CHAPTER
1
Introduction to Financial
Statements
Forms of Business Organizations
• Proprietorship: simple to establish, ownercontrolled
• Partnership: simple to establish, shared
control, broader skills and resources
• Corporation: easier to transfer ownership,
easier to attract investors, no personal
liability, tax advantages possible
Users of Financial Information
• Internal Users
– Managers plan, organize and run a business
Users of Financial Information
• External Users
– Investors
– Creditors
– Others
•
•
•
•
•
Primary users
Tax authorities
Regulatory agencies
Customers
Labour unions
Economic planners
Ethics in Financial Reporting
• Ethical dilemmas in financial reporting
– e.g., Enron
• To solve an ethical dilemma
– Recognize situation and ethical issues
– Identify and analyse principal elements
– Identify alternatives and determine impact
on stakeholders
3 Types of Business Activities
• Financing
• Investing
• Operating
Financing Activities
• Borrowing money
(debt)
• Selling shares
(equity)
Investing Activities
• Obtaining the resources or assets needed to
operate the business for the long term
• Examples
– Purchase or sale of investments
– Purchase or sale of long-lived assets such as
property, plant and equipment and intangible
assets
Operating Activities
• Operating activities are the main
activities for which the organization
is in business
Accounting Equation
Assets = Liabilities + Shareholders’ Equity
Basic Terms
• Assets - resources owned by a business
• Liabilities - obligations of the business
• Shareholders’ equity
– Share capital - represents the primary ownership
interest in a corporation
– Retained earnings – accumulated earnings of the
corporation that have not been distributed to
shareholders
Revenues
• Revenues arise
from the sale of a
product or service
• Revenues result in
an inflow of assets
Expenses
• Expenses are the costs of assets
consumed or the costs of services used to
generate revenues
• Examples
– Cost of goods sold
– Operating expenses
– Interest expense
Net Earnings
• Net earnings (or net income) is the amount by
which revenues exceed expenses
Revenue
Less: Expenses
Net earnings
$10,000
3,000
$ 7,000
(Net loss is the amount by which expenses
exceed revenues)
Financial Accounting Statements
• Statement of Earnings (also called Income
Statement)
– Reports the results of operations for a specific
period of time
• Statement of Retained Earnings
– Reports the changes in retained earnings for a
specific period of time
Financial Accounting Statements
• Balance Sheet
– Reports the assets, liabilities, and shareholders’
equity as at a specific point in time
• Cash Flow Statement
– Reports the cash receipts and payments for a
specific period of time
CSU CORPORATION
Statement of Earnings
Year Ended December 31, 2004
First:
Statement of Earnings
Name of company
Name of statement
Period of time covered
CSU CORPORATION
Statement of Earnings
Year Ended December 31, 2004
List revenues
Revenues
Service revenue
$22,200
CSU CORPORATION
Statement of Earnings
Year Ended December 31, 2004
List and total the expenses. Note that income tax
is shown separately from other expenses.
Revenues
Service revenue
Expenses
Rent expense
Insurance expense
Supplies expense
Total expenses
Earnings before income tax
Income tax expense
$22,200
$9,000
1,000
200
10,200
12,000
5,200
CSU CORPORATION
Statement of Earnings
Year Ended December 31, 2004
Subtract expenses from revenues to obtain net
earnings (loss)
Revenues
Service revenue
Expenses
Rent expense
Insurance expense
Supplies expense
Total expenses
Earnings before income tax
Income tax expense
Net earnings
$22,200
$9,000
1,000
200
10,200
12,000
5,200
$ 6,800
CSU CORPORATION
Statement of Retained Earnings
Year Ended December 31, 2004
Second:
Statement of Retained Earnings
Name of company
Name of statement
Period of time covered (same period as
statement of earnings)
CSU CORPORATION
Statement of Retained Earnings
Year Ended December 31, 2004
Start with beginning retained earnings
(same as ending retained earnings of prior
period)
Retained earnings, January 1
$
0
CSU CORPORATION
Statement of Retained Earnings
Year Ended December 31, 2004
Add net earnings (subtract loss) from the current
year (see Statement of Earnings)
Subtotal
Retained earnings,
January 1
Add: Net earnings
$
0
6,800
6,800
CSU CORPORATION
Statement of Retained Earnings
Year Ended December 31, 2004
Subtract current year’s dividends (if any) and
total
Retained earnings, January 1
Add: Net earnings
Less: Dividends
Retained earnings, December 31
$
0
6,800
6,800
0
$6,800
CSU CORPORATION
Balance Sheet
December 31, 2004
Third:
Balance Sheet
Name of company
Name of statement
Date (as at a specific point in time)
CSU CORPORATION
Balance Sheet
December 31, 2004
List the assets and total
Assets
Cash
$ 2,000
Accounts receivable
4,000
Supplies
1,800
Equipment
Total assets
16,000
$23,800
CSU CORPORATION
Balance Sheet
December 31, 2004
List the liabilities and subtotal
Assets
Cash
$ 2,000
Accounts receivable
4,000
Supplies
1,800
Equipment
16,000
Total assets
$23,800
Liabilities and Shareholders’ Equity
Liabilities
Accounts payable
$ 2,000
Notes payable
5,000
Total liabilities
7,000
CSU CORPORATION
Balance Sheet
December 31, 2004
List shareholders’ equity; subtotal
Add shareholders’ equity to liabilities; total
CSU CORPORATION
Balance Sheet
December 31, 2004
Assets
Cash
Accounts receivable
Supplies
Equipment
Total assets
$ 2,000
4,000
1,800
16,000
$23,800
Liabilities and Shareholders’ Equity
Liabilities
Accounts payable
Notes payable
Total liabilities
Shareholders’ equity
Common shares
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders’ equity
$ 2,000
5,000
7,000
$10,000
6,800
16,800
$23,800
Stop and Check
 Total assets must equal total liabilities and
shareholders’ equity
Financial Accounting Statements
In what order are financial statements
prepared? Presented?
WHY?
CSU CORPORATION
Statement of Earnings
Year Ended December 31, 2004
Revenues
Service revenue
Expenses
Rent expense
Insurance expense
Supplies expense
Total expenses
Earnings before income tax
Income tax expense
Net earnings
$22,200
$9,000
1,000
200
Net earnings is needed for the
Statement of Retained Earnings
10,200
12,000
5,200
$ 6,800
CSU CORPORATION
Statement of Retained Earnings
Year Ended December 31, 2004
Retained earnings, January 1
Add: Net earnings
Less: Dividends
Retained earnings, December 3
$
0
6,800
6,800
0
$ 6,800
Ending retained earnings is needed
for the Balance Sheet
CSU CORPORATION
Balance Sheet
December 31, 2004
Assets
Cash
Accounts receivable
Supplies
Equipment
Total assets
$ 2,000
4,000
1,800
16,000
$23,800
Liabilities and Shareholders’ Equity
Liabilities
Accounts payable
Notes payable
Total liabilities
Shareholders’ equity
Common shares
Retained earnings
Total shareholders’ equity
Total liabilities and shareholders’ equity
$ 2,000
5,000
7,000
$10,000
6,800
16,800
$23,800
CSU CORPORATION
Cash Flow Statement
Year Ended December 31, 2004
Operating activities
Net earnings
Adjustments to reconcile net earnings to net
cash provided by operating activities:
Increase in accounts receivable
Increase in supplies
Increase in accounts payable
$ 6,800
$(4,000)
(1,800)
2,000
Net cash provided by operating activities
Investing activities
Purchase of equipment
Net cash used by investing activities
(3,800)
3,000
$(16,000)
(16,000)
CSU CORPORATION
Cash Flow Statement
Year Ended December 31, 2004
(Continued)
Financing activities
Increase in notes payable
Increase in common shares
Net cash provided by financing activities
Net increase in cash
Cash, January 1
Cash, December 31
$ 5,000
10,000
15,000
2,000
0
$2,000
Assumptions and Principles in
Financial Reporting
• Assumptions
–
–
–
–
Monetary unit
Economic entity
Time period
Going concern
• Generally accepted
accounting principles
– Cost
– Full disclosure
Monetary Unit Assumption
• Only those things that can be expressed in
terms of money should be included in the
accounting records
Economic Entity
• Every economic entity can be separately
identified and accounted for
Time Period Assumption
• The economic life of a business can
be divided into artificial time periods
Going Concern Assumption
• The business will continue operating
long enough to carry out its existing
objectives
Cost Principle
• Assets should be recorded at cost
Full Disclosure Principle
• Circumstances and events
that make a difference to
financial statement users
should be disclosed