Chapter 1 Analysis of Financial Statements

Introduction to Analysis of
Financial Statements
Chapter 1
Study Objectives
1. Describe the primary forms of business
organization.
2. Identify the users and uses of accounting
information.
3. Explain the three principal types of
business activity.
4. Describe the content and purpose of each
of the financial statements.
Study Objectives
5. Explain the meaning of assets, liabilities,
and stockholders equity, and state the
basic accounting equation.
6. 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?
Give raises?
Cost per unit?
Which product is
profitable?

External
Investors
Creditors
Others
Regulatory agencies
Tax authorities
Customers
Labor Unions
Economic planners

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.
Income Statement
Do this statement first!
Shows changes in retained earnings for

period: month, quarter, or year
Beginning balance
Add Net Income from income

statement!
Deduct Dividends
Ending balance
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!
Balance Sheet
From
Retained
Earnings
Statement
Provides information about cash

receipts and cash payments
Summarizes for period: month, quarter,

or year.
Cash effects of operating, investing,

and financing activities.
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 cant survive without cash!
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
Auditors report
Managements Discussion and

Analysis covers three items:
1. Liquidity
2. Capital resources
3. Results of operations
Managements Discussion and

Analysis

Explanatory notes and supplementary
schedules
Clarifies information in financial statements
Expands with additional detail
Describes accounting policies
Explains uncertainties and contingencies
Auditors Report
Certified Public Accountant CPA
Auditor (CPA) conducts independent
examination of financial statements
Fair representation?
Follow generally accepted accounting
principles (GAAP)?
Unqualified opinion
Auditors Report
Monetary Unit Assumption
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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

Service revenue
Accounts receivable
Accounts payable
Building rental expense
Notes payable
Common stock
Retained earnings
Equipment
Insurance expense
Supplies
Supplies expense
Cash
Dividends
$17,000
$4,000
$2,000
$9,000
$5,000
$10,000
?
$16,000
$1,000
$1,800
$200
$2,000
$600
CSU begins on
Jan. 1, 2005
For year ended
Dec. 31, 2005,
prepare
Income statement
Retained earnings
statement
Balance sheet

Service revenue
Accounts receivable
Accounts payable
Notes payable
Common stock
Retained earnings
Equipment
Insurance expense
Supplies
Supplies expense
Cash
Dividends
$17,000
$4,000
$2,000
$9,000
$5,000
$10,000
?
$16,000
$1,000
$1,800
$200
$2,000
$600
Action step 1:
Report the
revenues &
expenses for a
period of time,
Income Statement

Service revenue
Accounts receivable
Accounts payable
Notes payable
Common stock
Retained earnings
Equipment
Insurance expense
Supplies
Supplies expense
Cash
Dividends
$17,000
$4,000
$2,000
$9,000
$5,000
$10,000
?
$16,000
$1,000
$1,800
$200
$2,000
$600
Action step 1:
Report the
revenues &
expenses for a
period of time,
Income Statement

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

CSU Corporation
Income Statement
Revenues
Service revenue
$17,000
List the revenues

Use dollar signs to denote U.S. currency

CSU Corporation
Income Statement
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

CSU Corporation
Income Statement
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

Service revenue
Accounts receivable
Accounts payable
Notes payable
Common stock
Retained earnings
Equipment
Insurance expense
Supplies
Supplies expense
Cash
Dividends
$17,000
$4,000
$2,000
$9,000
$5,000
$10,000
?
$16,000
$1,000
$1,800
$200
$2,000
$600
Action step 2:
Show amounts
and causes of
changes in
retained earnings
Use Net Income
from Income
Statement
Dividends

CSU Corporation
Retained earnings, January 1
Add: Net income
________
Less: Dividends
Retained earnings, Dec. 31
6,800
6,800
________
600
________
________
$ 6,800

Service revenue
Accounts receivable
Accounts payable
Notes payable
Common stock
Retained earnings
Equipment
Insurance expense
Supplies
Supplies expense
Cash
Dividends
$17,000
$4,000
$2,000
$9,000
$5,000
$10,000
$6,800
$16,000
$1,000
$1,800
$200
$2,000
$600
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

Chapter 1 Analysis of Financial Statements

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What are the three main forms of business organization discussed?

What are the three main forms of business organization discussed?

What are the two types of users of financial information mentioned?

What are the two types of users of financial information mentioned?

Introduction to Analysis of

Business owned by one person

Two or more owners

2 Users of Financial Information

Managers who plan,

Users of Financial Information

Cash to pay bills?

Cost per unit?

Users of Financial Information

Users of Financial Information

Will the company be able to pay bills

3 Types of Business Activity

Selling stock creates

4 Describe Content and Purpose

Retained Earnings Statement

Statement of Cash Flows

Reports operating success or failure for a

Summarizes revenues and expenses for

If revenue > expense = Net Income.

Do this statement first!

Retained Earnings Statement

Shows changes in retained earnings for

Add Net Income from income

Retained Earnings Statement

Do this statement second!

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!

Statement of Cash Flows

Provides information about cash

Summarizes for period: month, quarter,

Cash effects of operating, investing,

Statement of Cash Flows

Where did the cash come from?

How was cash used during the period?

What was the change in the cash

You cant survive without cash!

Statement of Cash Flows

#5 Explain the Meaning of

Basic Accounting Equation

6 Components that Supplement

Managements Discussion and

Managements Discussion and

Notes to Financial Statements

Notes to Financial Statements

Monetary Unit Assumption

Only what can be expressed in money

Economic Entity Assumption

Economic events identified with unit

Time Period Assumption

Divide life of business into artificial time periods

Going Concern Assumption

Divide life of business into artificial time periods