Financial Statements Two Lectures Andrew Graham Queens University

Financial Statements Two Lectures Andrew Graham Queens University School of Policy Studies Canadian Public Sector Financial Management

The Road to Financial Statement Enlightenment Cash Flow s t en. Inc. tem p a Com e St m nco I S/H E quity S t mt Balance Sheet Should I stop and ask for directions? Canadian Public Sector Financial Management 2

A number must be kept in context with the financial statement where it is presented… Warning! All numbers are not the same! Canadian Public Sector Financial Management 3

Beware of Financial Vertigo • Easy to get confused with terminology • Much of what passes for complexity in financial statements is a terminology issue • Sometimes this is counterintuitive – debits and credits as an example • Terminology used often has the same meaning, e. g. revenue and income do not mean the same thing Canadian Public Sector Financial Management 4

Purpose of Financial Statements • To establish the basic rules and assumptions that are used to provide financial information • They will tell the accountant and end user what financial items are to be measured and when and how to measure them. Canadian Public Sector Financial Management 5

Source: Public Service Accounting Canadian Board, CICA Public Sector Financial Management 6

Section 1 The Accounting Cycle Canadian Public Sector Financial Management 7

Canadian Public Sector Financial Management 8

The Accounting Cycle • • The accounting process is a series of activities that begins with a transaction and ends with the closing of the books. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps: 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. Canadian Public Sector Financial Management 9

The Accounting Cycle • Post general journal entries to the ledger accounts. The above steps are performed throughout the accounting period as transactions occur or in periodic batch processes. The following steps are 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: v posting of the wrong amount, v omitting a posting, v posting in the wrong column, or v posting more than once. Canadian Public Sector Financial Management 10

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. v Income statement: prepared from the revenue, expenses, gains, and losses. v Balance sheet: prepared from the assets, liabilities, and equity accounts. v Cash flow statement: derived from the other financial statements Canadian Public Sector Financial using either the direct or indirect method. Management 11

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. Canadian Public Sector Financial Management 12

The Accounting Cycle • Prepare the after-closing trial balance to make sure that debits equal credits. • Prepare reversing journal entries (optional). Canadian Public Sector Financial Management 13

Section 2 The Fundamental Accounting Equation Canadian Public Sector Financial Management 14

The Fundamental Accounting Equation - Definitions The Basic Logic of the Equation: What you have minus what you is what you are worth. • 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 buildings Canadian Public Sector Financial Management 15

The Fundamental Accounting Equation - Definitions Grouping of assets for presentation on Financial Reports: v Very liquid – cash and securities v Assets for immediate use - inventory v Productive Assets – plant and machinery v Accounts receivable v Fixed Assets – capital holdings v Restricted Assets – non-mission holdings or assets held subject to highly restrictive conditions. Canadian Public Sector Financial Management 16

The Fundamental Accounting Equation - Definitions • Liabilities = Owe – Outsider claims which are economic obligations payable to outsiders – Outside parties are called creditors Canadian Public Sector Financial Management 17

The Fundamental Accounting Equation - Definitions • Equity or Capital = Value to Owners = Worth – 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 Canadian Public Sector Financial Management 18

The Fundamental Accounting Equation - Definitions • All receivables are assets • All payables are liabilities Canadian Public Sector Financial Management 19

The Fundamental Accounting Equation - Definitions • Capital stock – amount invested in the corporation by its owners • Retained Earnings – amount earned by income-producing activities and kept for use in the organization • Net Income, Earnings, Profit or Loss – result of taking total revenues and total expenses into account over a Canadian specified period Public Sector Financial Management 20

The Fundamental Accounting Equation Assets = Liabilities + Equity or Assets - Liabilities = Equity What you own minus what you owe is what you are worth. Canadian Public Sector Financial Management 21

The Fundamental Accounting Equation Claims by Outsiders Resources Assets = Liabilities + Equity Sources of Resources What you own - What you owe = What you are worth Equation must always be in balance! Canadian Public Sector Financial Management 22

Components of Retained Earnings: Flow Chart to Better Understand Financial Statements Revenues of the Period minus Expenses for the Period Beginning Balance of Retained Earnings equals plus or minus Net Income (or Net Loss) for the Period minus Dividends for the Period Canadian Public Sector Financial Management equals Ending Balance of Retained Earnings 23

Section 3 Recording Financial Information Canadian Public Sector Financial Management 24

Recording Financial Information n 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. Canadian Public Sector Financial Management 25

Recording Financial Information – Debits and Credits • 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. Canadian Public Sector Financial Management 26

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). Canadian Public Sector Financial Management 27

Debits, Credits and the T-Account Increases are recorded on one side of the Taccount, and decreases are recorded on the other side. Canadian Public Sector Financial Management Title of Account Left or Debit Side Right or Credit Side 28

Debit A debit in an increase in an asset item; a decrease in a claim or expense item Credit A credit is an increase in a claim item; a decrease in an asset or revenue item. Canadian Public Sector Financial Management 29

Debit and Credit Rules Debits and credits affect accounts as follows: A = L + NA ASSETS LIABILITIES NET ASSETS Debit Credit for Increase Debit Credit for Decrease Increase Canadian Public Sector Financial Management 30

A Sample Transaction n Suppose HOS buys inventory for $2, 000. We could just add it to assets. But, that puts the Fundamental Equation out of balance. Assets = Liabilities + Net Assets $2, 000 = no change + no change In a sense, we have not "paid" for the supplies. Suppose the seller sent HOS 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! Canadian Public Sector Financial 31 Management

A One-Sided Change Example n Not every financial event (transaction) results in changes to both sides of the fundamental equation. Suppose HOS paid for the inventory in cash. Then the transaction would have been recorded as follows: Assets = Assets Inventory + $2, 000 change n Liabilities Cash - $2, 000 = no change + Net + no The fundamental equation is still in balance. But, all of the 32 changes occurred on Canadian Publicside. Financial the left Sector of the equation. Management

Recording Transactions n n n 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, HOS 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. - HOS owns a new $100 asset called "prepaid insurance. " Here's the way the transaction would be recorded: Assets = Liabilities + Net Assets P/I + $100 Cash - $100 Canadian Public Sector Financial + = no change Management no change 33

Another Example n n HOS 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. - HOS's accounts payable have decreased by $2, 000. Here's the way the transaction would be recorded: Assets = Cash = - $2, 000 = Liabilities Accounts Payable - $2, 000 Canadian Public Sector Financial Management + Net Assets + no change 34

A Non Transaction n n HOS 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 the rules for recognition. - The value of the transaction is known. - The timing of the transaction is known. - But, HOS does not yet own the equipment. There has been no exchange. So HOS does not owe the money. No liability unless we owe the Canadian Public Sector Financial 35 creditor. Management

Section 4 The Long March Through Financial Statements beginning with the Statement of Financial Position or Balance Sheet Canadian Public Sector Financial Management 36

There are only types of accounts in the accounting world Assets Liabilities Equity Cumulative Transactions Revenue Expense Canadian Public Transactions Current Period Sector Financial Management 37

There are only Formal Financial Statements Balance Sheet Income Statement of Cash Flows Statement of Shareholders’ Equity Statement of Comprehensive Income Canadian Public Sector Financial Management 38

The Principal Financial Statements of an Organization Balance Sheet Income Statement of Cash Flows Canadian Public Sector Financial Management All Governed by Accounting Policies of the Organization – an integral part of the financial statements 39

Balance Sheet Income Statement of Cash Flows Canadian Public Sector Financial Management Describes where the organization stands at a specific date. 40

Balance Sheet Income Statement of Cash Flows Canadian Public Sector Financial Management Depicts the revenue and expenses for a designated period of time. 41

Balance Sheet Income Statement of Cash Flows Canadian Public Sector Financial Management Depicts the ways cash has changed during a designated period of time. 42

The Balance Sheet Operating Liabs Assets = Short-term & + Paid-in Capital + Retained Earnings + Liabilities Equity Long-term Accum. Other Comprehensive Income Debt The Income Statement Revenues - Expenses = Net Income Statement of Cash Flows Reconciliation of the Change in Cash and Cash Equivalents Statement of Shareholders’ Equity Reconciliation of the Changes in the Owners’ Equity Accounts Statement of Comprehensive Income Canadian Public Sector Financial Reconciliation of Fair Value Changes and Adjustments Management 43

Statement of Financial Position or The Balance Sheet reports: Has Today = Owes today + Worth today A Snapshot in time Canadian Public Sector Financial Management 44

Statement of Financial Position (The Balance Sheet) Balance sheets report: - what an organization owns (Assets), - what it owes to outsiders (Liabilities), and - the portion of the organization's assets owned by its owners. Called: – Owner's Equity, Partner's Equity, Net Worth, or Stockholders’ Equity (for-profit organizations). Net Assets or Fund Balance (not-for-profit and governments). - at a specific point in time. - For example, at the end of the organization's Fiscal Year. Canadian Public Sector Financial 45 – Management

Meals for the Homeless Balance Sheet ASSETS LIABILITIES & NET ASSETS Current Assets Cash Liabilities $ 1, 000 Marketable Securities 3, 000 Accounts Receivable 55, 000 Inventory 2, 000 Prepaid Expenses 1, 000 Total Current Assets $62, 000 Long-Term Assets Equipment, Net Investments Total Long-Term Assets Wages Payable (Accrued Expenses) $ 2, 000 Accounts Payable 2, 000 Notes Payable 6, 000 Current Portion - Mortgage Payable Total Current Liabilities 4, 000 $ 14, 000 Long-Term Liabilities Fixed Assets Property Current Liabilities Mortgage Payable $ 40, 000 Total Long-Term Liabilities $ 12, 000 35, 000 8, 000 TOTAL LIABILITIES $ 83, 000 NET ASSETS Canadian Public Sector Financial Management $ 26, 000 119, 000 46

Current and Long-Term Assets n n 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 longterm (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 Public Sector Financial Charges) Canadian 47 Management

Cash and Cash Equivalents • 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 Canadian Public Sector Financial Management 48

Marketable Securities n n n 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. Canadian Public Sector Financial Management 49

Accounts Receivable • 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 Canadian Public Sector Financial Management 50

Inventory • 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 This becomes an accounts • Three kinds of inventory: – Raw material inventory – Work-in-progress inventory – Finished goods Canadian Public Sector Financial inventory Management receivable when it is sold and cash when the customer pays for it. 51

Pre-paid expenses • 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 Canadian Public Sector Financial Management 52

Current Asset Cycle – a way to think of the relationship of these categories Cash Accounts Receivable This is why they are called “Working Assets” Inventory Canadian Public Sector Financial Management 53

Long-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, and 3. Intangibles Canadian Public Sector Financial Management 54

Fixed Assets • 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: blued at original cost minus an allowance for depreciation Canadian Public Sector Financial Management 55

Net Fixed Asset Determination n n 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? Canadian Public Sector Financial Management 56

A Net Book Value Example Record the Van at Cost = $30, 000 Subtract two years of depreciation [($30, 000 - $5, 000 salvage)/5 yr life] x 2 = $10, 000 Net Book Value = $30, 000 cost - $10, 000 Accumulated Depreciation = $20, 000 Canadian Public Sector Financial Management 57

Fixed Assets on the Balance Sheet All three values - cost, accumulated depreciation, and net book value are shown. Museum A Museum B Net Fixed Assets or Net Book Value $1, 000 $ 1, 000 PP&E at cost $40, 000 $ 2, 000 Accumulated Depreciation (39, 000) (1, 000) $ 1, 000, 000 Net Book Value Are these two museums really similar or different? Canadian Public Sector Financial Management 58

Recognizing Asset Transactions Financial events are recorded at the time of Recognition n Asset transactions are recognized when: - they are owned by the organization, - they have a monetary value, - that monetary value can be objectively determined. n Canadian Public Sector Financial Management 59

Recognizing Asset Transactions • 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? Canadian Public Sector Financial Management 60

Can Intangible Assets Appear on a Balance Sheet? • What are intangible assets? An asset that has no substance or physical properties. Intangible assets include goodwill, patent rights, permits, copyrights and licenses. • How are they assets? An intangible is any event that creates or modifies perceptions of the future behavior, value or relevance, of the organization but that are seen as usable assets that can be converted into (ultimately) cash. Canadian Public Sector Financial Management 61

Can Intangible Assets Appear on a Balance Sheet? • 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. (Because of this they are ignored by traditional accounting systems – conservatism concept, materiality concept). • Rule of quantification – slippery slope of quantification • Good will and knowledge Public Sector Financial Canadian assets……… Management 62

Meals for the Homeless Balance Sheet ASSETS LIABILITIES & NET ASSETS Current Assets Cash Marketable Securities Accounts Receivable, Net Liabilities $ 1, 000 3, 000 55, 000 Current Liabilities Wages Payable (Accrued Expenses) $ 2, 000 Accounts Payable 2, 000 Inventory 2, 000 Notes Payable 6, 000 Prepaid Expenses 1, 000 Current Portion – Mortgage 4, 000 $62, 000 Total Current Liabilities $ 14, 000 Total Current Assets Long-Term Liabilities Fixed Assets Property Equipment, Net Investments Total Long-Term Assets TOTAL ASSETS Mortgage Payable $ 40, 000 Total Long-Term Liabilities $ 12, 000 35, 000 8, 000 $ 83, 000 TOTAL LIABILITIES $ 26, 000 NET ASSETS 119, 000 Canadian Public Sector. TOTAL LIABILITIES & NET ASSETS Financial $145, 000 Management 63 $145, 000

Liabilities n n n 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: n To whom the debt is owned and n Whether the debt is payable within the year Canadian Public Sector Financial Management 64

Short-term or current liabilities • 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 65 • Taxes owed Canadian Public Sector Financial Management

Accrued Expenses – Wage Payable • 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 Financial Canadian Public Sector Management 66

Accounts Payable • Bills, 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 – notes payable – i. e. , short-term loans, and that portion of long-term debt which is due during the coming year. Canadian Public Sector Financial Management 67

Notes Payable/Current Portion of Debt • 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 Canadian Public Sector Financial Management 68

Long-Term Liabilities n 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. Canadian Public Sector Financial Management 69

Amortizing Long-Term Debt Suppose that Meals buys a delivery van for $32, 000. n It finances $25, 000 of the purchase price with a five-year loan at 8% interest per annum. n The loan calls for annual payments (in arrears) of $6, 261. 41. n How much of each year's payment would be interest? n What would be the amounts shown on the Balance Sheet at the end of year 3? n Canadian Public Sector Financial Management 70

Amortizing Long-Term Debt Beginning Total Interest Balance ($) Payment ($) Portion ($) Ending Principal ($) Balance ($) Year 1 25, 000 6, 261 2, 000 4, 261 20, 739 Year 2 20, 739 6, 261 1, 659 4, 602 16, 136 Year 3 16, 136 6, 261 1, 291 4, 971 11, 166 Year 4 11, 166 6, 261 893 5, 368 5, 798 Year 5 5, 798 6, 261 464 5, 798 0 End of Year 3 Bal. Sheet: Short-term Liability $5, 368; Long-term Liability $5, 798. How was the $6, 261. 41 calculated? Canadian Public Sector Financial Management 71

Liability Recognition n n Liabilities are recognized when: n they are legally owed, n have to be paid, and n the amount to be paid can be objectively measured. Which of the following should be recognized as a liability? n a bill received from a vendor? n wages that are due to a worker? n a $5 million lawsuit filed against an organization? Canadian Public Sector Financial Management 72

Net Asset Categories n n 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. Both ‘net worth’ and ‘book value’ hold the same meaning as ‘net assets’ and ‘shareholder value’ The net worth of an organization represents the sum of the organization's earnings from inception plus any paid-in capital (in for-profits) less any payments that have been made to the organization's owners. Also call Capital Stock Retained earnings: money that is held after all liabilities have been discharged and not used for assets – can also be negative value, i. e. debt Canadian Public Sector Financial Management 73

Net Asset Categories • In not-for-profit organizations, net worth is called "Net Assets" and is broken down into three categories. – Unrestricted Net Assets, which have not been restricted by donors (also cumulative profits appear here). – Temporarily Restricted Net Assets, the use of which has been restricted by donors. – Permanently Restricted Net Assets, Canadian Public which are restricted in. Sector Financial perpetuity. Management 74

Balance Sheet with Net Asset Categories ASSETS LIABILITIES Current Assets Cash Accounts Receivable Inventory Prepaid Insurance Total Current Assets Current Liabilities $ 52, 000 18, 000 5, 000 Accounts Payable Total Current Liabilities 30, 000 $ 37, 000 0 $ 75, 000 Long-Term Assets Long-Term Liabilities Total Long-Term Liabilities Fixed Assets Total Long-Term Assets 7, 000 Wages Payable Mortgage Payable Property and Equipment-Net $ Total Liabilities $240, 000 $140, 000 $177, 000 NET ASSETS Unrestricted $113, 000 Temporarily Restricted 15, 000 Permanently Restricted 10, 000 Total Net Assets Total Assets $315, 000 Total Liabilities and Net Assets Canadian Public Sector Financial Management $138, 000 $315, 000 75

Section 5 Generating a Balance Sheet Canadian Public Sector Financial Management 76

Generating a Balance Sheet n Generating a balance sheet involves: v. Beginning with the starting balance sheet, v. Recording all of the transactions for the period, v. Adding the impact of the transactions to the starting balance sheet, v. Formatting the resulting balance sheet accounts into the balance sheet reporting format. Canadian Public Sector Financial Management 77

The Starting Balance Sheet ASSETS LIABILITIES AND NET ASSETS Current Assets Cash Accounts Receivable Inventory Prepaid Insurance Total Current Assets Current Liabilities $ 52, 000 18, 000 5, 000 Accounts Payable Wages Payable Total Current Liabilities $ 7, 000 30, 000 $ 37, 000 0 $ 75, 000 Long-Term Liabilities Mortgage Payable Long-Term Assets Total Long-Term Liabilities Fixed Assets $140, 000 Total Liabilities Property and Equipment, Net $240, 000 Total Net Assets 138, 000 $240, 000 Total Long-Term Assets $177, 000 Total Assets $315, 000 Public Sector Liabilities and Net Assets Total Financial Canadian Management $315, 000 78

Transactions Work Sheet ASSETS Cash Beginning Balance $52, 000 Buy Fire Insurance LIABILITIES & Accounts Receivabl e Inventor y $18, 000 $5, 000 (100) Pay Supplies Ending Balance Plant & Equipme nt $240, 000 Accoun ts Payable Wages Payable Mortgage Payable Net Assets $7, 000 $30, 000 $140, 000 $138, 000 $100 (2, 000) Buy Inventory Receive Payment Ppd. Ins. NA 3, 000 (12, 000) $61, 900 $ 6, 000 3, 000 $8, 000 $100 $240, 000 $8, 000 $30, 000 Canadian Public Sector Financial Management 79

The Ending Balance Sheet ASSETS LIABILITIES Current Assets Cash Current Liabilities $ 61, 900 Accounts Receivable 6, 000 Inventory 8, 000 Prepaid Insurance Total Current Assets Accounts Payable Total Current Liabilities $ 76, 000 $ 38, 000 Long-Term Liabilities Total Long-Term Liabilities Fixed Assets Total Assets 30, 000 100 Long-Term Assets Total Long-Term Assets 8, 000 Wages Payable Mortgage Payable Property and Equipment, Net $ $140, 000 Total Liabilities $178, 000 $240, 000 Total Net Assets 138, 000 $316, 000 Total Liabilities and Net Assets $240, 000 Canadian Public Sector Financial Management $316, 000 80

Section 6 The Income Statement or Statement of Operations (Also called Activity Statement, Statement of Revenues and Expenses, or Profit and Loss (P&L) Statement) Canadian Public Sector Financial Management 81

What is an Income Statement? • Reports on cash movements in the organization • 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 Canadian Public Sector Financial Management 82

What is an Income Statement? • Linkage is that the net income for this year as shown on an Income Statement is added to Retained Earnings on the Balance Sheet to show increase/decrease in Net Assets as a result of this year’s income • Therefore, the Income Statement shows for a period all the transactions taken by the organization to either increase assets or decrease liabilities on the Balance Sheet • Key tool in financial control and budgetary management: used to inform of current financial situation, identify surplus/deficits, measure performance Financial Canadian Public Sector 83 Management

Basic Income Statement Formula Revenues – Expenses = Net Income (Net Loss) Canadian Public Sector Financial Management 84

Revenues and Support 2000 1999 $ 10, 000 $ 8, 000 20, 000 16, 000 Client Revenue 1, 000 County Revenue 10, 000 Foundation Grants 70, 000 50, 000 Annual Ball 12, 000 11, 000 Telephone Solicitation 25, 000 28, 000 45, 000 $196, 000 $169, 000 $ 17, 000 $ 16, 000 Kitchen Staff 35, 000 33, 000 Counseling Staff 35, 000 34, 000 Rent on Kitchen Locations 15, 000 14, 000 Administration and General 75, 000 65, 000 4, 000 10, 000 Total Expenses $191, 000 $176, 000 Canadian Public Change in Net Assets Sector Financial Management $ Meals Client Revenue City Revenue Shelter Counseling Meals for the Homeless Activity Statement Fundraising Mail Solicitation Total Revenue and Support Expenses: Food Bad Debts Depreciation 5, 000 85 (7, 000) $

The Income Statement: Revenues and Support – 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. Canadian Public Sector Financial Management 86

The Income Statement: Revenues and Support • Revenues are generally the result of an exchange for goods and services that the organization has provided or budgetary decisions that a government makes • Support is the result of gifts, grants, and other contributions to the organization. • Category of other income from fees or non -tax income streams Canadian Public Sector Financial Management 87

Expenses and Net Income n n Expenses represent the recognition of the use of an asset to generate revenue and support or otherwise carry on the operations of the entity which result in an outflow of assets and a decrease in Net Assets. Net Income is the difference between revenues and support and expenses. Canadian Public Sector Financial Management 88

Expenses and Net Income • Profits are an excess of revenues over expenses. Also called a surplus or increase in net assets. • Losses are an excess of expenses over revenues. Also called a deficit or decrease in net assets. Canadian Public Sector Financial Management 89

Cost vs. Expense • Cost describes how money is spent to build inventories or add to plant or capacity • Expense is any other operating expenditure. • Note: An expenditure can be either a cost or an expense. Expenditure simply means the use of cash to pay for an item Canadian Public Sector Financial purchased. Management 90

Recognizing Revenue and Support v v 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. Canadian Public Sector Financial Management 91

Recognizing Expenses n Expense 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. Canadian Public Sector Financial Management 92

Expired and Unexpired Costs n n Suppose Meals bought 100 canned hams at a cost of $1, 000 in March. At acquisition, Meals would recognize the hams as an asset (Inventory). They are also an unexpired cost. If they paid for the hams in cash, Cash would go down by $1, 000. Otherwise Accounts Payable increases $1, 000. In May, Meals used 50 of the hams to produce meals. At use, the hams become an expense (expired cost) of $500 (50 hams * $10 per ham = $500), and the value of the asset (Inventory) is reduced by $500. This is a Product Cost. The inventory becomes an expense as used to provide service. Canadian Public Sector Financial Management 93

Inventory Expense n Inventory expenses represent the cost of using supplies to operate an organization. Inventory expense and the ending inventory value are calculated using the following relationship: Beginning Inventory + Purchases - Consumption = Ending 5 + 10 - Canadian Public Sector Financial Management 13 =2 94

Deferred Revenue n 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? n 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? Canadian Public Sector Financial Management 95

Where the Income Statement and Balance Sheet Meet Event Statement Impact Revenue Recognized You provide a service and earn revenue AR or Cash up B/S Revenue up I/S No impact on revenue Someone pays a bill you sent AR down Cash up No impact on expenses When you buy something AP up or Cash down Inventory up Expense Recognized When you use something Note AR is a “holding area”for unpaid bills that you have sent out Asset down or Liability up B/S Expense up I/S B/S B/S Canadian Public Sector Financial Management AP is where you keep track of what you owe to others 96

Reflecting the Change in Net Assets on the Balance Sheet Net income is reported as a change in net assets on the balance sheet. Total Revenue and Support $81, 000 Total Expenses - 80, 050 Increase in Net Assets $ Activity Statement Balance Sheet 950 Unrestricted Beginning Balances Increase in Net Assets Ending Balances Temp. Rest. Perm. Rest. $113, 000 $15, 000 $10, 000 950 $113, 950 Canadian Public Sector Financial Management 97

Section 7 Cash Flow Statements Canadian Public Sector Financial Management 98

The Cash Flow Statement • The Cash Flow Statement shows: ØCash on hand at the start of the period ØCash received in the period ØCash spent in the period ØCash on hand at the end of the period Canadian Public Sector Financial Management 99

There are only Sections on the Cash Flow Statement • Change in Cash & Cash Equivalents • Net Income Line • Cash Generated by Operating Activities • Cash Generated by Investing Activities • Cash Generated by Financing Activities Canadian Public Sector Financial Management 100

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 Canadian Public Sector Financial Management 101

The Cash Flow Statement – Isn't knowing if cash increased or decreased enough? • No, source and availability are important Canadian Public Sector Financial Management 102

The Cash Flow Statement Start with Change in Net Assets [i. e. , net income] as a first approximation of cash flow, and then make adjustments. Why isn't this good enough? Why are the other adjustments needed? Assets = Liabilities + Net Assets = Liabilities + Net Assets Cash + Other Assets = Liabilities + Net Assets Cash = Liabilities + Net Assets Other Assets The Cash Flow Statement is equal to the change in the other balance sheet accounts. Canadian Public Sector Financial Management 103

Example: Assume This Activity Statement for Meals The first estimate of cash flow from operations is the change in net assets Revenue Clients City Donations Total Revenue Expense Food Labor Depreciation Total Expenses Increase in Net Assets Canadian Public Sector Financial Management 5, 000 35, 000 20, 000 $60, 000 $20, 000 25, 000 10, 000 $55, 000 $ 5, 000 104

Adjusting the Increase in Net Assets to Cash Flow §The Increase in Net Assets is an approximation of cash flow. Adjustments are needed to arrive at true cash flow. §The first adjustment is for "Expenses not requiring cash" such as depreciation or amortization. Why doesn't depreciation require cash? §The remainder of the adjustments to operating cash flow are for changes in balance sheet accounts related to operations. Canadian Public Sector Financial Management 105

Adjusting the Increase in Net Assets to Cash Flow §Why subtract an increase in Accounts Receivable? The increase in net assets includes all revenue. §What if A/R increases? Was all revenue collected in cash? If not, then how would you have to adjust the Change in Net Assets to make it a closer measure of cash flow? Canadian Public Sector Financial Management 106

The Statement of Cash Flows from Operating Activities Increase in Net Assets 2000 1999 $ 5, 000 $ (7, 000) 10, 000 Add Decrease in Inventory 2, 000 Add Increase in Notes Payable 1, 000 3, 000 (17, 000) (12, 000) Add Expenses Not Requiring Cash: Depreciation Other Adjustments: Subtract Increase in Receivables Subtract Decrease in Wages Payable (1, 000) Subtract Decrease in Accounts Payable (1, 000) Subtract Increase in Prepaid Expenses (1, 000) Net Cash Used for Operating Activities Canadian Public Sector Financial Management $ (2, 000) 0 $ (6, 000) 107

The Statement of Cash Flows, continued 2000 1999 Cash Flows from Investing Activities Sale Stock Investments $ 4, 000 $ Purchase of Delivery Van 5, 000 (32, 000) Net Cash from Investing Activities $ 4, 000 $ (27, 000) Cash Flows from Financing Activities Increase in Mortgages $ 25, 000 Repayments of Mortgages $ (5, 000) (4, 000) Net Cash from Financing Activities $ (5, 000) $ 21, 000 $ (3, 000) $ (12, 000) 5, 000 17, 000 Net Increase/(Decrease) in Cash, Beginning of Year Cash, End of Year $ 2, 000 Canadian Public Sector Financial Management $ 5, 000 108

The Cash Flow Statement n n Cash flows relating to investment and financing activities are listed separately. The method shown was the indirect method. The direct method is easier, just requiring a listing of all cash inflows and outflows (could be taken from transactions worksheet cash column). But indirect method provides more information. Canadian Public Sector Financial Management 109

How to Cook the Books • There is fraud and there is distortion possible in all this. So too is creative accounting. • So much relies upon issues such as recognition rules, when expenses and expenditures are actually recognized Canadian Public Sector Financial Management 110

How to Cook the Books • Some common means to cook the books: • • Padding revenue expectations Accelerating and decelerating expenditures flows Improperly lowering costs Assuming ‘efficiencies’ planned will be achieved Not accruing liabilities Flipping lower valued assets for higher ones Shifting expenses between periods and years Accelerating depreciation rates Canadian Public Sector Financial Management 111

Are we having fun yet? Canadian Public Sector Financial Management 112