Introduction to Financial Statements CHAPTER 1

Proprietorship: simple to establish, owner- controlledProprietorship: simple to establish, owner- controlled Partnership: simple to establish, shared control, broader skills and resourcesPartnership: simple to establish, shared control, broader skills and resources Corporation: easier to transfer ownership, easier to attract investors, no personal liability, tax advantages possibleCorporation: easier to transfer ownership, easier to attract investors, no personal liability, tax advantages possible Forms of Business Organizations

Internal UsersInternal Users –Managers plan, organize and run a business Users of Financial Information

External UsersExternal Users –Investors –Creditors –Others Tax authoritiesTax authorities Regulatory agenciesRegulatory agencies CustomersCustomers Labour unionsLabour unions Economic plannersEconomic planners Primary users Users of Financial Information

Ethical dilemmas in financial reportingEthical dilemmas in financial reporting –e.g., Enron To solve an ethical dilemmaTo solve an ethical dilemma –Recognize situation and ethical issues –Identify and analyse principal elements –Identify alternatives and determine impact on stakeholders Ethics in Financial Reporting

3 Types of Business Activities FinancingFinancing InvestingInvesting OperatingOperating

Borrowing money (debt)Borrowing money (debt) Selling shares (equity)Selling shares (equity) Financing Activities

Obtaining the resources or assets needed to operate the business for the long termObtaining the resources or assets needed to operate the business for the long term ExamplesExamples –Purchase or sale of investments –Purchase or sale of long-lived assets such as property, plant and equipment and intangible assets Investing Activities

Operating Activities Operating activities are the main activities for which the organization is in businessOperating 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 businessAssets - resources owned by a business Liabilities - obligations of the businessLiabilities - obligations of the business Shareholders’ equityShareholders’ 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 arise from the sale of a product or serviceRevenues arise from the sale of a product or service Revenues result in an inflow of assetsRevenues result in an inflow of assets Revenues

Expenses are the costs of assets consumed or the costs of services used to generate revenuesExpenses are the costs of assets consumed or the costs of services used to generate revenues ExamplesExamples –Cost of goods sold –Operating expenses –Interest expense Expenses

Net Earnings Net earnings (or net income) is the amount by which revenues exceed expensesNet earnings (or net income) is the amount by which revenues exceed expenses (Net loss is the amount by which expenses exceed revenues) Revenue$10,000 Less: Expenses 3,000 3,000 Net earnings $ 7,000

Financial Accounting Statements Statement of Earnings (also called Income Statement)Statement of Earnings (also called Income Statement) –Reports the results of operations for a specific period of time Statement of Retained EarningsStatement of Retained Earnings –Reports the changes in retained earnings for a specific period of time

Financial Accounting Statements Balance SheetBalance Sheet –Reports the assets, liabilities, and shareholders’ equity as at a specific point in time Cash Flow StatementCash Flow Statement –Reports the cash receipts and payments for a specific period of time

CSU CORPORATION Statement of Earnings Year Ended December 31, 2004First: Statement of Earnings  Name of company  Name of statement  Period of time covered

 List revenues CSU CORPORATION Statement of Earnings Year Ended December 31, 2004Revenues Service revenue Service revenue$22,200

 List and total the expenses. Note that income tax is shown separately from other expenses. CSU CORPORATION Statement of Earnings Year Ended December 31, 2004Revenues Service revenue Service revenue$22,200 Expenses Rent expense Rent expense$9,000 Insurance expense Insurance expense1,000 Supplies expense Supplies expense Total expenses Total expenses10,200 Earnings before income tax 12,000 Income tax expense 5,200 5,200

 Subtract expenses from revenues to obtain net earnings (loss) CSU CORPORATION Statement of Earnings Year Ended December 31, 2004Revenues Service revenue Service revenue$22,200 Expenses Rent expense Rent expense$9,000 Insurance expense Insurance expense1,000 Supplies expense Supplies expense Total expenses Total expenses 10,200 10,200 Earnings before income tax 12,000 Income tax expense 5,200 5,200 Net earnings $ 6,800

CSU CORPORATION Statement of Retained Earnings Year Ended December 31, 2004Second: 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

 Add net earnings (subtract loss) from the current year (see Statement of Earnings)  Subtotal CSU CORPORATION Statement of Retained Earnings Year Ended December 31, 2004 Retained earnings, January 1 $ 0 Add: Net earnings 6,800 6,800 6,800

 Subtract current year’s dividends (if any) and total CSU CORPORATION Statement of Retained Earnings Year Ended December 31, 2004 Retained earnings, January 1 $ 0 Add: Net earnings 6,800 6,800 6,800 Less: Dividends 0 Retained earnings, December 31 $6,800

CSU CORPORATION Balance Sheet December 31, 2004Third: Balance Sheet  Name of company  Name of statement  Date (as at a specific point in time)

 List the assets and total CSU CORPORATION Balance Sheet December 31, 2004Assets Cash $ 2,000 Accounts receivable 4,000 Supplies1,800 Equipment 16,000 16,000 Total assets $23,800

 List the liabilities and subtotal CSU CORPORATION Balance Sheet December 31, 2004Assets Cash $ 2,000 Accounts receivable 4,000 Supplies1,800 Equipment 16,000 16,000 Total assets $23,800 Liabilities and Shareholders’ Equity Liabilities Accounts payable Accounts payable $ 2,000 Notes payable Notes payable 5,000 5,000 Total liabilities Total liabilities7,000

 List shareholders’ equity; subtotal  Add shareholders’ equity to liabilities; total CSU CORPORATION Balance Sheet December 31, 2004

Assets Cash Accounts receivable SuppliesEquipment Total assets Total assets $ 2,000 4,0001,800 16,000 16,000$23,800 Liabilities and Shareholders’ Equity Liabilities Accounts payable Accounts payable Notes payable Notes payable Total liabilities Total liabilities Shareholders’ equity Common shares Common shares Retained earnings Retained earnings Total shareholders’ equity Total shareholders’ equity Total liabilities and shareholders’ equity $10,000 6,800 6,800 $ 2,000 5,000 5,0007,000 16,800 16,800$23,800

Stop and Check Total assets must equal total liabilities and shareholders’ equity Total assets must equal total liabilities and shareholders’ equity

In what order are financial statements prepared? Presented? WHY? Financial Accounting Statements

CSU CORPORATION Statement of Earnings Year Ended December 31, 2004 Net earnings is needed for the Statement of Retained Earnings Revenues Service revenue Service revenueExpenses Rent expense Rent expense Insurance expense Insurance expense Supplies expense Supplies expense Total expenses Earnings before income tax Income tax expense Net earnings $9,0001, $22,200 10,200 10,20012,000 5,200 5,200 $ 6,800

CSU CORPORATION Statement of Retained Earnings Year Ended December 31, 2004 Ending retained earnings is needed for the Balance Sheet Retained earnings, January 1 Add: Net earnings Less: Dividends Retained earnings, December 3 $ 0 6,800 6,800 6,800 6,800 0 $ 6,800

CSU CORPORATION Balance Sheet December 31, 2004Assets Cash Accounts receivable SuppliesEquipment Total assets Total assets $ 2,000 4,0001,800 16,000 16,000$23,800 Liabilities and Shareholders’ Equity Liabilities Accounts payable Accounts payable Notes payable Notes payable Total liabilities Total liabilities Shareholders’ equity Common shares Common shares Retained earnings Retained earnings Total shareholders’ equity Total shareholders’ equity Total liabilities and shareholders’ equity $10,000 6,800 6,800 $ 2,000 5,000 5,0007,000 16,800 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 Net cash provided by operating activities Investing activities Purchase of equipment Net cash used by investing activities $(4,000)(1,800) 2,000 2,000$(16,000) $ 6,800 (3,800)3,000(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 10,00015,0002,000 0$2,000

Assumptions and Principles in Financial Reporting AssumptionsAssumptions –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 recordsOnly 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 forEvery economic entity can be separately identified and accounted for

Time Period Assumption The economic life of a business can be divided into artificial time periodsThe 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 objectivesThe business will continue operating long enough to carry out its existing objectives

Cost Principle Assets should be recorded at costAssets should be recorded at cost

Full Disclosure Principle Circumstances and events that make a difference to financial statement users should be disclosedCircumstances and events that make a difference to financial statement users should be disclosed