Introduction to Financial Statements Principles of Accounting Kimmel • Weygandt • Kieso Introduction to Financial Statements Chapter 1 Prepared by Carol A. Hartley Providence College

Study Objectives Describe the primary forms of business organization. Identify the users and uses of accounting information. Explain the three principal types of business activity. Describe the content and purpose of each of the financial statements.

Study Objectives Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation. Describe the components that supplement the financial statements in an annual report.

#1 Forms of Business Organization Sole proprietorship Partnership Corporation

Sole Proprietorship Business owned by one person Simple to establish Owner controlled Tax advantages Owner personally liable Financing difficult

Partnership Two or more owners Simple to establish Shared controlled Broader skills & resources Tax advantages Personal liability

Corporation Separate legal entity owned by stockholders Easy to transfer ownership Greater capital raising potential Lower legal liability Unfavorable tax treatment

#2 Users of Financial Information Internal Managers who plan, organize and run a business Marketing managers Production supervisors Finance directors Company officers

Users of Financial Information Internal Users Ask? Cash to pay bills? Cost per unit? Give raises? Which product is profitable?

Users of Financial Information External Investors Creditors Others Regulatory agencies Tax authorities Customers Labor Unions Economic planners

Users of Financial Information External Users Ask? Earning enough? Compare to competition? Will the company be able to pay bills when due?

#3 Types of Business Activity Financing Investing Operating

Financing Activities Borrowing creates liabilities Bank loans Debt securities Goods on credit or payables Selling stock creates stockholders’ equity

Investing Activities Obtaining resources or assets to operate the business Land Buildings Vehicles Computers Furniture

Operating Activities Primary activity of business Selling goods Providing services Manufacturing Cost of Sales Advertising Paying employees Paying utilities

Operating Activities Revenue is generated from sales or services Expenses are the cost of doing business If revenue > expense = Net Income If revenue < expense = Net Loss!

#4 Describe Content and Purpose of Financial Statements Accountants communicate with users through four financial statements Income Statement Retained Earnings Statement Balance Sheet Statement of Cash Flows

Income Statement Reports operating success or failure for a period. Summarizes revenues and expenses for period: month, quarter, or year. If revenue > expense = Net Income.

Do this statement first! Income Statement Do this statement first!

Retained Earnings Statement Shows changes in retained earnings for period: month, quarter, or year Beginning balance Add Net Income from income statement! Deduct Dividends Ending balance

Retained Earnings Statement Do this statement second!

Balance Sheet Reports assets and claims to assets. Claims of creditors, liabilities. Claims of owners, stockholders’ equity. Assets = Liabilities + Stockholders’ Equity Specific date – one point in time!

From Retained Earnings Statement Balance Sheet From Retained Earnings Statement

Statement of Cash Flows Provides information about cash receipts and cash payments Summarizes for period: month, quarter, or year. Cash effects of operating, investing, and financing activities.

Statement of Cash Flows Where did the cash come from? How was cash used during the period? What was the change in the cash balance during the period? You can’t survive without cash!

Statement of Cash Flows Agrees with Balance Sheet

#5 Explain the Meaning of Assets, Liabilities, and Stockholders’ Equity. State the Basic Accounting Equation

Assets Resources owned by the business Cash Accounts receivable Inventories Building Furniture and fixtures Equipment Supplies

Liabilities Obligations or debts of business Notes payable Accounts payable Interest payable Salaries payable Unearned revenue

Stockholders’ Equity Ownership claims on assets Paid-in capital Common stock Retained earnings

Basic Accounting Equation Assets = Liabilities + Stockholders’ Equity

#6 Components that Supplement the Financial Statements in an Annual Report Managements Discussion and Analysis Notes to Financial Statements Auditor’s report

Management’s Discussion and Analysis covers three items: Liquidity Capital resources Results of operations

Management’s Discussion and Analysis

Notes to Financial Statements Explanatory notes and supplementary schedules Clarifies information in financial statements Expands with additional detail Describes accounting policies Explains uncertainties and contingencies

Notes to Financial Statements

Auditor’s Report Certified Public Accountant – CPA Auditor (CPA) conducts independent examination of financial statements Fair representation? Follow generally accepted accounting principles (GAAP)? Unqualified opinion

Auditor’s Report

Monetary Unit Assumption © PhotoDisc/Getty Images Only what can be expressed in money Assumes unit of measure stays constant

Economic Entity Assumption Economic events identified with unit Separately identified apart from owner

Time Period Assumption Divide life of business into artificial time periods Monthly, quarterly, yearly

Going Concern Assumption Divide life of business into artificial time periods Monthly, quarterly, yearly

Cost Principle Assets must be recorded at cost Verifiable vs. subjective

Full Disclosure Principle All circumstances and events that would make a difference to users must be disclosed

Do It Problem: CSU Corporation CSU begins on Jan. 1, 2005 For year ended Dec. 31, 2005, prepare Income statement Retained earnings statement Balance sheet

Do It Problem: CSU Corporation Action step 1: Report the revenues & expenses for a period of time, Income Statement

Do It Problem: CSU Corporation Action step 1: Report the revenues & expenses for a period of time, Income Statement

Do It Problem: CSU Corporation Create the heading Name of the company CSU Corporation Income Statement For the Year Ended December 31, 2005 Name of the statement Period of time

Do It Problem: CSU Corporation Income Statement For the Year Ended December 31, 2005 Revenues Service revenue $17,000 List the revenues Use dollar signs to denote U.S. currency

Do It Problem: CSU Corporation Income Statement For the Year Ended December 31, 2005 Revenues Service revenue $17,000 Expenses Rent expense $9,000 Insurance expense 1,000 Supplies expense 200 Total expenses 10,200 ________ ________ List the expenses & underline sub-totals

Do It Problem: CSU Corporation Income Statement For the Year Ended December 31, 2005 Revenues Service revenue $17,000 Expenses Rent expense $9,000 Insurance expense 1,000 Supplies expense 200 Total expenses 10,200 Net Income $ 6,800 Calculate net income: revenues - expenses ________ ________ ________ ________

Do It Problem: CSU Corporation Action step 2: Show amounts and causes of changes in retained earnings Use Net Income from Income Statement Dividends

Do It Problem: CSU Corporation Retained Earnings Statement For the Year Ended December 31, 2005 Retained earnings, January 1 $ 0 Add: Net income 6,800 6,800 Less: Dividends 600 Retained earnings, Dec. 31 $ 6,800 ________ ________ ________ ________

Do It Problem: CSU Corporation Action step 3: Present assets and claims to those assets at a specific point in time on the Balance Sheet Use $6,800 Retained earnings from previous statement!

CSU CORPORATION Balance Sheet December 31, 2005 Assets Cash $ 2,000 Accounts receivable 4,000 Supplies 1,800 Equipment 16,000 Total assets $23,800 Liabilities and Stockholders’ Equity Liabilities Accounts payable $ 2,000 Notes payable 5,000 Total liabilities 7,000 Stockholders’ equity Common stock $10,000 Retained earnings 6,800 Total Stockholders’ equity 16,800 Total liabilities and stockholders’ equity $23,800