings is the e;cess of total re)enues o)er total e;penses incurred to
generate re)enue during a specific period- Nestl78s profit for the year (easures its success in selling nutrition and
health goods for (ore than it cost to generate those sales- If total e;penses e;ceed total re)enues, a loss is
reported- +Losses are nor(ally noted by parentheses around the reported figure- hen re)enues and e;penses are
e
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Dust by 1= percent, forcing Nestl7 to do the sa(e in order to retain its (ar*et share, or if Nestl7 had to triple
(ar*et de)elop(ent to catch up to a co(petitor, its profit could be reduced significantly and (ay turn into a loss-
$hese factors and others help in)estors and creditors esti(ate the co(pany8s future profit based on past
infor(ation-
&EL/?&$4C6 H4IJ 1?.
Learning which ite(s belong in each of the inco(e state(ent categories is an i(portant first step in understanding
their (eaning- 5ar* each inco(e state(ent ite( in the following list as a re)enue +R or an e;pense +E, without
referring to E;hibit 1-2-
#ost of goods sold &elling and ad(inistrati)e
&ales
Curing the year .==>, Nestl7 deli)ered nutrition and health products to custo(ers for which the custo(ers paid, or
pro(ised to pay in the future, a(ounts totalling #/ 1=,910 (illion- Curing the sa(e period, it collected #/
11=,=9= (illion in cash fro( its custo(ers- ithout referring to E;hibit 1-2, indicate which of the two a(ounts
will be shown on Nestl78s inco(e state(ent as sales re)enue for .==>- E;plain-
Curing the year .==>, Nestl7 produced nutrition and health ite(s with a total production cost of #/ 32,1
(illion- Curing the sa(e period, itdeli)ered to custo(ers goods that had cost a total of #/ 3,.=0 (illion to
produce- ithout referring to E;hibit 1-2, indicate which of the two a(ounts will be shown on Nestl78s inco(e
state(ent as cost of goods sold for .==>- E;plain-
After you co(plete your answers, go online
for the solutions-
&elf?&tudy Hui' 1?. &olution
Page 1.
$he &tate(ent of #hanges in E
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!eginning retained earnings M Profit Q Ci)idends Ending retained earnings
Ele(ents $he state(ent begins with Nestl78s balances to share capital, retained earnings, and other e
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di)idends, #/ 3,>0. (illionK cost of goods sold, #/ 3,22> (illionK and profit, #/ 1>,=1 (illion- ithout
referring to E;hibit 1-3, co(pute ending retained earnings-
After you co(plete your answers, go online
for the solutions-
&elf?&tudy Hui' 1?2 &olution
E;hibit 1-&tate(ent of #ash /lows
$he &tate(ent of #ash /lows
&tructureNestl78s state(ent of cash flows, presented in E;hibit 1-, di)ides Nestl78s cash inflows +receipts and
outflows +pay(ents into three pri(ary categories of cash flows in a typical business: cash flows fro( operating,
in)esting, and financing acti)ities- $he heading identifies the na(e of the entity, title of the state(ent, and unit of
(easure used- Li*e the inco(e state(ent, the state(ent of cash flows co)ers a specified period of ti(e +the
accounting period, which in this case is one year-
As discussed earlier in this chapter, reported re)enues do not always e
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period- !ecause the inco(e state(ent does not pro)ide any infor(ation concerning cash flows, accountants
prepare the state(ent of cash flows to report inflows and outflows of cash-
$he &$A$E5EN$ / #A& /L& reports cash inflows and outflows that are related to operating,
in)esting, and financing acti)ities during the accounting period-
$he state(ent of cash flows e (illion by signing on long?
ter( borrowings-
Page 1
/INAN#IALANAL6&I&IN$ERPRE$ING $E &$A$E5EN$ / #A& /L&
5any analysts belie)e that the state(ent of cash flows is particularly useful for predicting future cash flows that
(ay be a)ailable for pay(ent of debt to creditors and di)idends to in)estors- !an*ers often consider the operating
acti)ities section to be the (ost i(portant because it indicates the co(pany8s ability to generate cash fro( sales to
(eet its current cash needs- Any a(ount left can be used to repay the ban* debt or e;pand the co(pany-
&hareholders will in)est in a co(pany if they belie)e that it will e)entually generate (ore cash fro( operations
than it uses, so that cash will beco(e a)ailable to pay di)idends and to e;pand- $he in)esting acti)ities section
shows that Nestl7 has (ade significant in)est(ents in new (anufacturing capacity, a good sign if de(andcontinues to increase- $he financing acti)ities section indicates that Nestl7 was able to pay di)idends to
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shareholders and repay part of its short?ter( and long?ter( borrowings because it generated cash fro( operating
acti)ities-
&EL/?&$4C6 H4IJ 1?3
Curing the period .==>, Nestl7 deli)ered nutrition and health products to custo(ers that paid, or pro(ised to pay
in the future, a(ounts totalling #/ 1=,910 (illion- Curing the sa(e period, it collected #/ 11=,=9= (illion in
cash fro( its custo(ers- ithout referring to E;hibit 1-, indicate which of the two nu(bers will be shown on
Nestl78s state(ent of cash flows for .==>-
Learning which ite(s belong in each category on the state(ent of cash flows is an i(portant first step in
understanding their (eaning- 5ar* each ite( in the following list as a cash flow fro( operating acti)ities +,
in)esting acti)ities +I, or financing acti)ities +/, without referring to E;hibit 1-- Also place parentheses around
the letter only if it is a cash outflow-
#ash paid for di)idends
#ash paid for interest
#ash recei)ed fro( ban* borrowings #ash paid for ta;es
#ash paid to purchase property, plant, and e
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E;hibit 1-9Relationships a(ong Nestl78s &tate(ents
&ource: Nestl7 &-A-
Page 19
/INAN#IALANAL6&I&5ANAGE5EN$ 4&E& / /INAN#IAL &$A$E5EN$&
In our discussion of financial analysis thus far, we ha)e focused on the perspecti)es of in)estors and creditors- In
addition, (anagers within the fir( often (a*e direct use of financial state(ents- /or e;a(ple, Nestl78s (ar*eting
(anagers and credit (anagers use custo(ers8 financial state(ents to decide whether to e;tend credit to the( for
their purchases of nutrition and health goods- Nestl78s purchasing (anagers analy'e financial state(ents of
suppliers to Dudge whether the suppliers ha)e the resources to (eet Nestl78s de(and for ingredients and in)est in
the de)elop(ent of new ingredients- !oth Nestl78s hu(an resource (anagers and the e(ployees8 union use the
co(pany8s financial state(ents as a basis for contract negotiations o)er pay rates- $he profit figure e)en ser)es as
a basis for co(putinge(ployee bonuses-
hen Nestl78s (anagers e;a(ine the financial state(ents of the co(pany8s custo(ers and suppliers, they rely on
these state(ents as the best source of financial infor(ation a)ailable to e;ternal users because they do not ha)e
access to internal financial infor(ation produced by their custo(ers and their suppliers- owe)er, when they
(a*e internal decisions regarding Nestl78s operations, they rely on (ore detailed financial infor(ation obtained
through the co(pany8s (anagerial accounting syste(-
Page 1
Notes to /inancial &tate(ents
At the botto( of each of the four basic financial state(ents you will typically find the following state(ent: O$he
notes are an integral part of these financial state(ents- $his is the accounting e
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N$E& +/$N$E&pro)ide supple(ental infor(ation about the financial condition of a co(pany,
without which the financial state(ents cannot be fully understood-
$here are three basic types of notes- $he first type pro)ides descriptions of the accounting rules applied in the
co(pany8s state(ents- $he second presents additional detail about a line on the financial state(ents- /or e;a(ple,
Nestl78s in)entory note indicates the costs of raw (aterials and supplies, nutrition and health ite(s that are in the
process of being co(pleted, and finished products that are ready for sale to custo(ers- $he third type of note
presents additional financial disclosures about ite(s not listed on the state(ents the(sel)es- /or e;a(ple, Nestl7
is e;posed to significant ris*sK the ris*s related to credit and fluctuations in e;change rates are disclosed in a note-
e will discuss (any note disclosures throughout the boo* because understanding their content is critical to
understanding the co(pany-9
&u((ary of the /our !asic /inancial &tate(ents
e learned a lot about the content of the four basic state(ents- E;hibit 1-su((ari'es this infor(ation- $a*e a
few (inutes to re)iew the infor(ation in the e;hibit before you (o)e on to the ne;t section of the chapter-
/INAN#IALANAL6&I&CE$ER5INING NE&$LS8& P4R#A&E PRI#E
E)en at this early stage of your study of accounting, we can illustrate part of the process that in)estors (ay use to
deter(ine the price they are willing to pay for Nestl7- $he price is decided by considering a )ariety of factors,
including the )alue of Nestl78s assets, its debts to others, its ability to sell goods for (ore than their production
cost, and its ability to generate the cash necessary to pay its current bills- $hese factors are the subDect (atter of
Nestl78s financial state(ents-
In general, in)estors use prior years8 financial perfor(ance to (a*e proDections about future perfor(ance- $hey
(ay be willing to pay for a fir( that reported high profit in the past if they belie)e it will produce higher profit in
the future-
ne (ethod for esti(ating the )alue of a co(pany that relies on net earnings and growth in earnings is with a
priceTearnings ratio +or PTE ratio or PTE (ultiple- $he PTE ratio (easures the (ultiple of current year8s earnings
that in)estors are willing to pay for the co(pany8s shares- A high PTE ratio (eans that in)estors ha)e confidence in
the co(pany8s ability to produce higher profits in future years-
Page 10
#o(petitors8 PTE ratios often ser)e as a starting point in analy'ing the price that should be paid for a co(pany or
its shares- If we assu(e that other co(panies in the sa(e industry with si(ilar perfor(ance and past growth were
selling for 1 ti(es their current year8s earnings, then the price per share could be deter(ined by using the
following co(putation:
$he role of net
earnings in
deter(ining
the )alue of a
co(pany will be discussed in (ore detail in your corporate finance course and (ore ad)anced courses in financial
state(ent analysis-
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E;hibit
1-&u((ary of
/our !asic
/inancial&tate(ents
1 &o(e co(panies
refer to this
state(ent as a
Obalance sheet, a
title that was
co((only used
prior to the
adoption of I/R& in
#anada-
. A corporation is a
business that is
incorporated under
the federal or
pro)incial laws- $he owners are called shareholdersor stoc*holders- wnership is represented by shares of capital
that usually can be bought and sold freely- $he corporation operates as a separate legal entity, separate and apart
fro( its owners- $he shareholders enDoy li(ited liabilityK they are liable for the debts of the corporation only to
the e;tent of their in)est(ents- Appendi; 1Adiscusses for(s of ownership in (ore detail-
2 A detailed )ersion of the state(ent of changes in e
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state(ents that do not represent what they clai( to are (eaningless and cannot be used effecti)ely to (a*e
decisions- /or e;a(ple, if the state(ent of financial position lists .,===,=== for a factory that does not e;ist, that
part of the state(ent does not con)ey useful infor(ation-
Cecision (a*ers also need to understand the (easure(ent rules applied in co(puting the nu(bers on the
state(ents- A swi( coach would ne)er try to e)aluate a swi((er8s ti(e in the O1== freestyle without first as*ing
whether the ti(e was for a race in (etres or in yards- Li*ewise, a decision (a*er should ne)er atte(pt to useaccounting infor(ation without first understanding the (easure(ent rules that were used to de)elop the
infor(ation- $hese (easure(ent rules are based on International /inancial Reporting &tandards +I/R&- $hese
enco(pass broad principles, specific rules, practices, and con)entions of general application that are used by
organi'ations to record transactions and report financial state(ent infor(ation to interested users-
IN$ERNA$INAL /INAN#IAL REPR$ING &$ANCARC& +I/R&are guidelines for the (easure(ent
rules used to de)elop the infor(ation in financial state(ents-
International /inancial Reporting &tandards +I/R&
ow are Accounting &tandards Ceter(ined$he accounting syste( that we use today has a long history- Its
foundations are nor(ally traced bac* to the wor*s of an Italian (on* and (athe(atician, /r- Luca Pacioli- In13>3, he described an approach de)eloped by Italian (erchants to account for their acti)ities as owner?(anagers
of business )entures- 5any others wrote wor*s on accounting after Pacioli, but prior to 1>22, each co(pany8s
(anage(ent largely deter(ined its own financial reporting practices- $hus, little unifor(ity in practice e;isted
a(ong co(panies-
$he &E#4RI$IE& ANC EB#ANGE #55I&&IN +&E#is the 4-&- go)ern(ent agency that deter(ines
the financial state(ents that public co(panies (ust pro)ide to shareholders and the (easure(ent rules that
they (ust use in producing those state(ents-
$he N$ARI &E#4RI$IE& #55I&&IN +is the (ost influential #anadian regulator of the flow of
financial infor(ation pro)ided by publicly traded co(panies in #anada-
/ollowing the dra(atic stoc* (ar*et decline of 1>.>, the &ecurities Act of 1>22 and the &ecurities E;change Act
of 1>23 were passed into law by the 4-&- #ongress- $hese acts created the &ecurities and E;change #o((ission
+&E# and ga)e it broad powers to deter(ine the (easure(ent rules for financial state(ents that co(panies (ust
pro)ide to shareholders- In #anada, pro)incial securities legislation created securities co((issions, (ost notably
the ntario &ecurities #o((ission +, to regulate the flow of financial infor(ation pro)ided by publicly
traded co(panies whose shares trade on #anadian stoc* e;changes, such as the $oronto &toc* E;change- &i(ilar
to the &E#, the plays an influential role in pro(otion, sur)eillance, and enforce(ent of sound accounting
practices by publicly traded co(panies- $he is one of 12 securities regulators of #anada8s pro)inces and
territories- $hese regulators ha)e for(ed the #anadian &ecurities Ad(inistrators, which coordinates andhar(oni'es regulation of the #anadian capital (ar*ets a(ong the(-
&ince their establish(ent, these securities co((issions ha)e wor*ed with organi'ations of professional
accountants to establish groups that are gi)en the pri(ary responsibilities to wor* out the detailed rules that
beco(e generally accepted accounting principles- $he current #anadian group that has this responsibility is the
Accounting &tandards !oard +Ac&! of the #anadian Institute of #hartered Accountants- $he Ac&! is responsible
for establishing standards of accounting and reporting by publicly accountable enterprises, pri)ate enterprises,
go)ern(ent organi'ations, and not?for?profit organi'ations- $hese standards or reco((endations, which are
published in the #I#A andboo*, ha)e e;panded o)er ti(e because of the increasing di)ersity and co(ple;ity of
business practices- $he perfor(s sur)eillance and enforce(ent functions for legal re
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(andate for the ne;t fi)e years:
Page .=
/or public co(panies, the Ac&!8s obDecti)e is to (o)e to a single set of globally accepted high?
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changes to the a(ount of bonuses recei)ed by (anage(ent and e(ployees, and
loss of co(petiti)e ad)antage o)er other co(panies-
Page .1
IN$ERNA$INALPER&PE#$I%E$E IN$ERNA$INAL A##4N$ING &$ANCARC& !ARC ANC
GL!AL #N%ERGEN#E / A##4N$ING &$ANCARC&
REAL RLC EB#ERP$Celoitte IA& Plus ebsite
+www-iasplus-co(V
/inancial accounting standards and disclosure re
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5anagers of co(panies that prepare fraudulent financial state(ents are subDect to cri(inal and ci)il penalties-
$he REPR$ $ 5ANAGE5EN$ +5ANAGE5EN$ #ER$I/I#A$INindicates (anage(ent8s pri(ary
responsibility for financial state(ent infor(ation and the steps to ensure the accuracy of the co(pany8s
records-
Page ..
$hree steps to ensure the accuracy of records:
$he role of the independent auditor is described in (ore detail in the audit report, or report of independent
auditors +E;hibit 1-0- $he audit report describes the auditor8s opinion of the fairness of the financial state(ents,
and the e)idence gathered to support that opinion- It is i(portant to note that the (ain difference between thereport of (anage(ent and the report of the independent auditors concerns the responsibility for the financial
infor(ation included in the co(pany8s annual report- As the report of the independent auditors indicates, the
auditor8s responsibility is to e;press an opinion on Nestl78s financial state(ents that ha)e been prepared by its
accounting personnel and re)iewed by the audit co((ittee of the board of directors, which assu(es responsibility
for the
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!ecause of the enor(ous nu(ber of transactions that total billions of dollars each year for a (aDor enterprise, such
as Air #anada, the auditor does not e;a(ine each transaction- Rather, professional approaches are used to
ascertain beyond reasonable doubt that transactions were (easured and reported properly-12
5any opportunities e;ist for (anagers to intentionally prepare (isleading financial reports- An audit perfor(ed
by an independent auditor is the best protection a)ailable to the public- hen that protection fails, howe)er, the
independent auditor is so(eti(es found liable for losses incurred by those who rely on the state(ents- In thisregard, the #anadian Public Accountability !oard was created in .==2 to pro)ide public o)ersight for auditors of
public co(panies-
E;hibit
1-0Auditors8 ReportPage .3
Ethics, Reputation,
and Legal Liability
L3Appreciate the
i(portance of
ethics, reputation,
and legal liability
in accounting-
If financialstate(ents are to be
of any )alue to
decision (a*ers,
users (ust ha)e
confidence in the
fairness of the
infor(ation- $hese
users will ha)e
greater confidencein the infor(ation
if they *now that
the people who
were associated with auditing the financial state(ents were re
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Association of #anada notes in its #ode of Ethical Principles and Rules of #onduct that an accountant8s actions
will ha)e an influence not only on the welfare of society but also on that of the profession- 1$he &ociety of
5anage(ent Accountants of #anada has also issued a few publications related to ethical conduct, such as #odes
of Ethics, Practice and #onduct and I(ple(enting Ethics &trategies within rgani'ations- 19
/ailure to co(ply with professional rules of conduct can result in serious penalties for professional accountants,
including rescinding the professional designation of an offending (e(ber- $he potential econo(ic effects ofda(age to reputation and (alpractice liability, howe)er, pro)ide e)en stronger incenti)es to abide by professional
standards- $hus, the profession recogni'es that its (e(bers8 reputations for ethical conduct and co(petence are
their (ost i(portant assets- /inally, recent changes in laws and securities regulation per(it the assess(ent of
personal financial penalties on professional accountants who are found guilty of non?co(pliance, and they (ust
co(pensate for the financial har( done to others-
/inancial state(ent fraud is a fairly rare e)ent, due in part to the diligent efforts of practising professional
accountants- In fact, (any such frauds are first identified by the fir(8s accounting staff or its e;ternal auditors who
ad)ise regulatory authorities of possible wrongdoing- In doing so, these Owhistle blowers place the interest of the
public at large ahead of their own interests and act accordingly- owe)er, in case of (alpractice, independent
auditors (ay be held liable for losses suffered by those who relied on the audited financial state(ents-
It is i(portant to note that the )ast (aDority of (anagers and owners do act in an honest and responsible (anner-
owe)er, when the top officers in an organi'ation collude to decei)e other parties, they (ay te(porarily succeed-
In (any cases, e)en the (ost diligent audit (ay not i((ediately unco)er the results of fraud in)ol)ing collusion
of the top officers of a corporation, such as occurred in a nu(ber of well?publici'ed cases such as 6!5 5agne;
International Inc- and Li)ent Inc- in #anada, A(erican In)est(ent Group Inc- +AIG in the 4nited &tates, &ie(ens
AG in Ger(any, and Par(alat &-p-A in Italy- owe)er, those who were in)ol)ed in fraudulent beha)iour were
e)entually identified and were sanctioned by the appropriate legal authorities-
5isrepresentations by (anagers highlight the i(portance of ensuring the integrity of the financial reporting
syste( by the public accounting profession- Cisclosure of financial infor(ation that does not confor( to e;istingaccounting standards i(poses significant costs on the shareholders, creditors, and e(ployees of co(panies
affected by fraudulent acti)ities- Recent refor(s of the accounting profession and the i(position of new
go)ern(ent regulations both in #anada and the 4nited &tates (a*e it (ore difficult and costly for co(pany
(anagers to engage in fraudulent acti)ities-
Page .
A##4N$ING &$ANCARC&/R PRI%A$E EN$ERPRI&E
$he use of International /inancial Reporting &tandards is re
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$he financial state(ents prepared by both types of co(panies are based on the sa(e conceptual fra(ewor*, but
they (ay differ with respect to the details that are reported in the financial state(ents and related notes- /or
e;a(ple, the concept of other co(prehensi)e inco(e is not applicable to pri)ate enterprises- ence, they are not
re3,=== was collected by year?end-
4sed up ,=== of supplies while rendering ser)ices-
Paid 3,=== for other ser)ice e;penses-
Paid 1,=== in annual interest e;pense on the note payable-
Paid 0,=== of inco(e ta;es to #anada Re)enue Agency-
Re
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Page .9
&4GGE&$EC &L4$IN
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Accounting &tandards in #anada: New CirectionsF&trategic Plan, #anadian Institute of #hartered Accountants,
.==9,page 1-
0 $he IA&!8s website +www-ifrs-orgV pro)ides (ore details about the process of producing I/R&-
> Legally this is enforced by the through National Instru(ent .?1=> ?#ertification of Cisclosure in Issuers8
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Annual and Interi( /ilings- #hief e;ecuti)e and chief financial officers (ust sign a legal docu(ent with e)ery
financial report filed with the - $hat docu(ent certifies that the #E and #/ ha)e designed or super)ised
the design of a financial data collection and reporting syste( that will result in financial state(ents free of
(aterial (isstate(ent and fraud- $his is an assurance of the
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shares of capital that usually can be bought and sold freely- hen an appro)ed application for incorporation is
filed by the organi'ers, a charter is issued by either the federal or the pro)incial go)ern(ent- $his charter gi)es the
corporation the right to operate as a legal entity, separate fro( its owners- $he shareholders enDoy li(ited liability-
&hareholders cannot lose (ore than they paid for their shares- $he corporate charter specifies the types and
a(ounts of share capital that can be issued- 5ost pro)inces re
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Appendi; 1!
E(ploy(ent in the Accounting Profession $oday
&ince 1>==, accounting has attained the stature of professions such as law, (edicine, engineering, and
architecture- As with all recogni'ed professions, accounting is subDect to professional co(petence re
Practice of Public AccountingAlthough an indi)idual (ay practice public accounting, usually two or (ore indi)iduals organi'e an accounting
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fir( in the for( of a partnership +in (any cases, a li(ited liability partnership, or LLP- Accounting fir(s )ary in
si'e fro( a one?person office to regional fir(s, to the O!ig /our fir(s +Celoitte X $ouche, Ernst X 6oung,
@P5G, and Pricewaterhouse#oopers, which ha)e hundreds of offices worldwide- Accounting fir(s usually
render three types of ser)ices: assurance ser)ices, (anage(ent consulting ser)ices, and ta; ser)ices-
Assurance &er)ices Assurance ser)ices are independent professional ser)ices that i(pro)e the
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#AP$ER $A@E?AA6&
Recogni'e the infor(ation con)eyed in each of the four basic financial state(ents and how it is used by different
decision (a*ers +in)estors, creditors, and (anagers-p- .
$he state(ent of financial position reports financial )alues for the assets, liabilities, and shareholders8 e
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@E6 $ER5&
Accountingp- .Accounting Entityp- Accounting Periodp- 1=Accounting &tandards !oard +Ac&!p- 1>Auditp-
..Audit Report +Report of Independent Auditorsp- ..!asic Accounting EInternational Accounting &tandards !oard +IA&!p- .=International /inancial Reporting &tandards +I/R&p-1>Notes +/ootnotesp- 1ntario &ecurities #o((ission +p- 1>Report to 5anage(ent +5anage(ent#ertificationp- .1Retained Earningsp- 1.&ecurities and E;change #o((ission +&E#p- 1>&tate(ent of #ash/lowsp- 12&tate(ent of #hanges in E&tate(ent of/inancial Position +!alance &heetp- 3
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After studying this chapter, you should be able to do the following:
. LEARNING !"E#$I%E&
. L1 4nderstand the obDecti)e of financial reporting and the related *ey accounting assu(ptions and principles- p-3
. L. Cefine the ele(ents of a classified state(ent of financial position-p- =
L2 Identify what constitutes a business transaction, and recogni'e co((on account titles used in business-p- 9
L3 Apply transaction analysis to si(ple business transactions in ter(s of the accounting (odel: Assets
Liabilities M &hareholders8 E
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/#4& #5PAN6:Nestl7 &-A-
EBPAN&IN &$RA$EG6 IN $E N4$RI$IN, EAL$, ANC ELLNE&& INC4&$R6
N
estl7 &-A- +www-nestle-co(, founded in 1099, produces and (ar*ets a wide assort(ent of nutrition, health, and
wellness products, including baby foods, brea*fast cereals, chocolate, coffee, dairy products, ice crea(, bottled
water, and pet foods- Its products are sold in o)er 1== countries in the fi)e continents-
Nestl7 grew rapidly o)er the past 9= years to beco(e the leading food co(pany worldwide, with a total of 33>(anufacturing facilities in 03 countries by Cece(ber 21, .==>, including 1= factories in #anada- $he co(pany
has e;ecuted its growth strategy by ac>0, Nestl7 has in)ested
o)er = billion &wiss francs to grow through ac, co(pared to Cece(ber 21, 1>>0, +in (illions of &wiss francs highlights its
growth:
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&ource: Nestl78s annual reports
Page 39
$he co(pany8s annual growth in sales and total assets since 1>>0 is highlighted in the graph-
4NCER&$ANCING $E !4&INE&&
Nutrition, health, and wellness are issues that concern all people- Indi)iduals stri)e to get proper nutrition and be
healthy for as long a period as possible- Go)ern(ents also e;ert e)ery effort to help their citi'ens get proper
nutrition to be producti)e (e(bers of society- /or this reason, nutrition, health, and wellness ha)e attracted the
attention of (any businesses worldwide- A large nu(ber of co(panies ha)e e(erged o)er ti(e to (eet the needs
of people see*ing basic nutrition and healthy lifestyles- Nestl7, @raft /oods, #onAgra /oods, &ara Lee, Le Groupe
Canone, and #adbury a(ong others capture (ost of the global retail (ar*et for nutrition and health foods and
drin*s- $hese and other co(panies co(pete ferociously, with Nestl7 capturing the lion8s share of the global
(ar*et-Nestl7 has been a global food (anufacturing giant since the 1>==s when it had operations on four continents- $he
co(pany relies on a strategy of , Nestl7 in)ested #/ . billion in
research and de)elop(ent- $he business (odel that has been so successful for Nestl7 rests also on sound scientific
e)idence of i(pro)ed nutrition- $he co(pany is proud of its history of both de)eloping reliable suppliers in
de)eloping countries and creating a safe (anufacturing setting, sourcing o)er two?thirds of its #/ .= billion of
raw (aterials +(il*, coffee, cocoa fro( the(- Nestl7 is co((itted to sustainable production, socially responsible
business practices, and reducing en)iron(ental pollution and waste-
$he co(pany8s financial perfor(ance, reported in its audited financial state(ents, helps users to understand how
well Nestl7 has i(ple(ented its strategy in the past and to e)aluate future growth potential-
/inancial state(ents are intended to co((unicate the econo(ic facts, (easured in (onetary units, in a
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standardi'ed, for(al way- $herefore, by applying accounting principles consistently, accountants for(ally
co((unicate co(parable esti(ates that faithfully represent i(portant econo(ic facts about co(panies li*e Nestl7
and its co(petitors- As e;plained in #hapter 1, financial state(ents include four co(ponents: the state(ent of
financial position, the state(ent of co(prehensi)e inco(e, the state(ent of changes in e
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financial reporting- $his fra(ewor* is the subDect of a (aDor proDect underta*en Dointly by the IA&! and the
/inancial Accounting &tandards !oard +/A&! of the 4nited &tates- .$his conceptual fra(ewor* is presented in
E;hibit .-1as an o)er)iew, with *ey concepts discussed in the ne;t fi)e chapters- An understanding of the
accounting concepts will be helpful as you study because learning and re(e(bering how the accounting process
wor*s is (uch easier if you *now why it wor*s a certain way- A clear understanding of these concepts will also
help you in future chapters as we e;a(ine (ore co(ple; business acti)ities-
#oncepts E(phasi'ed in #hapter .
$he PRI5AR6 !"E#$I%E / EB$ERNAL /INAN#IAL REPR$INGis to pro)ide useful econo(ic
infor(ation about a business to help e;ternal parties (a*e sound financial decisions-
bDecti)e of /inancial Reporting $he pri(ary obDecti)e of e;ternal financial reporting is to pro)ide useful
econo(ic infor(ation about a business to help e;ternal parties, pri(arily in)estors and creditors, (a*e sound
financial decisions in their capacity as capital pro)iders- $he users of accounting infor(ation are identified as
decision (a*ers- $hese decision (a*ers include a)erage in)estors, creditors, and e;perts who pro)ide financial
ad)ice- $hey are all e;pected to ha)e a reasonable understanding of accounting concepts and procedures +this (aybe one of the reasons why you are studying accounting- f course, as we discussed in #hapter 1, (any other
groups, such as suppliers and custo(ers, also use e;ternal financial state(ents- $o achie)e this obDecti)e, financial
reports (ust enable decision (a*ers not only to assess the a(ounts, ti(ing, and uncertainty of future cash inflows
and outflows but also to understand the financial )alue of both the assets owned and clai(s against those assets
+liabilities and e
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co(pany for personal use should not be (i;ed with buildings owned by the co(pany- 4nder the unit?of?(easure
assu(ption, each business entity accounts for and reports its financial results pri(arily in ter(s of the national
(onetary unit +dollars in #anada, euros in European union countries, pesos in 5e;ico, etc-, e)en if the entity has
business operations in (any countries-
Page 3>
$he &EPARA$E?EN$I$6 A&&45P$INstates that business transactions are separate fro( the transactionsof the owners-
$he 4NI$?/?5EA&4RE A&&45P$IN states that accounting infor(ation should be (easured and
reported in the national (onetary unit-
$he use of a specific unit of (easure allows for (eaningful aggregation of financial a(ounts- /urther(ore,
accountants assu(e that the unit of (easure has a stable )alue o)er ti(e, e)en though we recogni'e that the price
we pay to purchase a specific ite(, such as a candy bar, tends to increase o)er ti(e- Nestl78s state(ent of financial
position includes (any assets (easured in &wiss francs fro( the 1>=s, 1>0=s, and 1>>=s- $he stable (onetary
unit assu(ption allows accountants to co(bine different a(ounts, e)en though the purchasing power of the
(onetary unit has changed o)er ti(e-
/or accounting purposes, a business nor(ally is assu(ed to continue operating long enough to carry out its
obDecti)es and to (eet contractual co((it(ents- $his continuity assu(ption is so(eti(es called the going?
concern assu(ption because we e;pect a business to continue to operate into the foreseeable future- %iolation of
this assu(ption (eans that assets and liabilities should be )alued and reported on the state(ent of financial
position as if the co(pany were to be li
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se)eral years ago and reports it on the state(ent of financial position at historical cost- Although the (ar*et price
or econo(ic )alue of the land has risen o)er ti(e, its recorded )alue re(ains unchanged at its original cost
because this a(ount is a )erifiable (easure based on an actual e;change that occurred in the past- It would be
desirable to show on the state(ent of financial position the land8s current (ar*et )alueK that is, the price at which
it could either be sold or replaced instead of its outdated historical cost- owe)er, the land8s current )alue (ay not
be reliable if different real estate appraisers produce different )alues for the sa(e piece of land- Accountantscontinue, therefore, to rely on historical cost (easures for reporting purposes because they are factual, although
they (ay not be useful for specific decision?(a*ing purposes- /urther(ore, as long as Nestl7 re(ains a going
concern it is unli*ely to sell the land at its current (ar*et )alue- $he land retains usefulness, often referred to as
the asset8s )alue?in?use, to Nestl7- If Nestl7 has no intent to sell the land, then its current (ar*et )alue is not
specifically rele)ant to understanding the financial health of the co(pany- $he use of alternati)e (easure(ent
bases for asset )aluation will be discussed in #hapter >-
Page =
Assets, liabilities, and e, and the other at Cece(ber 21, .==0, one year earlier- $his syste( allows in)estors to
co(pare, at a glance, the )alue of each classified ele(ent fro( year to year, and then analy'e these changes to
understand whether the co(pany8s financial position has i(pro)ed or deteriorated o)er ti(e-
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E;hibit .-.Nestl78s &tate(ent of /inancial Position
Nestl78s state(ent of financial position is shown in colu(n or report for(at, with assets listed first, followed by
liabilities, and then shareholders8 e
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&hort?ter( in)est(ents
$rade and other recei)ables
Page .
In)entories
Prepay(ents +i-e-, e;penses paid in ad)ance of use
ther current assetsNon?current assets +long?ter(
Property, plant, and e
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Notice the balance of trade recei)ables decreased fro( #/ 1=,. (illion at Cece(ber 21, .==0, to #/ >,3.
(illion at Cece(ber 21, .==>, indicating that the cash collected fro( custo(ers e;ceeded the a(ount of sales on
credit- An in)estor would also obser)e that cash and cash e- In)estors would e;a(ine the state(ent of cash
flows to gain clearer insight on how e)ents in the past year resulted in the change in cash and cash e
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#urrent liabilities +short?ter(
$rade payables
&hort?ter( borrowings
Inco(e ta;es payable
Page 3
Accrued liabilitiesther current liabilities
Non?current liabilities +long?ter(
Long?ter( borrowings
Ceferred inco(e ta; liabilities
Pro)isions
ther liabilities
#4RREN$ LIA!ILI$IE&are obligations that will be paid in cash +or other current assets or satisfied by
pro)iding ser)ice within the co(ing year-
Li*e assets, liabilities are di)ided into two subgroups: current and non?current- $hey are listed by order of ti(e to(aturity +how soon an obligation (ust be paid- #urrent liabilities, *nown as short?ter( liabilities, (ust be paid
within the ne;t year or operating business cycle of the co(pany, whiche)er is longer- Nor(ally, the cash fro(
con)erting current assets is used to pay current liabilities- $he first current liability is trade payables, which
represents the total a(ount owed to suppliers of (aterials that Nestl7 used in producing and pac*aging its
products for sale- $he second current liability, short?ter( borrowings, represents short?ter( loans fro( ban*s-
!an* loans are co((on when the co(pany does not ha)e a sufficient a(ount of cash to pay its creditors- $he
third liability,inco(e ta;es payable, is si(ply an esti(ate of the a(ount of ta;es Nestl7 is e;pected to pay to
ta;ation authorities- Accrued liabilities represent the total a(ount owed to suppliers for )arious types of ser)ices
such as payroll, rent, and other obligations- ther current liabilities, when reported, will include a nu(ber of
liabilities with relati)ely s(all a(ounts that are co(bined-
/INAN#IALANAL6&I&ANAL6&I& / #ANGE IN $RACE PA6A!LE&
4sing both current assets and current liabilities for Nestl7, we can i(pro)e our analysis of the a)ailability of cash
to repay debts to creditors and di)idends to shareholders-
$he co(pany8s current liabilities shows that Nestl7 owes #/ .,.1 (illion (ore in current liabilities at
Cece(ber 21, .==>, than it did at Cece(ber 21, .==0- As in)estors, we would tentati)ely conclude that the
co(pany has increased its reliance on suppliers to finance its current assets- owe)er, in)estors (ust learn far
(ore about the business cycle for nutrition and health products, the outloo* for the industry sectors in which
Nestl7 operates, and its (ain co(petitors before co(ing to a fir( conclusion-
At the beginning of this chapter, we stated that in)estors are (ost interested in rele)ant infor(ation that helps
the( predict future cash inflows and outflows- /ro( this )ery preli(inary analysis, in)estors can predict that,
because Nestl7 has increased its current liabilities by #/ .,.1 (illion, a larger a(ount of cash to repay the
outstanding debt to creditors is needed ne;t year than in the current year-
NN?#4RREN$ LIA!ILI$IE&are a co(pany8s debts that ha)e (aturities e;tending beyond one year fro(
the date of the state(ent of financial position-
Non?current liabilities are a co(pany8s debts ha)ing (aturities e;tending beyond one year fro( the date of the
state(ent of financial position- $hey include long?ter( borrowings fro( ban*s and other lenders, deferred inco(e
ta; liabilities that arise fro( te(porary differences between the profit (easured in accordance with I/R& and
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ta;able profit that is deter(ined in confor(ity with applicable ta; laws, pro)isions that are esti(ated liabilities
characteri'ed by uncertainty about the e;act a(ount to be paid and the ti(ing of the pay(ent, and other liabilities
that include a nu(ber of other liabilities- $hese )arious types of non?current liabilities will be co)ered in future
chapters-
Page
A H4E&$IN/ A##4N$A!ILI$6EN%IRN5EN$AL LIA!ILI$IE&F$E GREENING /A##4N$ING &$ANCARC&
/or (any years, co(panies faced growing pressure to esti(ate and disclose en)iron(ental liabilities such as the
cleanup of ha'ardous waste- International /inancial Reporting &tandards +I/R& re financial state(ents, representing
appro;i(ately 0 percent of its total liabilities at Cece(ber 21, .==>- It is esti(ated, howe)er, that a significant
percentage of co(panies under?report or fail to report such liabilities, often because of the way disclosure rules
are applied-
A *ey econo(ic concern for (any #anadian co(panies is how to (anage their resources in an econo(ically
sustainable way- Nestl7, li*e (any co(panies, publishes a report on en)iron(ental sustainability, which includes
both financial and non?financial perfor(ance indicators that (easure its progress toward (eeting its sustainable
de)elop(ent targets-
Nestl78s (anage(ent belie)es that a business has to create )alue, not only for its shareholders but also for society
at large in order to be successful in the long ter(- Nestl78s co(prehensi)e report on en)iron(ental sustainability
pro)ides detailed infor(ation about the steps it has ta*en to reduce the i(pact of its acti)ities on the en)iron(ent-
$he co(pany uses en)iron(ental perfor(ance indicators to (onitor the i(pact of its acti)ities on greenhouse gas
e(issions, energy consu(ption, water consu(ption, and waste?water (anage(ent-
Nestl7 #anada8s En)iron(ental &ustainability Report for .==0 indicates that its (anage(ent ta*es its
en)iron(ental responsibility seriously- $he report illustrates how non?financial infor(ation is rele)ant to e;ternal
decision (a*ers-
&ource: Nestl7 #anada En)iron(ental &ustainability Report .==0- Nestl7 &-A-
&hareholders8 e
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Retained earnings +accu(ulated earnings that ha)e not been declared as di)idends
ther co(ponents
&hare capital reflects the proceeds recei)ed when the corporation issued the shares- ccasionally, shareholders
will contribute in e;cess of the a(ount allocated to share capital, such as pre(iu(s on shares issuedK these
contributions are called contributed surplus- $he su( of share capital and contributed surplus represents the
contributed capital of the corporation- Nestl78s share capital of #/ 9,.30 (illion has resulted fro( selling sharesto in)estors at different points in the co(pany8s history-3
&ARE #API$ALresults fro( owners pro)iding cash +and so(eti(es other assets to the business-
Page 9
5ost co(panies that operate profitably retain part of their earnings for rein)est(ent in their business- $he other
part is distributed as di)idends to shareholders- $he annual earnings that are not distributed to shareholders are
called retained earnings- Nestl78s retained earnings e, and
represent the net a(ount of earnings that ha)e not been distributed to shareholders since the co(pany was
incorporated in 102- Nestl78s growth o)er ti(e has been financed by a substantial rein)est(ent of retained
earnings- In addition to share capital and retained earnings, shareholders8 e, /ra(ewor* for the Preparation and Presentation of
/inancial &tate(ents- Adopted by the International Accounting &tandards !oard, .==1-
. /inancial Accounting &tandards !oard, #onceptual /ra(ewor* for /inancial Reporting: $he bDecti)e of
/inancial Reporting and Hualitati)e #haracteristics and #onstraints of Cecision?4seful /inancial Reporting
Infor(ation, E;posure Craft, 5ay .>, .==0-
2 $he rules for consolidation of financial state(ents are co)ered in ad)anced accounting courses-
3 In fact, this a(ount consists of #/ 29 (illion of share capital and #/ ,002 (illion of pre(iu(s recei)ed
fro( shareholders in e;change of issued shares- e ha)e co(bined these two a(ounts for si(plicity-
A$ $6PE / !4&INE&& A#$I%I$IE& #A4&E #ANGE& IN /INAN#IAL &$A$E5EN$ A54N$&
L2Identify what constitutes a business transaction, and recogni'e co((on account titles used in business-
Nature of !usiness $ransactions
Accounting focuses on specific e)ents that ha)e an econo(ic i(pact on the entity- $hose e)ents that are recorded
as a part of the accounting process are called transactions- $he first step in translating the results of business
e)ents to financial state(ent a(ounts is deter(ining which e)ents to recogni'e as transactionsK only transactions
are reflected in the state(ents- As the definitions of assets and liabilities indicate, only econo(ic resources and
debts resulting fro( past transactions are recorded on the state(ent of financial position- $ransactions include two
types of e)ents:A $RAN&A#$INis +1 an e;change between a business and one or (ore e;ternal parties to a business or +.
a (easurable internal e)ent, such as adDust(ents for the use of assets in operations-
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E;ternal e)ents are e;changes of assets, goods, or ser)ices by one party for assets, ser)ices, or pro(ises to pay
+liabilities by one or (ore other parties- E;a(ples include the purchase of a (achine fro( a supplier, the sale of
(erchandise to custo(ers, borrowing of cash fro( a ban*, and in)est(ent of cash in the business by the owners-
$ransactions that affect ele(ents of the state(ent of financial position are discussed in this chapter, and those that
affect inco(e state(ent ele(ents will be co)ered in #hapter 2-
Internal e)ents include certain e)ents that are not e;changes between the business and other parties butne)ertheless ha)e a direct and (easurable effect on the accounting entity- E;a(ples include using up insurance
paid in ad)ance and using buildings and e
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$rade recei)ables Notes payable Retained earnings Interest
re)enue
Rent e;pense
Notes recei)able $a;es payable Rent re)enue Interest e;pense
In)entory +to be sold Ceferred
re)enue
Cepreciation e;pense
&upplies !onds payable Ad)ertising e;pense
Prepay(ents Insurance e;pense
Long?ter(
in)est(ents
Repair e;pense
E
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do not use the ter( Opro)ision to report esti(ated liabilitiesK they do recogni'e such liabilities, howe)er, under
different titles- $he *ey to a)oiding confusion is to pay attention to the subheadings in the financial state(ents and
read the notes related to specific financial state(ent ele(ents-
&EL/?&$4C6 H4IJ .?1
!enetton Group
$he following is a list of accounts fro( a recent state(ent of financial position for the Italian co(pany !enetton
Group, which sells fashion apparel in o)er 1.= countries- Indicate on the line pro)ided whether each of the
following is an asset +A, liability +L, or shareholders8 e
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$he two concepts underlying the transaction analysis process follow:
E)ery transaction affects at least two accountsK it is critical to correctly identify the accounts affected and the
direction of the effect +increase or decrease-
$he accounting e
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Page 9=
As noted earlier, not all i(portant business e)ents result in a transaction that affects the financial state(ents- 5ost
i(portant, signing a contract in)ol)ing the e;change of pro(ises to perfor( a future business transaction does not
result in a transaction that is recorded- /or e;a(ple, if Nestl7 sent an order to its paper supplier for (ore paper
without (a*ing any pay(ent, and the supplier accepted the order but did not fill it i((ediately, then notransaction has ta*en place for accounting purposes because Nestl7 and the paper supplier ha)e e;changed only
pro(ises-9/ro( the supplier8s perspecti)e, the sa(e holds true- No transaction has ta*en place, so the supplier8s
financial state(ents are not affected- As soon as the paper is shipped to Nestl7, howe)er, the supplier gi)es up
in)entory in e;change for a pro(ise fro( Nestl7 to pay for the paper it recei)es, and Nestl7 e;changes its pro(ise
to pay for the paper it recei)es- !ecause a pro(ise has been e;changed for goods, a transaction has ta*en place,
and the financial state(ents of both Nestl7 and the supplier will be affected-
!alancing the Accounting E
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following the state(ent of financial position in E;hibit .-.- $he (onth will end on "anuary 21- /or si(plicity,
account titles are based on that state(ent of financial position- Note that all (onetary a(ounts are usually
preceded by the sy(bol of the currency used in the e;change transactions +e-g-, for #anadian dollars, [ for
euros, #/ for &wiss francs- In the following illustration, all a(ounts are in (illions of &wiss francs, but we
o(it including #/ before the (onetary a(ount, for si(plicity-
Page 91+a Nestl7 issues shares to new in)estors in e;change for 1,2== in cash-
+b $he co(pany
borrows 1,=== fro(
its local ban*,
signing a note to bepaid in two years-
$ransactions +a
and +b are
financing
transactions-
#o(panies that
need cash for
in)esting purposes +to buy or build additional facilities as part of their plans for growth often see* funds by
selling shares to in)estors, as in transaction +a, or borrowing fro( creditors, usually ban*s, as in transaction +b-
+c /or e;pansion, Nestl7 opened a new production facility- $he co(pany purchased .,.== of new coffee roasters,
counters, refrigerators, and other e
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Hui' .?.- &pace is left in the chart for your answers to the
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After you co(plete your answers,go onlineV
for the solutions-
&elf?&tudy Hui' .?. &olution+i Nestl78s board of directors appro)ed the opening of two new production plants at a (eeting in "anuary .=1=
and the borrowing of .== fro( the local ban*s to finance the construction of the new plants in /ebruary .=1=-
4nli*e transactions +a through +h, which reflect e;changes between Nestl7 and e;ternal parties, these two
decisions of the board of directors are not transactions because no e;changes ha)e ta*en place yet- $he co(pany8s
board of directors (ade co((it(ents that will li*ely translate into actions in /ebruary .=1=- &pecific state(ent
of financial position accounts will be affected only when the actual e;changes occur in /ebruary .=1=- owe)er,
such co((it(ents will nor(ally be disclosed in a financial state(ent note-
/ro( this concept, accountants ha)e de)eloped what is *nown as the double?entry syste( of record*eeping-
9 #ontracts of this nature that are li*ely to result in significant future liabilities (ust be noted in the financial
state(ents as co((it(ents-
C #5PANIE& @EEP $RA#@ / A##4N$ !ALAN#E&LCeter(ine the i(pact of business
transactions on the state(ent of financial position by using two basic tools: Dournal entries and $?accounts-
/or (ost organi'ations, recording transaction effects and *eeping trac* of account balances in the (anner Dust
presented is i(practical- $o handle the (ultitude of daily transactions that businesses generate, co(panies
establish accounting syste(s, usually co(puteri'ed, that follow a cycle- $he accounting cycle, illustrated in
E;hibit .-3, highlights the pri(ary acti)ities perfor(ed during the accounting period to analy'e, record, and post
transactions- In #hapters . and 2, we will illustrate these acti)itiesduring the period- In #hapter 3, we will
co(plete the accounting cycle by discussing and illustrating acti)ities at the end of the period to adDust the
records, prepare financial state(ents, and close the accounting records-
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E;hibit .-3$he Accounting #ycle
Page 93
Curing the accounting period, transactions that result in e;changes between the co(pany and other e;ternal
parties are analy'ed and recorded in thegeneral Dournal in chronological order, and the related accounts are
updated in the general ledger- $hese for(al records are based on two )ery i(portant tools used by accountants:
Dournal entries and $?accounts- /ro( the standpoint of accounting syste(s design, these analytical tools are (ore
efficient (echanis(s for reflecting the effects of transactions and for deter(ining account balances for financial
state(ent preparation- As future business (anagers, you should de)elop your understanding and use of these tools
in financial analysis- /or those studying accounting, this *nowledge is the foundation for understanding the
accounting syste( and future coursewor*- After we e;plain how to perfor( transaction analysis by using thesetools, we illustrate their use in financial analysis-
$he Cirection of $ransaction Effects
$he $?A##4N$is a tool for su((ari'ing transaction effects for each account, deter(ining balances, and
drawing inferences about a co(pany8s acti)ities-
CE!I$(eans the left side of an account-
#RECI$(eans the right side of an account-
As we saw earlier, transactions change the balances of assets, liabilities, and shareholders8 e
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E;hibit .-$ransaction Analysis 5odel
Each $?account has two sides: a left side, *nown as the debit side, and a right side, *nown as the credit side-
$he increase sy(bol, M, is located on the left side of the $ for accounts that appear on the left side of the
accounting e
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Page 99
Notice the following:
It is useful to include a date or so(e for( of reference for each transaction- $he debits are written first +on top
with the a(ounts on the left side of the two colu(ns- $he credits are written below the debits and are indented to
the right in (anual recordsK the credited a(ounts are written in the right colu(n- $he order of the debited
accounts or credited accounts does not (atter, as long as the debits are on top and the credits are on the botto(
and indented to the right-
$otal debits +.,.== e
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As a group, the accounts are called a general ledger- In a (anual accounting syste( used by so(e s(all
organi'ations, the ledger is often a three?ring binder with a separate page for each account- In a co(puteri'ed
syste(, accounts are part of a database and stored on a dis*- &ee E;hibit .-9for an illustration of a Dournal page
and the related #ash ledger page- Note that the cash effects fro( the Dournal entries ha)e been posted to the #ash
ledger page- $he three digits under the ORef- colu(n in the general Dournal are e;a(ples of account codes used in
the chart of accounts-
E;hibit .-9Posting
$ransaction Effects
fro( the "ournal to
the Ledger
E;hibit .- shows
the $?accounts forthe cash and long?
ter( borrowings
accounts for Nestl7,
based on
transactions +a
through +h- Notice
that for cash, which
is an asset,
increases are shown
on the left and
decreases are on
the right side of the
$?account- /or
long?ter(
borrowings,
howe)er, increases
are shown on the
right and decreases on the left since notes payable is a liability- &o(e s(all businesses still use handwritten or
(anually (aintained accounts in this $?account for(at- #o(puteri'ed syste(s retain the concept but not thefor(at of the $?account-
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E;hibit .-$?Accounts Illustrated
Page 90
In E;hibit .-, notice that the ending balance is indicated on the positi)e side with a double underline- $o find the
account balances, we can e;press the $?accounts as e
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throughout the rest of the te;tboo* is to practise, practise, practise-
+a Nestl7 issues shares to new in)estors in e;change for 1,2== in cash-
+b $he co(pany
borrows 1,=== fro(
its local ban*,
signing a note to be
paid in two years-
Page 9>
+c /or e;pansion, Nestl7 opened a new production facility- $he co(pany purchased .,.== of new coffee roasters,
counters, refrigerators, and other e
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+f Nestl78s board of directors declares cash di)idends of .== for shareholders- $he di)idends are paid
i((ediately-
Page =
&EL/?&$4C6 H4IJ .?2
/or transactions +g and +h, fill in the (issing infor(ation, including postings to the $?accounts-
+g Nestl7 collects 2== cash fro( the trade supplier-
&elf?&tudy Hui' .?
2 &olution
+h Nestl7 paid 3== on the note owed to the local ban*-
After you co(plete your answers, )isit
#onnect atgo onlineVfor the solutions-
$he $?accounts that changed during the period because of these transactions are shown below- $he beginning
balances are the a(ounts fro( Nestl78s state(ent of financial position at Cece(ber 21, .==>- $he balances of all
other accounts re(ained the sa(e-
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6ou can )erify that you posted the entries
properly by adding the increase side and
subtracting the decrease side and then co(paring your answer to the ending balance for each $?account- %isit
#onnect atgo onlineVto chec* your answers-
Page 1
/INAN#IALANAL6&I&IN/ERRING !4&INE&& A#$I%I$IE& /R5 $?A##4N$&
$?accounts are useful pri(arily for instructional and analytical purposes- In (any cases, we will use $?accounts to
deter(ine what transactions a co(pany engaged in during a period- /or e;a(ple, the pri(ary transactions
affecting trade payables for a period are purchases of assets on account and cash pay(ents to suppliers- If we
*now the beginning and ending balances of trade payables and all of the a(ounts that were purchased on credit
during a period, we can deter(ine the a(ount of cash paid- A $?account will include the following:
I& $E &$A$E5EN$ / /INAN#IAL P&I$IN PREPAREC ANC ANAL6JEC As discussed in
#hapter 1, a state(ent of financial position is one of the financial state(ents that will be co((unicated to users,
especially those e;ternal to the business- It is possible to prepare a classified state(ent of financial position at any
point in ti(e fro( the balances in the accounts-
L9Prepare a classified state(ent of financial position and analy'e it by using the debt?to?e
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E;hibit .-0Nestl78s &tate(ent of /inancial PositionPage .
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@E6 RA$IANAL6&I&$E CE!$?$?EH4I$6 RA$I
4sers of financial infor(ation co(pute a nu(ber of ratios in analy'ing a co(pany8s past perfor(ance and
financial condition as input in predicting its future potential- /or e;a(ple, by using the ele(ents and classification
in the state(ent of financial position, creditors can assess a co(pany8s ability to pay off its debt, or see what the
co(pany8s trend is in ta*ing on (ore debt- $he change in ratios o)er ti(e and how they co(pare to the ratios ofthe co(pany8s co(petitors pro)ide )aluable infor(ation for users8 decisions-
Page 2
e introduce here the first of (any ratios that will be presented throughout the rest of this te;tboo*, with a final
su((ary of ratio analysis in #hapter 12- In #hapters ., 2, and 3, we present four ratios that pro)ide infor(ation
about (anage(ent8s effecti)eness at (anaging debt and e
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IN$ERPRE$A$IN&
In General \ $he debt?to?e
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LiabilitiesF1,3>.,>29K &hareholders8 e0,>2
#o(pute !enetton8s debt?to?e
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co(panies for 2,=== resulted in a total cash outflow of 3,>=- $he net change to cash fro( in)est(ent acti)ities is
an outflow of 3,9=-
$he second set of transactions relates to financing acti)ities and includes two transactions that increased cash and
two transactions that decreased cash- $he issuance of shares for 1,2== and borrowing 1,=== fro( the ban*
increased cash by .,2==- In contrast, pay(ent of di)idends of .== and partial repay(ent on a ban* loan of 3==
decreased cash by 9== during the sa(e period- $he net change to cash fro( financing acti)ities is an inflow of
1,==- In su((ary, the change in the cash balance fro( ,0. at Cece(ber 21, .==>, to .,0 at "anuary 21,
.=1=, can be e;plained as follows:
Page
$he state(ent of cash flows pro)ides infor(ation that not only shows the sources and uses of cash but also helps
both in)estors and creditors predict future cash flows for Nestl7 and (a*e appropriate financial decisions- $he
pattern of cash flows shown in E;hibit .->+net cash outflows for in)esting acti)ities and net cash flows fro(
financing acti)ities is typical of Nestl78s past se)eral annual state(ents of cash flows- #o(panies see*ing to
e;pand usually report cash outflows for in)esting acti)ities-
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E;hibit .->Nestl78s &tate(ent of #ash /lows
&EL/?&$4C6 H4IJ .?
Lance Inc- (anufactures and sells snac* products- Indicate whether the following transactions fro( a recent
state(ent of cash flows were in)esting +I or financing +/ acti)ities, and show the direction of the effect on cash
+M (eans increases cashK Q (eans decreases cash:
$ransactions $ype of Acti)ity +I or
/
Effect on #ash /lows +M or
Q
1- Paid di)idends
.- &old property
2- &old (ar*etable securities+in)est(ents
3- Purchased )ending (achines
- Repurchased its own shares
After you co(plete your answers, )isit
#onnect atgo onlineVfor the solutions-
&elf?&tudy Hui' .? &olution
Page 9&o(e 5isconceptions
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&o(e people confuse boo**eeping with accounting- In effect, they confuse a part of accounting with the whole-
!oo**eeping in)ol)es the routine, clerical part of accounting and re
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Issued 1,== shares in e;change for >,=== cash- Each in)estor recei)ed == shares-
Ac
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Page 0
+c $his is not a transactionK no e;change has ta*en place- No accounts are affected-
+g $his is not a transaction that in)ol)es the co(pany- $he separate?entity assu(ption states that transactions of
the owners are separate fro( transactions of the business-
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&tate(ent of financial position:
Page >
Notice that the state(ent of financial position presented earlier in the te;t listed assets on the top and liabilities
and shareholders8 e
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to help e;ternal parties, pri(arily in)estors and creditors, (a*e sound financial decisions-
@ey accounting assu(ptions and principles:
&eparate?entity assu(ptionFtransactions of the business are accounted for separately fro( transactions of the
owner-
4nit?of?(easure assu(ptionFfinancial infor(ation is reported in the national (onetary unit-
#ontinuity +going?concern assu(ptionFa business is e;pected to continue to operate into the foreseeable future-istorical cost principleFfinancial state(ent ele(ents should be recorded at their cash?e
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$?accounts su((ari'e transaction effects for each account- $hese tools can be used to deter(ine balances and
draw inferences about a co(pany8s acti)ities-
Prepare a classified state(ent of financial position and analy'e it by using the debt?to?e
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@E6 $ER5&Accountp- Assetsp- =#ontinuity +Going?#oncern Assu(ptionp- 3>#ost Principlep- 3>#reditp- 93#urrent
Assetsp- .#urrent Liabilitiesp- 3Cebitp- 93"ournal Entryp- 9Liabilitiesp- 2Non?current Assetsp- 2Non?
current Liabilitiesp- 3Pri(ary bDecti)e of E;ternal /inancial Reportingp- 30Retained Earningsp- 9&eparate?
Entity Assu(ptionp- 30&hare #apitalp- &hareholders8 E
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#ost principle
hy is it i(portant to ha)e accounting assu(ptions
ow is the debt?to?e
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A publishing fir( purchases the copyright +an intangible asset to a (anuscript for an introductory accounting te;t
fro( the author for 3=,===-
A (anufacturing fir( pays di)idends of 1==,=== to shareholders in cash-
A co(pany purchases 3== shares of est"et Airlines for ,=== cash-
Page 02
A co(pany purchases a piece of land for =,=== cash- An appraiser for the buyer )alued the land at .,==-
A (anufacturing co(pany purchases the patent +an intangible asset on a new digital satellite syste( for
tele)ision reception for ==,=== cash and a note for 3==,===, payable in one year at an annual interest of 1=
percent-
A local co(pany is a sole proprietorship +one ownerK its owner buys a car for 1=,=== for personal use- Answerfro( the co(pany8s point of )iew-
A co(pany signs a si;?(onth note for a 1,=== loan on "une 2=, .=11, to be paid bac* on Cece(ber 21, .=11,
with 1= percent annual interest-
A co(pany pays 1,== principal on its note payable-
Re
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Account &tate(ent of /inancial Position
#lassification
Cebit or #redit
!alance
1- In)est(ent properties
.- Retained earnings
2- Notes payable +due in 2 years
3- Prepay(ents- Long?ter( in)est(ents
9- &hare capital
- Aircraft, spares, and spare engines
0- $rade and other payables
>- &hort?ter( in)est(ents
1=- #urrent ta; payable
11- $rade recei)ables
1.- In)est(ent in associated co(panies
12- #ash and ban* balances
13- In)entories
1- Land and buildings
19- Ceferred re)enue
E.W3Identifying Effects on Ele(ents of the &tate(ent of /inancial Position
L3
#o(plete the following table by entering either the word increases ordecreases in colu(ns +1 and +., and either
the word debit or creditin colu(ns +2 and +3-
+1
Cebi
t
+.
#redit
+2
Increases
+3
Cecreases
Assets
Liabilities
&hareholders8
e
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Purchased 1.,=== in landK paid 1,=== in cash and signed a (ortgage note with a local ban* for the balance +due
in 1 years-
Loaned 2== to an e(ployee who signed a note due in three (onths-
Paid the ban* the a(ount borrowed in +b-
Purchased 0,=== of e
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L
E.WRecording In)esting and /inancing Acti)ities
Refer to E.W-
Re
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Paid the a(ount of the note payable in +b-
#onor 5ul*een borrowed 1=,=== for personal use fro( a local ban* and signed a note payable in one year-
Re
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Re
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E.W12Recording "ournal Entries
L
Philippine Long Cistance $elephone #o(pany
Philippine Long Cistance $elephone #o(pany is the leading teleco((unications pro)ider in the
Philippines- $he (onetary unit is the Philippine peso +- $he following e)ents were adapted fro( a recent
annual report- A(ounts are in (illions of pesos-
Ceclared 2,=23 in di)idends to be paid ne;t (onth-
rdered 93= in e
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Re
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Re
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ilton otels #orporation
ilton otels #orporation constructs, operates, and franchises do(estic and international hotel and hotel?casino
properties- Infor(ation fro( the co(pany8s recent annual state(ent of cash flows indicates the following
in)esting and financing acti)ities during that year +si(plified:
Pay(ent of debt principal .3
Purchase of in)est(ents 12>
&ale of property +assu(e sold at cost .2=
Issuance of shares 9=
Purchase and reno)ation of properties 2=
Additional borrowing fro( ban*s >>.
Receipt of principal pay(ent on a note
recei)able
1.
Re/inding /inancial Infor(ation as a Potential In)estor
L2, 9,
6ou are considering in)esting the cash you inherited fro( your grandfather in )arious co(pany shares-
6ou ha)e recei)ed the annual reports of se)eral (aDor co(panies-
Re
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Cate of the state(ent of financial position-
PR!LE5&
P.W1Identifying Accounts on a #lassified &tate(ent of /inancial Position and $heir Nor(al Cebit or #redit
!alances +AP.W1
L1, 2
$otal, &-A-
$otal, &-A- is a large, international, publicly traded integrated oil and gas co(pany that e;plores, produces,
refines, (ar*ets, and supplies crude oil and petroleu( products- It is a (aDor actor in the che(icals business, and
has operations in (ore than 12= countries on fi)e continents- $he following are se)eral of the accounts that
appeared on the co(pany8s recent state(ent of financial position-
Account &tate(ent of /inancial Position
#lassification
Cebit or
#redit
!alance
1- #ash and cash e- Accrued liabilities
1=- Ceferred re)enue
11- #urrent financial assets
1.- In)est(ent in associates
12- $rade recei)ables
13- #rude oil products and
(erchandise
1- Land and buildings
19- Pro)isions +short?ter(
Page 0>
Re
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Purchased a building for 9,===, e
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E=,===
/actory building >=,=== Retained earnings 2=,===
Curing the year .=1., the following su((ari'ed transactions were co(pleted:
Purchased e,=== in cash-
Paid ,=== on the note in transaction +a-
!orrowed 1.,=== cash on Cece(ber 21, .=1., fro( a local ban* and signed a note, payable "une 2=, .=12-
Purchased a patent +an intangible asset for 2,=== cash-
!uilt an addition to the factory for .,===K paid >,=== in cash and signed a three?year note for the balance-
ired a new president at the end of the year- $he contract was for 0,=== per year plus options to purchase
co(pany shares at a set price based on co(pany perfor(ance-
Returned defecti)e e:
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Page >.Assu(e that the following transactions occurred in the second half of .==>:
Issued additional shares for [1,.== in cash-
!orrowed [2,>. fro( ban*s due in two years-
Ceclared and paid [>2 in di)idends to shareholders-
Purchased additional intangibles for [3 cash-
Purchased property, plant, and e
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#reate $?accounts for each financial state(ent account and include the "une 2=, .==>, balances- Post each Dournal
entry to the appropriate $?accounts-
Prepare a state(ent of financial position for !ayer based on the $?account ending balances at Cece(ber 21, .==>-
#o(pute !ayer8s debt?to?e- hat does this suggest about the co(pany
P.W9Preparing the In)esting and /inancing &ections of a &tate(ent of #ash /lows +AP.W9
L!ayer AG
Refer to P.W-
Re, prepare the in)esting and financing sections of the state(ent of
cash flows of !ayer for the second half of .==>-
P.W4sing /inancial Reports: Preparing a #lassified &tate(ent of /inancial Position and Analy'ing the Cebt?to?
E-> 3- Long?ter( debt 0,>2-
3
0,2-
2
Accounts payable 90>-3 13-2 Notes payable +short ter( 33-= F
Accrued liabilities .,233-. .,133-
=
ther long?ter( liabilities 1,09>-= 1,0-.
#ash and e-
0
ther non?current assets 1,.3-= 1,220-3
#urrent (aturities of long?ter( debt 90- 09.-. Prepaid e;penses and other current assets 939-3 0-=
Intangible assets, net 1,>=- 1,0.0-
2
Property and e=2-
1
In)entories 13-= 13- Retained earnings 1.,221-
>
11,>>0->
In)est(ents in and ad)ances to
affiliates
1,=2-3 1,1=>-
>
&hare capital .,013-. .,.=.-9
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you to re)iew the infor(ation and (a*e a reco((endation on lending the funds- $he following transactions
occurred during year .=11 +the co(pany8s first year of operations:
Recei)ed cash fro( the organi'ers, 3=,===-
Purchased land for 1.,=== and signed a one?year note +at a 1= percent annual interest rate-
!ought two used deli)ery truc*s for operating purposes at the start of the year at a cost of 1=,=== eachK paid
.,=== cash and signed a pro(issory note for the balance, payable o)er the ne;t three years +at an annual interestrate of 11 percent-
&old one?fourth of the land for 2,=== to !ir*ins 5o)ing, which pro(ised to pay in si; (onths-
Paid .,=== cash to a truc* repair shop for a new (otor for one of the truc*s- +int: Increase the account you used
to record the purchase of the truc*s since the usefulness of the truc* has been i(pro)ed-
$raded the other truc* and 9,=== cash for a new one- $he old truc*8s fair )alue is 1=,===-
&hareholder "onah Lee paid ..,=== cash for a )acant lot +land for his personal use-
#ollected the a(ount of the note due fro( !ir*ins 5o)ing in +d-
Paid one?third of the principal of the note due for the deli)ery truc*s in +c-
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+1 $rade accounts recei)able +3 Long?ter( debt
+. &hort?ter( borrowings + Prepaid e;penses and other assets
+2 &hare capital +9 Intangible assets
+ Property, plant, and e $rade accounts payable +12 In)entories+1= #ash and short?ter(
in)est(ents
+13 Inco(e ta;es payable
Page >3
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!ased on beginning balances plus the co(pleted tabulation, calculate the following a(ounts at the end of .=11
+show co(putations:
$otal assets
$otal liabilities
$otal shareholders8 e
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#o(pute the debt?to?e- hat does this suggest about Gildan Acti)ewear
AP.W3Identifying Effects of $ransactions on the &tate(ent of #ash /lows +P.W3
L
Gildan Acti)ewear
Refer to AP.W2-
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Page >9Assu(e that the following transactions +in (illions of dollars occurred in the re(ainder of fiscal year .=1=
+ending on /ebruary ., .=1=:
Issued additional shares for .== in cash-
!orrowed 2= fro( ban*sK due in two years-
Purchased additional in)est(ents for 12,=== cashK one?fifth were long ter( and the rest were short ter(-
Purchased property, plant, and e
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Post each Dourn