Understanding Accounting

ADMN 201 — Ch11: Understanding Accounting

Accounting is a comprehensive information system for collecting, analyzing, and communicating financial information. Chapter 11 covers who does accounting (and how Canada unified its profession), the foundational equation, the four financial statements, reporting standards, ratio analysis, ethics, and the evolving CPA role.

mindmap
  root((Ch11<br/>Accounting))
    LO1 - Who Does Accounting
      CA, CGA, CMA → unified CPA 2013
      Financial vs. Managerial Accounting
      Auditing, Tax, Forensic, Consulting
    LO2 - Accounting Equation
      Assets = Liabilities + Equity
      Balance Sheet Insolvency
    LO3 - Four Financial Statements
      Balance Sheet - snapshot
      Income Statement - period
      Cash Flow Statement - period
      Statement of Retained Earnings - bridge
    LO3 - Reporting Standards
      IFRS, ASPE, GAAP
      Matching, Revenue Recognition
      Going Concern, Cost Principle
    LO4 - Financial Ratios
      Solvency - risk
      Profitability - earnings
      Activity - efficiency
      Valuation - P/E, M/B
    LO5 - Ethics
      Maintain public confidence
      CPA Code of Conduct
    LO6 - Evolving Role
      Strategic advisor
      Tech driving change

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LO1 — Role of Accountants and the CPA Designation

What Accountants Do

Accountants serve as the architects of a firm’s Accounting Information System (AIS) — an organized procedure for identifying, measuring, recording, and retaining financial data. Their goal is to give managers, investors, and regulators an accurate picture of financial health.

Core services accountants provide:

• Bookkeeping — recording every financial transaction
• Auditing — examining records to verify they follow proper procedures
• Forensic Accounting — tracking hidden funds and investigating white-collar crime
• Tax Services — preparing returns and planning for tax efficiency
• Management Consulting — solving problems in finance, production, and operations

Financial Accounting vs. Managerial Accounting

Type	Audience	Purpose
Financial Accounting	External (shareholders, creditors, regulators)	Keep external groups informed about the firm’s financial condition
Managerial Accounting	Internal (managers at all levels)	Aid planning, decision-making, and alert managers to problems

The Controller is the chief accounting officer who manages all of a firm’s accounting activities.

Five Users of Accounting Information

User	Why They Need It
Business managers	Set goals, develop plans, evaluate performance
Employees and unions	Plan wages, benefits, health care, retirement
Investors and creditors	Assess creditworthiness and growth prospects
Tax authorities	Determine tax liabilities; ensure correct amounts paid
Government regulatory agencies	Enforce financial disclosure requirements

Three Traditional Designations (Pre-2013)

Designation	Full Name	Focus	Typical Work
CA	Chartered Accountant	External auditing and reporting	Outside accountant for client firms
CGA	Certified General Accountant	Auditing and external reporting	Private industry or CGA firms
CMA	Certified Management Accountant	Internal management accounting	Employed directly by a specific firm

The CPA Unification

In 2013, CA, CMA, and CGA merged into the Chartered Professional Accountant (CPA) designation. By 2021, there were over 220,000 CPAs in Canada. Transitional suffixes (CPA, CA / CPA, CGA / CPA, CMA) were used until November 2022, after which everyone uses simply CPA. Governed by CPA Canada (cpacanada.ca).

Why it happened: To create well-rounded accountants who can specialize (auditing, tax, strategy, finance) rather than being siloed into one area from the start.

CPA Services

• Auditing — examination of financial records to verify proper procedures were followed
  • Internal audit: done by company’s own staff
  • External audit: done by outside CPA firm; produces independent opinion for stakeholders
• Tax services — tax return preparation AND strategic tax planning
• Management consulting — plant layout, marketing studies, production scheduling, executive recruitment

Forensic accountants — track down hidden funds; investigate white-collar crime; called in by law enforcement; can earn CFF (Certified in Financial Forensics) credential from CPA Canada.

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LO2 — The Accounting Equation

Assets = Liabilities + Owners’ Equity

• Assets — anything of economic value owned by the firm
• Liabilities — debts and obligations owed to others
• Owners’ Equity — what remains for owners if all assets were sold and all debts paid

Every financial transaction must keep this equation in balance (double-entry accounting). If it doesn’t, an accounting error has occurred.

Asset Categories

Category	Definition	Examples
Current assets	Cash or convertible to cash within 1 year	Cash, marketable securities, merchandise inventory, prepaid expenses
Fixed assets	Long-term physical assets used in operations	Land, buildings, equipment, machinery
Intangible assets	Non-physical assets with economic value	Patents, trademarks, copyrights, goodwill

• Marketable securities — short-term investments (stocks, bonds, money market certs) that can be sold quickly
• Merchandise inventory — goods acquired for sale, still on hand
• Prepaid expenses — supplies on hand, rent paid in advance
• Depreciation — accounting method for spreading the cost of a fixed asset over its useful life (e.g. $50ktruck,5-yrlife\to$10k/yr expense)
• Goodwill — amount paid for an existing business beyond the value of its identifiable assets (brand, reputation, customer base)

Liability Categories

Category	Definition	Examples
Current liabilities	Debts due within 1 year	Accounts payable, wages payable, taxes payable
Long-term liabilities	Debts not due for at least 1 year	Bank loans, bonds payable (carry interest)

• Accounts payable — amounts owed to suppliers for goods/services purchased on credit

Owners’ Equity Components

Component	Definition
Common stock	Value of shares issued to shareholders
Paid-in capital	Additional money invested by owners beyond stock’s stated value
Retained earnings	Net profits minus dividends paid to shareholders; accumulates over time

How Transactions Move the Equation

Transaction Type	Example	Effect
Increasing both sides	Borrow $100 cash	+$100Asset,+$100 Liability
Decreasing both sides	Pay off a loan	−Asset (cash), −Liability
Shifting within one side	Buy $1,000 stock with cash	Cash ↓, Investment ↑ — total assets unchanged

Solvency vs. Insolvency

• Positive Equity (Assets > Liabilities) — healthy; owners would receive cash if liquidated
• Balance Sheet Insolvency (Liabilities > Assets) — assets cannot cover debts; creditors may not be fully paid
• Cash Flow Insolvency (Liquidity Crisis) — has assets but can’t convert them to cash fast enough to pay bills on time
• Bankruptcy — a legal term; solvency is an accounting term — they are not the same

graph TD
    A[Assets vs. Liabilities] --> B{Assets > Liabilities?}
    B -->|Yes| C[Positive Equity - Healthy]
    B -->|No| D[Balance Sheet Insolvent]
    E[Can you convert assets to cash in time?] -->|No| F[Cash Flow Insolvent - Liquidity Crisis]
    G[Legal proceeding filed?] -->|Yes| H[Bankruptcy - Legal Term]
    D -.->|May lead to| H
    F -.->|May lead to| H

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LO3 — The Four Financial Statements

Quick Overview

Statement	Metaphor	Time Frame	Core Formula
Balance Sheet	Photograph	Point in time	Assets = Liabilities + Equity
Income Statement	Scoreboard	Period (month/quarter/year)	Revenue − Expenses = Net Income
Cash Flow Statement	Checkbook	Period	Starting Cash + Inflows − Outflows = Ending Cash
Statement of Retained Earnings	Bridge	Period	Beginning RE + Net Income − Dividends = Ending RE

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1. The Balance Sheet

A snapshot of the firm’s financial position at one specific date. Shows what the company owns (assets) and who has claims on those assets (liabilities and equity).

Structure:

• Assets listed in order of liquidity (most liquid first)
  • Current Assets: Cash, Accounts Receivable, Inventory, Prepaid Expenses
  • Fixed Assets: Property, Plant, Equipment
  • Intangible Assets: Patents, Goodwill
• Liabilities listed in order of when they are due
  • Current Liabilities (due within 1 year): Accounts Payable, Accrued Liabilities
  • Long-Term Liabilities: Mortgages, Bonds
• Owners’ Equity: Capital Stock + Retained Earnings − Repurchased Stock

Dividends are not an expense — they are a redistribution of earnings and reduce Retained Earnings, not Net Income.

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2. The Income Statement (Profit & Loss)

Reports revenues and expenses over a period of time and shows whether the firm earned a profit or suffered a loss.

Income Cascade:

Revenue
  − Cost of Goods Sold (COGS)
= Gross Profit
  − Operating Expenses (salaries, advertising, rent)
= Operating Income (EBIT)
  − Interest & Taxes
= Net Income ("Bottom Line")

EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization — shows how the core business performs before accounting and tax adjustments.

Critical: Income ≠ Cash Revenue is booked when a deal is made (accrual accounting). Cash is recorded when money actually arrives. A company can appear profitable while running out of cash to pay its bills. “Cash is King.”

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3. The Statement of Cash Flows

Tracks actual cash movement over a period — not profit. Covers three types of business activity:

Activity	Description	Examples
Operating	Day-to-day selling of products/services	Sales receipts, payroll, rent
Investing	Buying/selling long-term assets	Equipment, buildings
Financing	Raising or repaying capital	Loans, stock issuance, dividends paid

Cash Flow ≠ Profit. Many investors look at this statement first because it is harder to manipulate than the income statement. A company can claim $1M in profit but if cash flow is negative, it may not be able to pay employees next week.

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4. The Statement of Retained Earnings

Acts as the bridge between the Income Statement and the Balance Sheet.

Beginning Retained Earnings + Net Income − Dividends = Ending Retained Earnings

• Net Income flows in from the Income Statement
• Ending Retained Earnings flows out to the Balance Sheet (under Owners’ Equity)
• If accumulated losses exceed profits, the balance becomes an Accumulated Deficit

flowchart LR
    IS[Income Statement\nNet Income] -->|adds to| RE[Statement of\nRetained Earnings]
    RE -->|Ending RE goes to| BS[Balance Sheet\nOwners Equity]

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Reporting Standards and Principles (also LO3)

Standards

Standard	Who Uses It	Scope
IFRS (International Financial Reporting Standards)	Public companies in 140+ countries	Global; developed by IASB
ASPE (Accounting Standards for Private Enterprise)	Private businesses in Canada	Canadian-specific
GAAP (Generally Accepted Accounting Principles)	Historical US/Canadian standard	Being replaced by IFRS globally

Key Principles

Principle	Plain-Language Meaning
Accounting Equation	Every transaction must keep Assets = Liabilities + Equity
Double-Entry Accounting	Every transaction affects at least two accounts to keep the equation balanced
Revenue Recognition	Record revenue when a deal is completed (goods delivered), not when cash arrives
Matching Principle	Match expenses to the revenues they helped generate in the same period
Cost Principle	Record assets at their original purchase price, not current market value
Going Concern	Assume the company will keep operating indefinitely — justifies spreading costs over time (depreciation)
Full Disclosure	Financial statements must include notes explaining anything that could affect an investor’s decision

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LO4 — Financial Ratio Analysis

Ratios use data from financial statements to help managers, investors, and creditors compare performance and assess risk.

Solvency Ratios — Can it pay its debts?

Ratio	Formula	What It Tells You
Current Ratio	Current Assets / Current Liabilities	Ability to pay debts due within 1 year using current assets
Quick Ratio (Acid Test)	(Current Assets − Inventory) / Current Liabilities	Stricter solvency test — excludes inventory (least liquid current asset)
Debt-to-Equity Ratio	Total Liabilities / Owners’ Equity	Long-term leverage; how much debt vs. owner capital
Debt Ratio	Total Liabilities / Total Assets	% of assets financed by debt
Times Interest Earned	Operating Income / Net Interest Expense	Ability to cover interest payments from operating profit

Profitability Ratios — Is it earning well?

Ratio	Formula	What It Tells You
Gross Profit Margin	Gross Profit / Sales	% of revenue left after COGS — production efficiency
Net Profit Margin	Net Income / Sales	% of each sales dollar that becomes profit after all costs
Return on Sales (ROS)	Net Income / Sales Revenue	Profit generated per dollar of sales
Return on Equity (ROE)	Net Income / Owners’ Equity	Return generated on owners’ invested capital
Return on Total Assets	Net Income / Total Assets	How effectively all assets are used to generate earnings
Earnings per Share (EPS)	Net Income / Shares Outstanding	Profit per individual share — key metric for stock investors

Activity Ratios — Is it using resources efficiently?

Ratio	Formula	What It Tells You
Inventory Turnover	COGS / Average Inventory	How many times per year inventory is sold and restocked
Average Collection Period	Accounts Receivable / (Net Sales / 365)	How many days on average it takes customers to pay
Total Assets Turnover	Net Sales / Total Assets	How many times total assets “turn over” in revenue per year

Average Inventory = (Beginning Inventory + Ending Inventory) / 2

Valuation Ratios — What does the market think?

Ratio	Formula	What It Tells You
P/E Ratio	Stock Price / EPS	What investors pay per dollar of earnings; high P/E = growth expectations
Market/Book Ratio (M/B)	Market Price per Share / Book Value per Share	Compares market value to accounting value
Book Value	Total Stockholders’ Equity / Shares Outstanding	Accounting value per share

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Income Cascade for Ratio Calculations

Revenue
  − COGS                  → Gross Profit Margin uses Gross Profit
= Gross Profit
  − Operating Expenses
= Operating Income        → Times Interest Earned uses Operating Income
  − Interest & Taxes
= Net Income              → ROE, ROS, EPS, Net Profit Margin all use Net Income

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LO5 — Ethics in Accounting

Purpose: Maintain public confidence in financial markets, business institutions, and the accounting profession.

Without ethics, all accounting tools are meaningless — their usefulness depends entirely on truthful application.

Real-World Example: Valeant Pharmaceuticals restated earnings due to accounting irregularities, triggering a 95% drop in stock value — illustrating how misrepresentation destroys stakeholder trust overnight.

CPA Code of Ethics — Six Principles

Principle	What It Means
Professional Responsibility	Act with high morality; bring credit to the profession
Public Interest	Respect and maintain public trust; serve the public honourably
Integrity	Be sincere and honest in all professional activities
Objectivity and Independence	Avoid conflicts of interest; be independent when certifying client statements
Technical and Ethical Standards	Exercise due care; maintain competence through continuing education
Professional Conduct	Follow the Code of Professional Conduct in all services provided

Professional associations prohibit misrepresentation, fraud, and inflating asset values. Ethics-related study is required for CPA certification.

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LO6 — Evolving Role of the Modern Accountant

The traditional accountant analyzed historical data and prepared financial statements. That role is shifting.

What’s driving the change:

• Automation and AI are taking over routine bookkeeping tasks
• Globalization requires CPAs to understand international standards (IFRS)
• Technology creates new demands around data management and cybersecurity

The new CPA role includes strategic leadership across:

• Overall business operations and strategy
• Data management and technical systems
• Human resources and organizational decisions
• Long-term financial planning — not just historical reporting

The modern CPA is increasingly a strategic advisor who interprets data, not just records it.

Five Emerging Competencies (Table 11.3)

Competency	What It Means
Strategic Thinking & Critical Problem Solving	Combine data with reasoning to solve critical business problems
Communications, Interpersonal Skills & Leadership	Communicate effectively across business contexts; provide leadership
Dedication to Meeting Customer Needs	Understand and anticipate client needs; surpass competition in service
Ability to Integrate Diverse Information	Combine financial and non-financial data to generate insights
Proficiency with Information Technology	Use IT to deliver services; identify IT applications that add value

Four Trends Driving the Evolving Role

1. Fewer geographic/physical restrictions — globalization + technology enables CPAs to serve clients remotely across countries
2. Social media-driven changes — LinkedIn and remote networking replace face-to-face meetings; build reputation and client relationships digitally
3. Need to be an effective communicator — technical knowledge only has value if communicated clearly in presentations, reports, and conversations
4. Project management — CPAs increasingly lead large multi-specialist teams on financial forecasting, cost estimation, and HR analysis

graph LR
    A[Traditional CPA\nHistorical data\nFinancial statements] -->|Automation + AI| B[Modern CPA\nStrategic advisor\nData analytics\nLeadership roles]
    C[Global competition] --> B
    D[Technology change] --> B

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Key Distinctions Worth Memorizing

• Balance Sheet Insolvency (assets < liabilities) ≠ Cash Flow Insolvency (can’t convert assets fast enough) ≠ Bankruptcy (legal proceeding)
• Accrual Accounting books revenue when the deal is made, not when cash is received → a company can look profitable while running out of cash
• Income Statement reports profit or loss — it does not show whether cash was received or paid
• IFRS (public companies, 140+ countries) vs. ASPE (private Canadian companies)
• CA + CMA + CGA → unified CPA designation in 2013
• Dividends are not an expense — they are a redistribution of earnings, deducted from Retained Earnings
• Financial Accounting = external audience | Managerial Accounting = internal audience

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Related Pages

AccountingEquation-FinancialStatements, FinancialRatios, Accounting, ADMN201-Ch15