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?

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.

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!

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 cant 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
Auditors report

Managements Discussion and

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

Managements 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

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

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

Action step 1:
Report the
revenues &
expenses for a
period of time,
Income Statement

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

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
Name of the
statement
Income Statement
For the Year Ended December 31, 2005
Period
of time

Do It Problem: CSU Corporation

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

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

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

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

Action step 2:
Show amounts
and causes of
changes in
retained earnings
Use Net Income
from Income
Statement
Dividends

Do It Problem: CSU Corporation

CSU Corporation
Retained Earnings Statement
For the Year Ended December 31, 2005
Retained earnings, January 1

Add: Net income

________

Less: Dividends
Retained earnings, Dec. 31

6,800
6,800
________
600
________
________
$ 6,800

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
$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