Understanding Financial Statements Gerald P. Weinstein, PHD, CPA KPMG Professor of Accountancy John and Mary Jo Boler School of Business John Carroll University Hudson Library and Historical Society’s MBA Lite mini-series February 23, 2015

2 Forms of Business Organization Sole proprietorship Sole proprietorship Partnership Partnership Corporation Corporation 11 1

3 Types of Business Activity Financing Financing Investing Investing Operating Operating 11 3

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

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

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

7 Operating Activities Revenues are the increases in assets resulting from the sale of a product or service Revenues are the increases in assets resulting from the sale of a product or service Expenses are the cost of assets consumed or services used in generating revenue. Expenses are the cost of assets consumed or services used in generating revenue. If revenue > expense = Net Income If revenue > expense = Net Income If revenue < expense = Net Loss! If revenue < expense = Net Loss!

8 Four Financial Statements Income Statement Income Statement Retained Earnings Statement Retained Earnings Statement Balance Sheet Balance Sheet Statement of Cash Flows Statement of Cash Flows

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

10 Income Statement Do this statement first!

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

12 Retained Earnings Statement Do this statement second!

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

14 Balance Sheet From Retained Earnings Statement

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

16 Statement of Cash Flows Statement 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 balance during the period? What was the change in the cash balance during the period? A company cannot survive without cash! A company cannot survive without cash!

17 Statement of Cash Flows.. Agrees with Balance Sheet

18 Assets Resources owned by the business Resources owned by the business Cash Cash Accounts receivable Accounts receivable Inventories Inventories Furniture and fixtures Furniture and fixtures Equipment Equipment Supplies Supplies 11 5

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

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

21 Basic Accounting Equation Basic Accounting Equation Assets = Liabilities + Stockholders’ Equity

22 Supplements to the Financial Statements in an Annual Report Management Discussion and Analysis Management Discussion and Analysis Notes to Financial Statements Notes to Financial Statements Auditor’s report Auditor’s report 11 6

23 Management’s Discussion and Analysis covers three items: 1. Liquidity 2. Capital resources 3. Results of operations

24 Management’s Discussion and Analysis

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

26 Notes to Financial Statements

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

28 Auditor’s Report