Health Care Accounting Discussion Post
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ges and benefits, health and safety, and the environment.
Employers such as Columbia Sportswear generally assume that managers in all areas of the company are “financially literate.” To help prepare you for that, in this text you will learn how to read and prepare financial statements, and how to use key tools to evaluate financial results using basic data analytics.
The Chapter Outline presents the chapter's topics and subtopics, as well as practice opportunities.
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Chapter Outline LEARNING OBJECTIVES
LO 1 Identify the forms of business organization and the uses of accounting information.
Forms of business organization
Users and uses of financial information
Ethics in financial reporting
DO IT! 1 Business Organization Forms
LO 2 Explain the three principal types of business activity.
Financing activities
Investing activities
Operating activities
DO IT! 2 Business Activities
LO 3 Describe the four financial statements and how they are prepared.
Income statement
Retained earnings statement
Balance sheet
Statement of cash flows
Interrelationships of statements
Other annual report elements
DO IT! 3a Financial Statements
DO IT! 3b Components of Annual Reports
Go to the Review and Practice section at the end of the chapter for a targeted summary and practice applications with solutions.
Visit WileyPLUS for additional tutorials and practice opportunities.
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Business Organization and Accounting Information Uses
LEARNING OBJECTIVE 1
Identify the forms of business organization and the uses of accounting information.
Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You enjoy working with people, especially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.
Forms of Business Organization Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation.
Sole Proprietorship
You might choose the sole proprietorship form for your outdoor guide service. A business owned by one person is a sole proprietorship. It is simple to set up and gives you control over the business. Small owner-operated businesses such as barber shops, law offices, and auto repair shops are often sole proprietorships, as are farms and small retail stores.
Partnership
Another possibility is for you to join forces with other individuals to form a partnership. A business owned by two or more persons associated as partners is a partnership. Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants), often organize as partnerships.
Corporation
As a third alternative, you might organize as a corporation. A business organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money (see Alternative Terminology). Therefore, it is easier for corporations to raise funds. Successful corporations often have thousands of stockholders, and their stock is
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traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate.
Alternative Terminology notes present synonymous terms that you may come across in practice.
ALTERNATIVE TERMINOLOGY
Stockholders are sometimes called shareholders.
Other factors to consider in deciding which organizational form to choose are taxes and legal liability. If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter.
Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. These hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. Probably the most common among these hybrids types are limited liability companies (LLCs) and subchapter S corporations. These forms are discussed extensively in business law classes.
The combined number of proprietorships and partnerships in the United States far exceeds the number of corporations. However, the revenue produced by corporations is many times greater. Most of the largest businesses in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this text is on the corporate form of organization.
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Users and Uses of Financial Information The purpose of financial information is to provide inputs for decision-making. Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users.
Accounting software systems collect vast amounts of data about the economic events experienced by a company and about the parties with whom the company engages, such as suppliers and customers. Business decision-makers take advantage of this wealth of data by using data analytics to make more informed business decisions. Data analytics involves analyzing data, often employing both software and statistics, to draw inferences. As both data access and analytical software improve, the use of data analytics to support decisions is becoming increasingly common at virtually all types of companies (see Helpful Hint).
Users of accounting information can be divided broadly into two groups: internal users and external users.
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Helpful Hints further clarify concepts being discussed.
HELPFUL HINT
Throughout this text, we will highlight examples where accounting information is used to support business decisions using data analytics.
Internal Users
Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, managers must answer many important questions, as shown in Illustration 1.1.
ILLUSTRATION 1.1 Questions that internal users ask
To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized financial information in the form of financial statements.
Accounting Across the Organization boxes show applications of accounting information in various business functions.
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Accounting Across the Organization Clif Bar & Company
Owning a Piece of the Bar
The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. The company has approximately 1,000 employees and was named one of Landor's Breakaway Brands®. One of Clif Bar & Company's proudest moments was the creation of an employee stock ownership plan (ESOP). This plan gives its employees 20% ownership of the company. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its finances. Armed with basic accounting knowledge, employees are more aware of the financial impact of their actions, which leads to better decisions.
What are the benefits to the company and to the employees of making the financial statements available to all employees? (Go to WileyPLUS for this answer and additional questions.)
External Users
There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1.2.
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ILLUSTRATION 1.2 Questions that external users ask
The information needs and questions of other external users vary considerably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws. Customers are interested in whether a company like General Motors will continue to honor product warranties and otherwise support its product lines. Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and benefits. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record profits at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to investigate the energy traders to make sure that the profits were earned by legitimate and fair practices.
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Accounting Across the Organization
Spinning the Career Wheel
How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every field of business. Some examples of how accounting is used in business careers include the following.
General management: Managers of Ford Motors, Massachusetts General Hospital, California State University–Fullerton, a McDonald's franchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions.
Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and benefits, which accounting helps them quantify and understand. Making a sale is meaningless unless it is a profitable sale.
Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These fields rely heavily on accounting knowledge to analyze financial statements. In fact, it is difficult to get a good job in a finance function without two or three courses in accounting.
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Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank—is almost always involved in financing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash flow from an industrial property justify the purchase price? What are the tax benefits of the purchase?
How might accounting help you? (Go to WileyPLUS for this answer and additional questions.)
Ethics in Financial Reporting People won't gamble in a casino if they think it is “rigged.” Similarly, people won't “play” the stock market if they think stock prices are rigged. At one time, the financial press was full of articles about financial scandals at Enron, WorldCom, HealthSouth, and AIG. As more scandals came to light, a mistrust of financial reporting in general seemed to be developing. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting.
United States regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting. Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals (see Ethics Note). As a result of SOX, top management must now certify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate financial statements and the oversight role of boards of directors.
Ethics Notes help sensitize you to some of the ethical issues in accounting.
ETHICS NOTE
Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.
Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this text. (1) A number of the Feature Stories and other parts of the text discuss the central importance of ethical behavior to financial reporting. (2) Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business
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settings. (3) Many of the People, Planet, and Profit Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. (4) At the end of each chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case.
When analyzing these various ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1.3.
ILLUSTRATION 1.3 Steps in analyzing ethics cases
Insight boxes provide examples of business situations from various perspectives— ethics, investor, international, and corporate social responsibility. Guideline answers to the critical thinking questions, as well as additional questions, are available in WileyPLUS.
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Ethics Insight Dewey & LeBoeuf LLP
I Felt the Pressure—Would You?
“I felt the pressure.” That's what some of the employees of the now-defunct law firm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former finance director and former chief financial officer (CFO) of the firm. Here are some of their comments:
“I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”
“I intentionally gave the auditors incorrect information in the course of the audit.”
What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their financial manipulations as accounting tricks, cooking the books, and fake income.
Sources: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014); and Sara Randazzo, “Dewey CFO Escapes Jail Time in Fraud Case Sentencing,” Wall Street Journal (October 10, 2017).
Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to WileyPLUS for this answer and additional questions.)
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DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.
DO IT! 1 | Business Organization Forms
In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated.
1. Easier to raise funds.
2. Simple to establish.
3. No personal legal liability.
4. Tax advantages.
5. Easier to transfer ownership.
ACTION PLAN
Know which organizational form best matches the business type, size, and preferences of the owner(s).
Solution
1. Easier to raise funds: Corporation.
2. Simple to establish: Sole proprietorship and partnership.
3. No personal legal liability: Corporation.
4. Tax advantages: Sole proprietorship and partnership.
5. Easier to transfer ownership: Corporation.
Related exercise material: BE1.1 and DO IT! 1.1.
The Three Types of Business Activity
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LEARNING OBJECTIVE 2
Explain the three principal types of business activity.
All businesses are involved in three types of activity—financing, investing, and operating. For example, Gert Boyle's parents, the founders of Columbia Sportswear, obtained cash through financing to start and grow their business. Some of this financing came from personal savings, and some likely came from outside sources like banks. The family then invested the cash in equipment to run the business, such as sewing equipment and delivery vehicles. Once this equipment was in place, they could begin the operating activities of making and selling clothing.
The accounting information system keeps track of the results of each of the various business activities—financing, investing, and operating. Let's look at each type of business activity in more detail.
Financing Activities It takes money to make money. The two primary sources of outside funds for corporations are borrowing money (debt financing) and issuing (selling) shares of stock in exchange for cash (equity financing).
Columbia Sportswear may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom Columbia owes money are its creditors. Amounts owed to creditors—in the form of debt and other obligations—are called liabilities. Specific names are given to different types of liabilities, depending on their source. Columbia may have a note payable to a bank for the money borrowed to purchase delivery trucks. Debt securities sold to investors that must be repaid at a particular date some years in the future are bonds payable.
Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase.
The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a payment schedule (e.g., payment at the end of three months). As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may legally force the company to sell property to pay its debts. In the case of financial difficulty, creditor claims must be paid before stockholders' claims.
Stockholders, on the other hand, have no claim to corporate cash until the claims of creditors are satisfied. Suppose you buy a company's stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company's creditors are paid amounts currently due. However, many corporations make payments to stockholders on a regular basis as long as there is sufficient cash to cover required payments to creditors. These cash payments to stockholders are called dividends.
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Investing Activities Once the company has raised cash through financing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. A growing company purchases many resources, such as computers, delivery trucks, furniture, and buildings. Resources owned by a business are called assets. Different types of assets are given different names. For example, Columbia Sportswear's sewing equipment is a type of asset referred to as property, plant, and equipment (see Alternative Terminology).
Cash is one of the more important assets owned by Columbia or any other business. If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations. Investments are another example of an investing activity.
ALTERNATIVE TERMINOLOGY
Property, plant, and equipment is sometimes called fixed assets.
Operating Activities Once a business has the assets it needs to get started, it begins operations. Columbia Sportswear is in the business of selling outdoor clothing and footwear. It sells TurboDown jackets, Millenium snowboard pants, Sorel® snow boots, Bugaboots™, rainwear, and anything else you might need to protect you from the elements. We call amounts earned
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on the sale of these products revenues. Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business. For example, Columbia records revenue when it sells a footwear product.
Revenues arise from different sources and are identified by various names depending on the nature of the business. For instance, Columbia's primary source of revenue is the sale of sportswear. However, it also generates interest revenue on debt securities held as investments. Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue.
The company purchases its longer-lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operating activities. For example, supplies are assets used in day-to-day operations. Goods available for future sales to customers are assets called inventory. Also, if Columbia sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future. This right to receive money in the future is called an account receivable.
Before Columbia can sell a single Sorel® boot, it must purchase wool, rubber, leather, metal lace loops, laces, and other materials. It then must process, wrap, and ship the finished product. It also incurs costs like salaries, rents, and utilities. All of these costs, referred to as expenses, are necessary to produce and sell the product. In accounting language, expenses are the cost of assets consumed or services used in the process of generating revenues.
Expenses take many forms and are identified by various names depending on the type of asset consumed or service used. For example, Columbia keeps track of these types of expenses: cost of goods sold (such as the cost of materials), selling expenses (such as the cost of salespersons' salaries), marketing expenses (such as the cost of advertising), administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corporate office), interest expense (amounts of interest paid on various debts), and income tax expense (corporate taxes paid to the government).
Columbia may also have liabilities arising from these expenses. For example, it may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable. Additionally, Columbia may have interest payable on the outstanding amounts owed to the bank. It may also have wages payable to its employees and sales taxes payable, property taxes payable, and income taxes payable to the government.
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Columbia compares the revenues of a period with the expenses of that period to determine whether it earned a profit. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.
DO IT! 2 | Business Activities
Classify each item as an asset, liability, common stock, revenue, or expense.
1. Cost of renting property.
2. Truck purchased.
3. Notes payable.
4. Issuance of ownership shares.
5. Amount earned from performing service.
6. Amounts owed to suppliers.
ACTION PLAN
Classify each item based on its economic characteristics. Proper classification of items is critical if accounting is to provide useful information.
Solution
1. Cost of renting property: Expense.
2. Truck purchased: Asset.
3. Notes payable: Liability.
4. Issuance of ownership shares: Common stock.
5. Amount earned from performing service: Revenue.
6. Amounts owed to suppliers: Liability.
Related exercise material: BE1.3, DO IT! 1.2, and E1.4.
The Four Financial Statements
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LEARNING OBJECTIVE 3
Describe the four financial statements and how they are prepared.
Assets, liabilities, expenses, and revenues are of interest to users of accounting information. This information is arranged in the format of four different financial statements, which form the backbone of financial accounting (see International Note):
To show how successfully your business performed during a period of time, you report its revenues and expenses in an income statement.
To indicate how much of previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth, you present a retained earnings statement.
To present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities), you prepare a balance sheet.
To show where your business obtained cash during a period of time and how that cash was used, you present a statement of cash flows.
International Notes highlight differences between U.S. and international accounting standards.
International Note
The primary types of financial statements required by International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same. Neither IFRS nor GAAP is very specific regarding format requirements for the primary financial statements. However, in practice, some format differences do exist in presentations commonly employed by IFRS companies as compared to GAAP companies.
To introduce you to these statements, we have prepared the financial statements for your outdoor guide service, Sierra Corporation, after your first month of operations. To summarize, you officially started your business in Truckee, California, on October 1, 2022. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe outdoor day trips, such as rafting, snowshoeing, and hiking, as well as multi-day backcountry experiences. To minimize your initial investment, at this point the company has limited outdoor equipment for customer use. Instead, your customers either bring their own equipment or rent equipment through local outfitters. The financial statements for Sierra's first month of business are provided in the following pages.
Income Statement
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The income statement reports a company's revenues and expenses and resulting net income or loss for a period of time (see Decision Tools). To indicate that its income statement reports the results of operations for a specific period of time, Sierra Corporation dates the income statement “For the Month Ended October 31, 2022.” The income statement lists the company's revenues followed by its expenses. Finally, Sierra determines the net income (or net loss) by deducting expenses from revenues. Sierra's income statement is shown in Illustration 1.4 (see Helpful Hint). Congratulations, you are already showing a profit!
Decision Tools that are useful for business decision-making are highlighted throughout the text. A summary of the Decision Tools is also provided in each chapter.
Decision Tools
The income statement helps users determine if the company's operations are profitable.
ILLUSTRATION 1.4 Sierra Corporation's income statement
Sierra Corporation
Income Statement
For the Month Ended October 31, 2022
Revenues Service revenue $10,600 Expenses Salaries and wages expense $5,200 Rent expense 900 Supplies expense 1,500 Depreciation expense 40 Interest expense 50 Insurance expense 50 Total expenses 7,740 Net income $ 2,860
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HELPFUL HINT
The financial statement heading identifies the company, the type of statement, and the time period covered. Sometimes, another line indicates the unit of measure, e.g., “in thousands” or “in millions.”
Why are financial statement users interested in net income? Investors are interested in a company's past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company's future performance. If investors believe that Sierra will be successful in the future and that this will result in a higher stock price, they will buy its stock.
Creditors also use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn't think it would be repaid, it wouldn't loan the money. Therefore, prior to making the loan the bank loan officer uses the income statement as a source of information to predict whether the company will be profitable enough to repay its loan. Thus, reporting a strong profit will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing.
Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (see Illustration 1.7), nor does it regard as a business expense the $500 of dividends paid (see Illustration 1.5) (see Ethics Note).
ETHICS NOTE
When companies find errors in previously released income statements, they restate those numbers. Perhaps because of the increased scrutiny shortly after Sarbanes- Oxley was implemented, companies filed a record 1,195 restatements.
Retained Earnings Statement If Sierra Corporation is profitable, at the end of each period it must decide what portion of profits to pay to shareholders in dividends. In theory, it could pay all of its current-period profits, but few companies do this. Why? Because they want to retain part of the profits to allow for further expansion. High-growth companies, such as Google and Facebook, often pay no dividends. Retained earnings is the net income retained in the corporation.
The retained earnings statement shows the amounts and causes of changes in retained earnings for a specific time period (see Decision Tools). The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the first line of the statement. Then, the company adds net income and deducts dividends to determine the retained earnings at the end of the period. If a company has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1.5 presents Sierra's retained earnings statement (see Helpful Hint).
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ILLUSTRATION 1.5 Sierra Corporation's retained earnings statement
Sierra Corporation
Retained Earnings Statement
For the Month Ended October 31, 2022
Retained earnings, October 1 $ 0 Add: Net income 2,860
2,860 Less: Dividends 500 Retained earnings, October 31 $2,360
By monitoring the retained earnings statement, financial statement users can evaluate dividend payment practices. Some investors seek companies, such as Dow Chemical, that have a history of paying high dividends. Other investors seek companies, such as Amazon.com, that reinvest earnings to increase the company's growth instead of paying dividends. Lenders monitor their corporate customers' dividend payments because any money paid in dividends reduces a company's ability to repay its debts.
Decision Tools
The retained earnings statement helps users determine the company's policy toward dividends and growth.
HELPFUL HINT
The heading of this statement identifies the company, the type of statement, and the time period covered by the statement.
Balance Sheet The balance sheet reports assets and claims to assets at a specific point in time (see Decision Tools). Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. The owners' claim to assets is called stockholders' equity.
Decision Tools
The balance sheet helps users determine if the company relies on debt or stockholders' equity to finance its assets.
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Illustration 1.6 shows the relationship among the categories on the balance sheet in equation form. This equation is referred to as the basic accounting equation.
ILLUSTRATION 1.6 Basic accounting equation
This relationship is where the name “balance sheet” comes from. Assets must balance with the claims to assets.
As you can see from looking at Sierra Corporation's balance sheet in Illustration 1.7, the balance sheet presents the company's financial position as of a specific date—in this case, October 31, 2022 (see Helpful Hint). It lists assets first. Assets are listed in the order of their liquidity, that is, how quickly they could be converted to cash. Assets are followed by liabilities and stockholders' equity (see Alternative Terminology). Stockholders' equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the company sells new shares of stock; retained earnings is the net income retained in the corporation. Sierra has common stock of $10,000 and retained earnings of $2,360, for total stockholders' equity of $12,360.
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ILLUSTRATION 1.7 Sierra Corporation's balance sheet
Sierra Corporation
Balance Sheet
October 31, 2022
Assets Cash $15,200 Accounts receivable 200 Supplies 1,000 Prepaid insurance 550 Equipment, net 4,960 Total assets $21,910
Liabilities and Stockholders' Equity Liabilities Notes payable $ 5,000 Accounts payable 2,500 Unearned service revenue 800 Salaries and wages payable 1,200 Interest payable 50 Total liabilities $ 9,550 Stockholders' equity Common stock 10,000 Retained earnings 2,360 Total stockholders' equity 12,360 Total liabilities and stockholders' equity $21,910
Creditors analyze a company's balance sheet to determine the likelihood that they will be repaid. They carefully evaluate the nature of the company's assets and liabilities. In operating Sierra's guide service, the balance sheet will be used to determine whether cash on hand is sufficient for immediate cash needs. The balance sheet will also be used to evaluate the relationship between debt and stockholders' equity to determine whether the company has a satisfactory proportion of debt and common stock financing.
ALTERNATIVE TERMINOLOGY
Liabilities are also referred to as debt.
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HELPFUL HINT
The heading of a balance sheet must identify the company, the statement, and the date.
Statement of Cash Flows The primary purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time (see Decision Tools). To help investors, creditors, and others in their analysis of a company's cash position, the statement of cash flows reports the cash effects of a company's operating, investing, and financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the amount of cash at the end of the period.
Decision Tools
The statement of cash flows helps users determine if the company generates enough cash from operations to fund its investing activities.
Users are interested in the statement of cash flows because they want to know what is happening to a company's most important resource. The statement of cash flows provides answers to these simple but important questions:
Where did cash come from during the period?
How was cash used during the period?
What was the change in the cash balance during the period?
The statement of cash flows for Sierra Corporation, in Illustration 1.8, shows that cash increased $15,200 during the month (see Helpful Hint). This increase resulted because operating activities (services to clients) increased cash $5,700, and financing activities increased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment.
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ILLUSTRATION 1.8 Sierra Corporation's statement of cash flows
Sierra Corporation
Statement of Cash Flows
For the Month Ended October 31, 2022
Cash flows from operating activities Cash receipts from operating activities
$11,200
Cash payments for operating activities
(5,500)
Net cash provided by operating activities
$ 5,700
Cash flows from investing activities Purchased office equipment (5,000) Net cash used by investing activities
(5,000)
Cash flows from financing activities Issuance of common stock 10,000 Issuance of note payable 5,000 Payment of dividend (500) Net cash provided by financing activities
14,500
Net increase in cash 15,200 Cash at beginning of period 0 Cash at end of period $15,200
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People, Planet, and Profit Insight
Beyond Financial Statements
Should we expand our financial statements beyond the income statement, retained earnings statement, balance sheet, and statement of cash flows? Some believe we should take into account ecological and social performance, in addition to financial results, in evaluating a company. The argument is that a company's responsibility lies with anyone who is influenced by its actions. In other words, a company should be interested in benefiting many different parties, instead of only maximizing stockholders' interests.
A socially responsible business does not exploit or endanger any group of individuals. It follows fair trade practices, provides safe environments for workers, and bears responsibility for environmental damage. Granted, measurement of these factors is difficult. How to report this information is also controversial. But many interesting and useful efforts are underway. Throughout this text, we provide additional insights into how companies are attempting to meet the challenge of measuring and reporting their contributions to society, as well as their financial results, to stockholders.
Why might a company's stockholders be interested in its environmental and social performance? (Go to WileyPLUS for this answer and additional questions.)
HELPFUL HINT
The heading of this statement identifies the company, the type of statement, and the time period covered by the statement. Negative numbers are shown in parentheses.
Interrelationships of Statements
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Illustration 1.9 shows the financial statements of Sierra Corporation (see Helpful Hints). Because the results on some financial statements become inputs to other statements, the statements are interrelated. These interrelationships can be seen in Sierra's financial statements, as follows.
1. The retained earnings statement uses the results of the income statement. Sierra reported net income of $2,860 for the period. Net income is added to the beginning amount of retained earnings to determine ending retained earnings.
2. The balance sheet and retained earnings statement are also interrelated. Sierra reports the ending amount of $2,360 on the retained earnings statement as the retained earnings amount on the balance sheet.
3. Finally, the statement of cash flows relates to information on the balance sheet. The statement of cash flows shows how the Cash account changed during the period. It shows the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the $15,200 of cash at the end of the period. The ending amount of cash shown on the statement of cash flows must agree with the amount of cash on the balance sheet.
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ILLUSTRATION 1.9 Sierra Corporation's financial statements
HELPFUL HINT
Note that final sums are double-underlined.
HELPFUL HINT
The arrows in this illustration show interrelationships of the four financial statements.
HELPFUL HINT
Negative amounts are presented in parentheses.
Study these interrelationships carefully. To prepare financial statements, you must understand the sequence in which these amounts are determined and how each statement impacts the next.
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DO IT! 3a | Financial Statements
CSU Corporation began operations on January 1, 2022. The following information is available for CSU on December 31, 2022:
Accounts receivable
1,800 Retained earnings
? Supplies expense
200
Accounts payable 2,000 Equipment 16,000 Cash 1,400 Rent expense 9,000 Insurance
expense 1,000 Dividends 600
Notes payable 5,000 Service revenue 17,000 Common stock 10,000 Supplies 4,000
Prepare an income statement, a retained earnings statement, and a balance sheet.
ACTION PLAN
Report the revenues and expenses for a period of time in an income statement.
Show the amounts and causes (net income and dividends) of changes in retained earnings during the period in the retained earnings statement.
Present the assets and claims to those assets (liabilities and equity) at a specific point in time in the balance sheet.
Solution
CSU Corporation
Income Statement
For the Year Ended December 31, 2022
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
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CSU Corporation
Retained Earnings Statement
For the Year Ended December 31, 2022
Retained earnings, January 1 $ 0 Add: Net income 6,800
6,800 Less: Dividends 600 Retained earnings, December 31 $6,200
CSU Corporation
Balance Sheet
December 31, 2022
Assets Cash $ 1,400 Accounts receivable 1,800 Supplies 4,000 Equipment 16,000 Total assets $23,200
Liabilities and Stockholders' Equity Liabilities Notes payable $ 5,000 Accounts payable 2,000 Total liabilities $ 7,000 Stockholders' equity Common stock 10,000 Retained earnings 6,200 Total stockholders' equity 16,200 Total liabilities and stockholders' equity
$23,200
Related exercise material: BE1.5, BE1.6, BE1.7, BE1.8, BE1.9, BE1.10, DO IT! 1.3a, E1.5, E1.6, E1.7, E1.8, E1.9, E1.10, E1.11, E1.12, E1.13, E1.14, E1.15, and E1.18.
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Other Elements of an Annual Report Publicly traded U.S. companies must provide shareholders with an annual report. The annual report always includes the financial statements introduced in this chapter. The annual report also includes other important information such as a management discussion and analysis section, notes to the financial statements, and an independent auditor's report. No analysis of a company's financial situation and performance is complete without a review of these items.
Management Discussion and Analysis
The management discussion and analysis (MD&A) section presents management's views on the company's ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. Management must highlight favorable or unfavorable trends and identify significant events and uncertainties that affect these three factors. This discussion obviously involves a number of subjective estimates and opinions. A brief excerpt from the MD&A section of Columbia Sportswear's annual report, which addresses its liquidity requirements, is presented in Illustration 1.10.
ILLUSTRATION 1.10 Columbia Sportswear's management discussion and analysis
Columbia Sportswear Company
Management's Discussion and Analysis of
Seasonality and Variability of Business Our operations are affected by seasonal trends typical in the outdoor apparel and footwear industry and have historically resulted in higher sales and profits in the third and fourth calendar quarters. This pattern has resulted primarily from the timing of shipments of fall season products to wholesale customers in the third and fourth quarters and proportionally higher sales in our direct-to-consumer channels in the fourth quarter, combined with an expense base that is spread more consistent throughout the year. We believe that our liquidity requirements for at least the next 12 months will be adequately covered by existing cash, cash provided by operations and existing short-term borrowing arrangements.
Notes to the Financial Statements
Explanatory notes and supporting schedules accompany every set of financial statements and are an integral part of the statements. The notes to the financial statements clarify the financial statements and provide additional detail. Information in the notes does not have to be quantifiable (numeric). Examples of notes are descriptions of the significant accounting policies and methods used in preparing the statements, explanations of uncertainties and contingencies, and various statistics and details too voluminous to be included in the statements. The notes are essential to understanding a company's operating performance and financial position.
Illustration 1.11 is an excerpt from the notes to Columbia Sportswear's financial statements. It describes the methods that the company uses to account for revenues.
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ILLUSTRATION 1.11 Notes to Columbia Sportswear's financial statements
Columbia Sportswear Company
Notes to Financial Statements
Revenue Recognition We record wholesale, distributor, e-commerce and licensed product revenues when title passes and the risks and rewards of ownership have passed to the customer. Title generally passes upon shipment to or upon receipt by the customer depending on the terms of sale with the customer. Retail store revenues are recorded at the time of sale.
Auditor's Report
An auditor's report is prepared by an independent outside auditor. It states the auditor's opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles.
An auditor is an accounting professional who conducts an independent examination of a company's financial statements. Only accountants who meet certain criteria and thereby attain the designation certified public accountant (CPA) may perform audits. If the auditor is satisfied that the financial statements provide a fair representation of the company's financial position and results of operations in accordance with generally accepted accounting principles, then the auditor expresses an unqualified opinion. If the auditor expresses anything other than an unqualified opinion, then readers should only use the financial statements with caution. That is, without an unqualified opinion, we cannot have complete confidence that the financial statements give an accurate picture of the company's financial health. For example, Blockbuster, Inc.'s auditor at one time stated that its financial situation raised “substantial doubt about the Company's ability to continue as a going concern.”
Illustration 1.12 is an excerpt from the auditor's report from Columbia Sportswear's 2016 annual report. Columbia received an unqualified opinion from its auditor, Deloitte & Touche.
ILLUSTRATION 1.12 Excerpt from auditor's report on Columbia Sportswear's financial statements
Columbia Sportswear Company
Excerpt from Auditor's Report In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Columbia Sportswear Company and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
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DO IT! 3b | Components of Annual Reports
State whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the financial statements, or the auditor's report.
1. Descriptions of significant accounting policies.
2. Unqualified opinion.
3. Explanations of uncertainties and contingencies.
4. Description of ability to fund operations and expansion.
5. Description of results of operations.
6. Certified public accountant (CPA).
ACTION PLAN
Realize that financial statements provide information about a company's performance and financial position.
Be familiar with the other elements of the annual report in order to gain a fuller understanding of a company.
Solution
1. Descriptions of significant accounting policies: Notes.
2. Unqualified opinion: Auditor's report.
3. Explanations of uncertainties and contingencies: Notes.
4. Description of ability to fund operations and expansion: MD&A.
5. Description of results of operations: MD&A.
6. Certified public accountant (CPA): Auditor's report.
Related exercise material: BE1.11, DO IT! 1.3b, and E1.21.
Using the Decision Tools comprehensive exercises ask you to apply business information and the decision tools presented in the chapter. Most of these exercises are based on the companies highlighted in the Feature Story.
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USING THE DECISION TOOLS | VF Corporation
There is a good chance that you may have never heard of VF Corporation. There is also a very good chance that you are wearing one of VF's products right now. VF owns North Face, Lee, Vans, Nautica, Wrangler, Timberland, and numerous other brands. VF is a direct competitor to Columbia Sportswear. Suppose that you are considering investing in shares of VF's common stock.
Instructions
Answer these questions related to your decision whether to invest.
a. What financial statements should you evaluate?
b. What should these financial statements tell you?
c. Do you care if the financial statements have been audited? Explain.
d. Appendix B contains financial statements for Columbia, and Appendix C contains those for VF. You can make many comparisons between Columbia and VF in terms of their respective results from operations and financial position. Compare their respective total assets, total revenues, and net cash provided by operating activities for 2016.
Solution
a. Before you invest, you should evaluate the income statement, retained earnings statement, balance sheet, and statement of cash flows.
b. You would probably be most interested in the income statement because it tells about past performance and thus gives an indication of future performance. The retained earnings statement provides a record of the company's dividend history. The balance sheet reveals the relationship between assets and liabilities. The statement of cash flows reveals where the company is getting and spending its cash. This is especially important for a company that wants to grow.
c. You would want audited financial statements. These statements indicate that a CPA (certified public accountant) has examined and expressed an opinion that the statements present fairly the financial position and results of operations of the company. Investors and creditors should not make decisions without studying audited financial statements.
d. Many interesting comparisons can be made between the two companies (all numbers are in thousands). Columbia is smaller, with total assets of $2,013,894 versus $9,739,287 for VF, and it has lower revenue—$2,377,045 versus $12,019,003 for VF. In addition, Columbia's net cash provided by operating activities of $275,167 is less than VF's $1,477,919. However, while useful, these basic measures are not enough to determine whether one company is a better investment than the other. In later chapters, you will learn tools that will allow you to compare the relative profitability and financial health of these and other companies.
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The Review and Practice section provides opportunities for students to review key concepts and terms as well as complete multiple-choice questions, brief exercises, and a comprehensive problem. Detailed solutions are also included.
Review and Practice
Learning Objectives Review
1 Identify the forms of business organization and the uses of accounting information.
A sole proprietorship is a business owned by one person. A partnership is a business owned by two or more people associated as partners. A corporation is a separate legal entity for which evidence of ownership is provided by shares of stock.
Internal users are managers who need accounting information to plan, organize, and run business operations. The primary external users are investors and creditors. Investors (stockholders) use accounting information to decide whether to buy, hold, or sell shares of a company's stock. Creditors (suppliers and bankers) use accounting information to assess the risk of granting credit or loaning money to a business. Other groups who have an indirect interest in a business are taxing authorities, customers, labor unions, and regulatory agencies.
2 Explain the three principal types of business activity.
Financing activities involve collecting the necessary funds to support the business. Investing activities involve acquiring the resources necessary to run the business. Operating activities involve putting the resources of the business into action to generate a profit.
3 Describe the four financial statements and how they are prepared.
An income statement presents the revenues and expenses of a company for a specific period of time. A retained earnings statement summarizes the changes in retained earnings that have occurred for a specific period of time. A balance sheet reports the assets, liabilities, and stockholders' equity of a business at a specific date. A statement of cash flows summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time.
Assets are resources owned by a business. Liabilities are the debts and obligations of the business. Liabilities represent claims of creditors on the assets of the business. Stockholders' equity represents the claims of owners on the assets of the business. Stockholders' equity is subdivided into two parts: common stock and retained earnings. The basic accounting equation is Assets = Liabilities + Stockholders' Equity.
Within the annual report, the management discussion and analysis provides management's interpretation of the company's results and financial position as well as a discussion of plans for the future. Notes to the financial statements provide
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additional explanation or detail to make the financial statements more informative. The auditor's report expresses an opinion as to whether the financial statements present fairly the company's results of operations and financial position.
Decision Tools Review
Decision Checkpoints
Info Needed
for Decision
Tool to Use for Decision How to Evaluate Results
Are the company's operations profitable?
Income statement
The income statement reports a company's revenue and expenses and resulting net income or loss for a period of time
If the company's revenue exceeds its expenses, it will report net income; otherwise, it will report a net loss.
What is the company's policy toward dividends and growth?
Retained earnings statement
The retained earnings statement reports how much of this year's income the company paid out in dividends to shareholders
A company striving for rapid growth will pay a low (or no) dividend.
Does the company rely primarily on debt or stockholders' equity to finance its assets?
Balance sheet
The balance sheet reports the company's resources and claims to those resources; There are two types of claims: liabilities and stockholders' equity
Compare the amount of debt versus the amount of stockholders' equity to determine whether the company relies more on creditors or owners for its financing.
Does the company generate sufficient cash from operations to fund its investing activities?
Statement of cash flows
The statement of cash flows shows the amount of net cash provided or used by operating activities, investing activities, and financing activities
Compare the amount of net cash provided by operating activities with the amount of net cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities.
Glossary Review
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Accounting The information system that identifies, records, and communicates the economic events of an organization to interested users.
Annual report A report prepared by corporate management that presents financial information including financial statements, a management discussion and analysis section, notes, and an independent auditor's report.
Assets Resources owned by a business.
Auditor's report A report prepared by an independent outside auditor stating the auditor's opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles.
Balance sheet A financial statement that reports the assets and claims to those assets at a specific point in time.
Basic accounting equation Assets = Liabilities + Stockholders' Equity.
Certified public accountant (CPA) An individual who has met certain criteria and is thus allowed to perform audits of corporations.
Common stock Term used to describe the total amount paid in by stockholders for the shares they purchase.
Corporation A business organized as a separate legal entity owned by stockholders.
Dividends Payments of cash from a corporation to its stockholders.
Expenses The cost of assets consumed or services used in the process of generating revenues.
Income statement A financial statement that reports a company's revenues and expenses and resulting net income or net loss for a specific period of time.
Liabilities Amounts owed to creditors in the form of debts and other obligations.
Management discussion and analysis (MD&A) A section of the annual report that presents management's views on the company's ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations.
Net income The amount by which revenues exceed expenses.
Net loss The amount by which expenses exceed revenues.
Notes to the financial statements Notes clarify information presented in the financial statements and provide additional detail.
Partnership A business owned by two or more persons associated as partners.
Retained earnings The amount of net income retained in the corporation.
Retained earnings statement A financial statement that summarizes the amounts and causes of changes in retained earnings for a specific time period.
Revenue The increase in assets or decrease in liabilities resul
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