Introduction to Financial Introduction to Financial StatementsStatements

Chapter 1Chapter 1

MBA Q-4MBA Q-4

Study ObjectivesStudy Objectives

1.1. Describe the primary forms of business Describe the primary forms of business organization.organization.

2.2. Identify the users and uses of accounting Identify the users and uses of accounting information.information.

3.3. Explain the three principal types of Explain the three principal types of business activity.business activity.

4.4. Describe the content and purpose of each Describe the content and purpose of each of the financial statements.of the financial statements.

Study ObjectivesStudy Objectives

5.5. Explain the meaning of assets, liabilities, Explain the meaning of assets, liabilities, and stockholders’ equity, and state the and stockholders’ equity, and state the basic accounting equation.basic accounting equation.

6.6. Describe the components that supplement Describe the components that supplement the financial statements in an annual the financial statements in an annual report.report.

##11 Forms of Business Forms of Business

OrganizationOrganization

• Sole proprietorshipSole proprietorship

• PartnershipPartnership

• CorporationCorporation

Sole ProprietorshipSole Proprietorship

• Business owned by one personBusiness owned by one person

• Simple to establishSimple to establish

• Owner controlledOwner controlled

• Tax advantagesTax advantages

• Owner personally liableOwner personally liable

• Financing difficultFinancing difficult

PartnershipPartnership

• Two or more ownersTwo or more owners

• Simple to establishSimple to establish

• Shared controlledShared controlled

• Broader skills & resourcesBroader skills & resources

• Tax advantagesTax advantages

• Personal liabilityPersonal liability

CorporationCorporation

• Separate legal entity owned by Separate legal entity owned by stockholdersstockholders

• Easy to transfer ownershipEasy to transfer ownership

• Greater capital raising potentialGreater capital raising potential

• Lower legal liabilityLower legal liability

• Unfavorable tax treatmentUnfavorable tax treatment

Forms of Business Entities Sole

Proprietorship Partnership Corporation

Number of owners 1 2 or more (partners)

Numerous (shareholders)

Legally separate from owners

No No Yes

Owners liable for business debts

Yes Yes No

Profits taxable To the owner To the owners

To the corporation as

earnings; to the owners

when dividends are received

Modified form

“LLC” limits liability of owner; may

increase income tax exposure

“Subchapter S” profits are

taxed at ownership level

only

##22 Users of Financial Information Users of Financial Information

InternalInternal• Managers who plan, Managers who plan,

organize and run a organize and run a businessbusiness– Marketing managersMarketing managers

– Production supervisorsProduction supervisors

– Finance directorsFinance directors

– Company officersCompany officers

Users of Financial InformationUsers of Financial InformationInternal Users Ask?Internal Users Ask?

Cash to pay bills?Cash to pay bills? Cost per unit?Cost per unit?

Give raises?Give raises? Which product is Which product is profitable?profitable?

Users of Financial InformationUsers of Financial InformationExternalExternal

• InvestorsInvestors

• OthersOthers– Regulatory agenciesRegulatory agencies

– Tax authoritiesTax authorities

– CustomersCustomers

– Labor UnionsLabor Unions

– Economic plannersEconomic planners

• CreditorsCreditors

Users of Financial InformationUsers of Financial InformationExternal Users Ask?External Users Ask?

Earning enough?Earning enough? Compare to competition?Compare to competition?

Will the company be able to pay bills Will the company be able to pay bills when due?when due?

##33 Types of Business Activity Types of Business Activity

• FinancingFinancing

• InvestingInvesting

• OperatingOperating

Financing ActivitiesFinancing Activities

• Borrowing createsBorrowing creates liabilitiesliabilities– Bank loansBank loans

– Debt securitiesDebt securities

– Goods on credit or payablesGoods on credit or payables

• Selling stockSelling stock creates creates stockholders’ equitystockholders’ equity

Investing ActivitiesInvesting Activities• Obtaining resources or Obtaining resources or

assets assets to operate the to operate the businessbusiness– LandLand

– BuildingsBuildings

– VehiclesVehicles

– ComputersComputers

– FurnitureFurniture

Operating ActivitiesOperating Activities

• Primary activity of businessPrimary activity of business– Selling goodsSelling goods– Providing servicesProviding services– ManufacturingManufacturing– Cost of SalesCost of Sales– AdvertisingAdvertising– Paying employeesPaying employees– Paying utilitiesPaying utilities

Operating ActivitiesOperating Activities

• RevenueRevenue is generated from sales or is generated from sales or servicesservices

• ExpensesExpenses are the cost of doing business are the cost of doing business

• If revenue If revenue >> expense expense == Net IncomeNet Income

• If revenue If revenue << expense expense == Net Loss!Net Loss!

##44 Describe Content and Purpose Describe Content and Purpose

of Financial Statementsof Financial Statements• Accountants communicate

with users through four financial statements

• Income StatementIncome Statement

• Retained Earnings StatementRetained Earnings Statement

• Balance SheetBalance Sheet

• Statement of Cash FlowsStatement of Cash Flows

Income StatementIncome Statement

• Reports operating success or failure for a Reports operating success or failure for a

period.period.

• Summarizes revenues and expenses for Summarizes revenues and expenses for

period: period: month, quarter, or year.month, quarter, or year.

• If revenue If revenue >> expense expense == Net Income.Net Income.

Income StatementIncome Statement

Do this statement first!Do this statement first!

Retained Earnings StatementRetained Earnings Statement

• Shows changes in retained earnings for Shows changes in retained earnings for

period: period: month, quarter, or yearmonth, quarter, or year

• Beginning balanceBeginning balance

• AddAdd Net Income from income Net Income from income

statement!statement!

• Deduct DividendsDeduct Dividends

• Ending balanceEnding balance

Retained Earnings StatementRetained Earnings Statement

Do this statement second!Do this statement second!

Balance SheetBalance Sheet

• Reports Reports assetsassets and claims to assets. and claims to assets.

• Claims of creditors, Claims of creditors, liabilitiesliabilities..

• Claims of owners, Claims of owners, stockholders’ equitystockholders’ equity..

• AssetsAssets = Liabilities + Stockholders’ Equity= Liabilities + Stockholders’ Equity

• Specific date – Specific date – one point in time!one point in time!

Balance SheetBalance Sheet

From From Retained Retained Earnings Earnings StatementStatement

Statement of Cash FlowsStatement of Cash Flows

• Provides information about cash Provides information about cash

receipts and cash paymentsreceipts and cash payments

• Summarizes for period: Summarizes for period: month, quarter, month, quarter,

or year.or year.

• Cash effects of operating, investing, Cash effects of operating, investing,

and financing activities.and financing activities.

Statement of Cash FlowsStatement of Cash Flows

• Where did the cash come from?Where did the cash come from?

• How was cash used during the period?How was cash used during the period?

• What was the change in the cash What was the change in the cash

balance during the period?balance during the period?

• You can’t survive without cash!You can’t survive without cash!

Statement of Cash FlowsStatement of Cash Flows

Agrees Agrees

withwith Balance Balance SheetSheet

#5#5 Explain the Meaning of Explain the Meaning of Assets, Liabilities, and Assets, Liabilities, and Stockholders’ Equity. Stockholders’ Equity.

State the Basic Accounting State the Basic Accounting EquationEquation

AssetsAssets• Resources owned by the businessResources owned by the business

– CashCash

– Accounts receivableAccounts receivable

– InventoriesInventories

– BuildingBuilding

– Furniture and fixturesFurniture and fixtures

– EquipmentEquipment

– SuppliesSupplies

LiabilitiesLiabilities

• Obligations or debts of businessObligations or debts of business– Notes payableNotes payable

– Accounts payableAccounts payable

– Interest payableInterest payable

– Salaries payableSalaries payable

– Unearned revenueUnearned revenue

Stockholders’ EquityStockholders’ Equity

• Ownership claims on assetsOwnership claims on assets

• Paid-in capitalPaid-in capital– Common stockCommon stock

• Retained earningsRetained earnings

Basic Accounting EquationBasic Accounting Equation

Assets = Assets =

Liabilities + Stockholders’ EquityLiabilities + Stockholders’ Equity

##66 Components that Supplement Components that Supplement the Financial Statements in an the Financial Statements in an

Annual ReportAnnual Report

• Managements Discussion and AnalysisManagements Discussion and Analysis

• Notes to Financial StatementsNotes to Financial Statements

• Auditor’s reportAuditor’s report

Management’s Discussion and Management’s Discussion and Analysis covers three items:Analysis covers three items:

1.1. LiquidityLiquidity

2.2. Capital resourcesCapital resources

3.3. Results of operationsResults of operations

Management’s Discussion and Management’s Discussion and AnalysisAnalysis

Notes to Financial StatementsNotes to Financial Statements

• Explanatory notes and supplementary Explanatory notes and supplementary schedulesschedules

• Clarifies information in financial statementsClarifies information in financial statements

• Expands with additional detailExpands with additional detail

• Describes accounting policiesDescribes accounting policies

• Explains uncertainties and contingenciesExplains uncertainties and contingencies

Notes to Financial StatementsNotes to Financial Statements

Auditor’s ReportAuditor’s Report

• Certified Public Accountant – CPACertified Public Accountant – CPA

• Auditor (CPA) conducts independent Auditor (CPA) conducts independent examination of financial statementsexamination of financial statements

• Fair representation?Fair representation?

• Follow Follow generally accepted accounting generally accepted accounting principlesprinciples (GAAP)?(GAAP)?

• Unqualified opinionUnqualified opinion

Auditor’s ReportAuditor’s Report

Monetary Unit AssumptionMonetary Unit Assumption

• Only what can be expressed in moneyOnly what can be expressed in money

• Assumes unit of measure stays constantAssumes unit of measure stays constant

© PhotoDisc/Getty Images© PhotoDisc/Getty Images

Economic Entity AssumptionEconomic Entity Assumption

• Economic events identified with unitEconomic events identified with unit

• Separately identified apart from ownerSeparately identified apart from owner

Time Period AssumptionTime Period Assumption

• Divide life of business into artificial time Divide life of business into artificial time periodsperiods

• Monthly, quarterly, yearlyMonthly, quarterly, yearly

Going Concern AssumptionGoing Concern Assumption

• Divide life of business into artificial time Divide life of business into artificial time periodsperiods

• Monthly, quarterly, yearlyMonthly, quarterly, yearly

Cost PrincipleCost Principle

• Assets must be recorded at costAssets must be recorded at cost

• Verifiable vs. subjectiveVerifiable vs. subjective

Full Disclosure PrincipleFull Disclosure Principle

• All circumstances and events that would All circumstances and events that would make a difference to users must be make a difference to users must be discloseddisclosed

Do It Problem: CSU CorporationDo It Problem: CSU CorporationService revenue $17,000Accounts receivable $4,000Accounts payable $2,000Building rental expense $9,000Notes payable $5,000Common stock $10,000Retained earnings ?Equipment $16,000Insurance expense $1,000Supplies $1,800Supplies expense $200Cash $2,000Dividends $600

• CSU begins on CSU begins on Jan. 1, 2005Jan. 1, 2005

• For year ended For year ended Dec. 31, 2005Dec. 31, 2005, , prepareprepare– Income statementIncome statement

– Retained earnings Retained earnings statementstatement

– Balance sheetBalance sheet

Do It Problem: CSU CorporationDo It Problem: CSU CorporationService revenue $17,000Accounts receivable $4,000Accounts payable $2,000Building rental expense $9,000Notes payable $5,000Common stock $10,000Retained earnings ?Equipment $16,000Insurance expense $1,000Supplies $1,800Supplies expense $200Cash $2,000Dividends $600

• Action step 1Action step 1: : Report the Report the revenues & revenues & expenses for a expenses for a period of time, period of time, Income StatementIncome Statement

Do It Problem: CSU CorporationDo It Problem: CSU CorporationService revenue $17,000Accounts receivable $4,000Accounts payable $2,000Building rental expense $9,000Notes payable $5,000Common stock $10,000Retained earnings ?Equipment $16,000Insurance expense $1,000Supplies $1,800Supplies expense $200Cash $2,000Dividends $600

• Action step 1Action step 1: : Report the Report the revenues & revenues & expenses for a expenses for a period of time, period of time, Income StatementIncome Statement

Do It Problem: CSU CorporationDo It Problem: CSU Corporation

CSU CorporationCSU CorporationIncome StatementIncome Statement

For the Year Ended December 31, 2005For the Year Ended December 31, 2005

Create the headingCreate the heading

Name of the Name of the statementstatement

Name of the Name of the companycompany

Period Period of timeof time

Do It Problem: CSU CorporationDo It Problem: CSU Corporation

CSU CorporationCSU CorporationIncome StatementIncome Statement

For the Year Ended December 31, 2005For the Year Ended December 31, 2005RevenuesRevenues

Service revenueService revenue $17,000$17,000

List the revenuesList the revenues

Use dollar signs to denote U.S. currencyUse dollar signs to denote U.S. currency

Do It Problem: CSU CorporationDo It Problem: CSU CorporationCSU CorporationCSU CorporationIncome StatementIncome Statement

For the Year Ended December 31, 2005For the Year Ended December 31, 2005RevenuesRevenues

Service revenueService revenue $17,000$17,000ExpensesExpenses

Rent expenseRent expense $9,000$9,000Insurance expenseInsurance expense 1,000 1,000Supplies expenseSupplies expense 200 200

Total expensesTotal expenses 10,200 10,200

________________

List the expenses & underline sub-totalsList the expenses & underline sub-totals________________

Do It Problem: CSU CorporationDo It Problem: CSU CorporationCSU CorporationCSU CorporationIncome StatementIncome Statement

For the Year Ended December 31, 2005For the Year Ended December 31, 2005RevenuesRevenues

Service revenueService revenue $17,000$17,000ExpensesExpenses

Rent expenseRent expense $9,000$9,000Insurance expenseInsurance expense 1,000 1,000Supplies expenseSupplies expense 200 200

Total expensesTotal expenses 10,200 10,200Net IncomeNet Income $ 6,800$ 6,800

Calculate net income: revenues - expensesCalculate net income: revenues - expenses

________________________________

________________________________

Do It Problem: CSU CorporationDo It Problem: CSU CorporationService revenue $17,000Accounts receivable $4,000Accounts payable $2,000Building rental expense $9,000Notes payable $5,000Common stock $10,000Retained earnings ?Equipment $16,000Insurance expense $1,000Supplies $1,800Supplies expense $200Cash $2,000Dividends $600

• Action step 2Action step 2: : Show amounts Show amounts and causes of and causes of changes in changes in retained earningsretained earnings

• Use Net Income Use Net Income from Income from Income StatementStatement

• DividendsDividends

Do It Problem: CSU CorporationDo It Problem: CSU CorporationCSU CorporationCSU Corporation

Retained Earnings StatementRetained Earnings StatementFor the Year Ended December 31, 2005For the Year Ended December 31, 2005

Retained earnings, January 1Retained earnings, January 1 $ 0$ 0

Add: Net incomeAdd: Net income 6,800 6,800 6,8006,800

Less: DividendsLess: Dividends 600 600Retained earnings, Dec. 31 Retained earnings, Dec. 31 $ 6,800$ 6,800________________________________

________________

________________

Do It Problem: CSU CorporationDo It Problem: CSU CorporationService revenue $17,000Accounts receivable $4,000Accounts payable $2,000Building rental expense $9,000Notes payable $5,000Common stock $10,000Retained earnings $6,800Equipment $16,000Insurance expense $1,000Supplies $1,800Supplies expense $200Cash $2,000Dividends $600

• Action step 3Action step 3: : Present assets and Present assets and claims to those claims to those assets at a assets at a specific point in specific point in time on the time on the Balance SheetBalance Sheet

• Use $6,800 Use $6,800 Retained earnings Retained earnings from previous from previous statement!statement!

CSU CORPORATION CSU CORPORATION Balance SheetBalance Sheet

December 31, 2005 December 31, 2005

AssetsAssetsCashCash $ 2,000$ 2,000Accounts receivableAccounts receivable 4,000 4,000SuppliesSupplies 1,800 1,800EquipmentEquipment 16,000 16,000Total assets Total assets $23,800$23,800

Liabilities and Stockholders’ EquityLiabilities and Stockholders’ EquityLiabilitiesLiabilities

Accounts payableAccounts payable $ 2,000$ 2,000Notes payableNotes payable 5,0005,000

Total liabilitiesTotal liabilities 7,000 7,000Stockholders’ equityStockholders’ equity

Common stockCommon stock $10,000$10,000Retained earningsRetained earnings 6,8006,800

Total Stockholders’ equityTotal Stockholders’ equity 16,80016,800Total liabilities and stockholders’ equityTotal liabilities and stockholders’ equity $23,800$23,800