Exercise 1 Accounting Principles
Rmadrid2015
chapter_1.pdf
study objectives
After studying this chapter, you should be able to:
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.
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.
chapter
INTRODUCTION TO FINANCIAL STATEMENTS
1
2 The Navigator is a learning system designed to prompt you to use the learning aids in the chapter and to set priorities as you study.
● Scan Study Objectives
● Read Feature Story
● Scan Preview
● Read Text and Answer p. 5 p. 11 p. 18 p. 20
● Work Using the Decision Toolkit
● Review Summary of Study Objectives
● Work Comprehensive p. 23
● Answer Self-Test Questions
● Complete Assignments
● Go to WileyPLUS for practice and tutorials
● Read A Look at IFRS p. 42
● the navigator
Do it!
Do it!
✓
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Many students who take this course do not plan to be accountants. If you are in that group, you might be thinking, “If I’m not going to be an accountant, why do I need to know accounting?” In response, consider this quote from Harold Geneen, the former chairman of IT&T: “To be good at your business, you have to know the numbers—cold.” Success in any business comes back to the numbers. You will rely on them to make decisions, and man- agers will use them to evaluate your performance. That is true whether your job involves marketing, production, management, or information systems.
In business, accounting and financial statements are the means for communicating the numbers. If you don’t know how to read financial statements, you can’t really know your business.
Many companies spend significant resources teaching their employees basic accounting so that they can read financial statements and understand how their actions affect the company’s financial results. One such company is Springfield ReManufacturing Corporation (SRC). When Jack Stack and 11 other managers purchased SRC for 10 cents a share, it was a failing division of International Harvester. Jack’s 119 employees were counting on him for their liveli- hood. He decided that for the company to survive, every employee needed to think like a businessperson and to act like an owner. To accomplish this, all em- ployees at SRC took basic accounting courses and participated in weekly reviews of the company’s finan- cial statements. SRC survived, and eventually thrived. To this day, every employee (now numbering more than 1,000) undergoes this same training.
Many other companies have adopted this approach, which is called “open-book management.” Even in companies that do not practice open-book management, employ- ers generally assume that managers in all areas of the company are “financially literate.”
Taking this course will go a long way to making you financially literate. In this book you will learn
how to read and prepare financial state- ments, and how to use basic tools to eval- uate financial results. In this first chapter we will introduce you to the financial
statements of a real company whose products you are probably familiar with—Tootsie Roll. Tootsie Roll’s presentation of its financial results is com- plete, yet also relatively easy to understand.
Tootsie Roll started off humbly in 1896 in a small New York City candy shop owned by an Austrian im- migrant, Leo Hirshfield. The candy’s name came from his five-year-old daughter’s nickname—“Tootsie.” Today the Chicago-based company produces more than 49 million Tootsie Rolls and 16 million Tootsie Pops each day. In fact, Tootsie Pops are at the center of one of science’s most challenging questions: How many licks does it take to get to the Tootsie Roll center of a Tootsie Pop? The answer varies: Licking machines created at Purdue University and the University of Michigan report an average of 364 and 411 licks, re- spectively. In studies using human lickers, the answer ranges from 144 to 252. We recommend that you take a few minutes today away from your studies to deter- mine your own results.
Source: Tootsie Roll information adapted from www.tootsie.com.
KNO W I NG TH E N U M B E RS
feature story
● The Scoop on Accounting (p. 6) ● Spinning the Career Wheel (p. 7) ● The Numbers Behind Not-for-Profit Organizations (p. 8) ● Rocking the Bottom Line (p. 15)
INSIDE CHAPTER 1 . . .
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Introduction to Financial Statements
How do you start a business? How do you determine whether your business is making or losing money? How should you finance expansion—should you borrow, should you issue stock, should you use your own funds? How do you convince lenders to lend you money or investors to buy your stock? Success in business requires making countless decisions, and decisions require financial information.
The purpose of this chapter is to show you what role accounting plays in providing financial information. The content and organization of the chapter are as follows.
Forms of Business Organization Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You know that you enjoy working with people, especially teaching them new skills. And, ever since you were young, you have spent most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You therefore realize that you might be most suc- cessful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.
Your next decision is to determine what organizational form your business will have. You have three choices—sole proprietorship, partnership, or corporation.
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.
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. Some- times, partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written part- nership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants), often organize as partnerships.
As a third alternative, you might organize as a corporation. A business or- ganized as a separate legal entity owned by stockholders is a corporation. In- vestors 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 part- nership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals
preview of chapter 1
• Sole proprietorship • Partnership • Corporation
Forms of Business Organization
• Internal users • External users • Ethics in financial reporting
Users and Uses of Financial Information
• Financing • Investing • Operating
Business Activities
• Income statement • Retained earnings statement • Balance sheet • Statement of cash flows • Interrelationships of
statements • Other elements of an annual
report
Communicating with Users
1 Describe the primary forms of business organization.
4
-Simple to establish -Owner controlled -Tax advantages
Sole Proprietorship
-Simple to establish -Shared control -Broader skills and resources -Tax advantages
Partnership
study objective
-Easier to transfer ownership -Easier to raise funds -No personal liability
Corporation
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Users and Uses of Financial Information 5
can become stockholders by investing relatively small amounts of money. There- fore, it is easier for corporations to raise funds. Successful corporations of- ten have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole pro- prietorships or partnerships and eventually incorporate. For example, in 1896 Leo Hirshfield started Tootsie Roll as a sole proprietorship, and by 1919 the com- pany had incorporated.
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 of the business; cor- porate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal liability. We will discuss these issues in more depth in a later chapter.
The combined number of proprietorships and partnerships in the United States is more than five times the number of corporations. However, the revenue produced by corporations is eight times greater. Most of the largest enterprises in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. busi- ness is transacted by corporations, the emphasis in this book is on the corpo- rate form of organization.
Action Plan
• Know which organizational form best matches the business type, size, and preferences of the owner(s).
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
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.
BUSINESS ORGANIZATION FORMS
before you go on...
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. Users of accounting in- formation can be divided broadly into two groups: internal users and external users.
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 (page 6).
Do it!
Action Plans give you tips about how to approach the problem.
Do it! exercises prompt you to stop and review the key points you have just studied.
Alternative Terminology notes present synonymous terms that you may come across in practice.
Alternative Terminology Stockholders are sometimes called shareholders.
2 Identify the users and uses of accounting information.
study objective
Related exercise material: BE1-1 and 1-1.Do it!
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6 chapter 1 Introduction to Financial Statements
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 cam- paigns, and forecasts of cash needs for the next year. In addition, companies pre- sent summarized financial information in the form of financial statements.
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 evalu- ate 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.
Illustration 1-1 Questions that internal users ask
The Scoop on Accounting
Accounting can serve as a useful recruiting tool even for the human resources department. Rhino Foods, located in Burlington, Vermont, is a manufacturer of specialty ice cream. Its corporate website includes the following:
“Wouldn’t it be great to work where you were part of a team? Where your input and hard work made a difference? Where you weren’t kept in the dark about what man- agement was thinking? . . . Well—it’s not a dream! It’s the way we do business . . . Rhino Foods believes in family, honesty and open communication—we really care about and appreciate our employees—and it shows. Operating results are posted and monthly group meetings inform all employees about what’s happening in the Company. Employees also share in the Company’s profits, in addition to having an excellent comprehensive benefits package.”
Source: www.rhinofoods.com/workforus/workforus.html.
What are the benefits to the company and to the employees of making the finan- cial statements available to all employees? (See page 41.)
Accounting Across the Organization
? Accounting Across the Organization stories show applications of accounting information in various business functions.
Illustration 1-2 Questions that external users ask
Illustrations like this one convey information in pictorial form to help you visualize and apply the ideas as you study.
Questions Asked by Internal Users
Is cash sufficient to pay dividends to
Microsoft stockholders?
Stockholder
Finance Can we afford to give
General Motors employees pay raises this year?
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Which PepsiCo product line is the most profitable? Should any
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Management What price for an Apple iPod will maximize the company's
net income?
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Questions Asked by External Users
Is General Electric earning satisfactory income?
Yeah!
Investors How does Disney compare in size and profitability with Time Warner?
Investors Will United Airlines be able
to pay its debts as they come due?
What do we do if they catch us?
BILL COLLECTOR
Creditors
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Users and Uses of Financial Information 7
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 oth- erwise support its product lines. Labor unions, such as the Major League Base- ball Players Association, want to know whether the owners have the ability to pay increased wages and benefits. Regulatory agencies, such as the Securities and Ex- change 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.
Spinning the Career Wheel
One question that business students frequently ask is, “How will the study of accounting help me?” It should help you a great deal, because a working knowledge of accounting is desirable for virtually every field of business. Some examples of how accounting is used in business careers include:
General management: Imagine running Ford Motors, Massachusetts General Hospital, California State University–Fullerton, a McDonald’s franchise, a Trek bike shop. All general managers need to understand accounting data in order to make wise business decisions.
Marketing: A marketing specialist at a company like Procter & Gamble develops strate- gies to help the sales force be successful. But making a sale is meaningless unless it is a profitable sale. Marketing people must be sensitive to costs and benefits, which ac- counting helps them quantify and understand.
Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, a stock broker for Merrill Lynch? These fields rely heavily on accounting. In all of them you will regularly examine and analyze financial statements. In fact, it is difficult to get a good job in a finance function without two or three courses in accounting.
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 af- ford 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?
Accounting Across the Organization
1“U.S. Share Prices Slump,” Wall Street Journal (February 21, 2002).
? How might accounting help you? (See page 41.)
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. In recent years the financial press has been 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.”1 Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared.
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What benefits does a sound accounting system provide to a not-for-profit organiza- tion? (See page 41.)
8 chapter 1 Introduction to Financial Statements
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 econ- omy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting. In 2002, Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now cer- tify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Also, SOX increased the independence of the outside auditors who review the accuracy of corporate financial state- ments, and increased the oversight role of boards of directors.
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 book: (1) A number of the Fea- ture Stories and other parts of the text discuss the central importance of ethical behavior to financial reporting. (2) Insight boxes with an ethics perspective high- light ethics situations and issues in actual business settings. (3) At the end of the 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.
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.
Illustration 1-3 Steps in analyzing ethics cases
Solving an Ethical Dilemma
#1 ALT
#2 ALT
2. Identify and analyze the principal elements in the situation. Identify the stakeholders— persons or groups who may be harmed or benefited. Ask the question: What are the responsibilities and obligations of the parties involved?
3. Identify the alternatives, and weigh the impact of each alternative on various stakeholders. Select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one right solution; these situations require you to evaluate each alternative and select the best one.
1. Recognize an ethical situation and the ethical issues involved. Use your personal ethics to identify ethical situations and issues. Some businesses and professional organizations provide written codes of ethics for guidance in some business situations.
The Numbers Behind Not-for-Profit Organizations
Accounting plays an important role for a wide range of business organiza- tions worldwide. Just as the integrity of the numbers matters for business, it matters at least as much for not-for-profit organizations. Proper control and reporting help ensure that money is used the way donors intended. Donors are less inclined to give to an or- ganization if they think the organization is subject to waste or theft. The accounting chal- lenges of some large international not-for-profits rival those of the world’s largest busi- nesses. For example, after the Haitian earthquake, the Haitian-born musician Wyclef Jean was criticized for the poor accounting controls in a relief fund that he founded. Since then, he has hired a new accountant and improved the transparency regarding funds raised and spent.
Ethics Insight
?
Insights provide examples of business situations from various perspectives—ethics, investor, and international.
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Business Activities All businesses are involved in three types of activity—financing, investing, and operating. For example, Leo Hirshfield, the founder of Tootsie Roll, ob- tained cash through financing to start and grow his business. Some of this financing came from personal savings, and some likely came from outside sources like banks. Hirshfield then invested the cash in equipment to run the business, such as mixing equipment and delivery vehicles. Once this equipment was in place, he could begin the operating activities of making and selling candy.
The accounting information system keeps track of the results of each of the various business activities—financing, investing, and operating. Let’s look in more detail at each type of business activity.
FINANCING ACTIVITIES
It takes money to make money. The two primary sources of outside funds for corporations are borrowing money and issuing (selling) shares of stock in ex- change for cash.
Tootsie Roll Industries may borrow money in a variety of ways. For exam- ple, it can take out a loan at a bank or borrow directly from investors by issu- ing debt securities called bonds. Persons or entities to whom Tootsie Roll 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. Tootsie Roll may have a note payable to a bank for the money borrowed to purchase delivery trucks. Debt se- curities sold to investors that must be repaid at a particular date some years in the future are bonds payable.
A corporation may also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stock- holders 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 spec- ify a payment schedule (e.g., payment at the end of three months). As a cred- itor, 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. If you buy a company’s stock instead of loan- ing it money, you have no legal right to expect any payments until all of its cred- itors are paid. 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 payments to stockholders are called dividends.
INVESTING ACTIVITIES
Once the company has raised cash through financing activities, it will then use 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. Tootsie Roll’s mixing equipment is a type of asset referred to as property, plant, and equipment.
Cash is one of the more important assets owned by Tootsie Roll or any other business. If a company has excess cash that it does not need for a while, it might
Business Activities 9
3 Explain the three principal types of business activity.
Essential terms are printed in blue. They are defined again in the glossary at the end of the chapter.
Financing
BONDSTOCK
Investing
CANDY TIME
CANDY TIME
CANDY TIME
study objective
Alternative Terminology Property, plant, and equipment is sometimes called fixed assets.
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10 chapter 1 Introduction to Financial Statements
choose to invest in securities (stocks or bonds) of other corporations. Investments are another example of an investing activity.
OPERATING ACTIVITIES
Once a business has the assets it needs to get started, it can begin its opera- tions. Tootsie Roll is in the business of selling all things that taste, look, or smell like candy. It sells Tootsie Rolls, Tootsie Pops, Blow Pops, Caramel Ap- ple Pops, Mason Dots, Mason Crows, Sugar Daddy, and Sugar Babies. We call amounts earned on the sale of these products revenues. Revenue is the in- crease in assets resulting from the sale of a product or service in the normal course of business. For example, Tootsie Roll records revenue when it sells a candy product.
Revenues arise from different sources and are identified by various names depending on the nature of the business. For instance, Tootsie Roll’s primary source of revenue is the sale of candy products. However, it also generates in- terest revenue on debt securities held as investments. Sources of revenue com- mon 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 Tootsie Roll 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 Tootsie Roll can sell a single Tootsie Roll, Tootsie Pop, or Blow Pop, it must purchase sugar, corn syrup, and other ingredients, mix these ingredi- ents, process the mix, and 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 depend- ing on the type of asset consumed or service used. For example, Tootsie Roll keeps track of these types of expenses: cost of goods sold (such as the cost of ingredients); selling expenses (such as the cost of salespersons’ salaries); marketing expenses (such as the cost of advertising); adminis- trative expenses (such as the salaries of administrative staff, and telephone and heat costs incurred at the corporate office); interest expense (amounts of interest paid on various debts); and income taxes (corporate taxes paid to government).
Tootsie Roll may also have liabilities arising from these expenses. For exam- ple, it may purchase goods on credit from suppliers; the obligations to pay for these goods are called accounts payable. Additionally, Tootsie Roll 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.
Tootsie Roll 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.
Operating
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Communicating with Users 11
BUSINESS ACTIVITIES
before you go on...
Do it! 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 providing service
6. Amounts owed to suppliers
Solution
Action Plan
• Classify each item based on its economic characteristics. Proper classification of items is critical if accounting is to provide useful information.
1. Cost of renting property: Expense.
2. Truck purchased: Asset.
3. Notes payable: Liabilities.
4. Issuance of ownership shares: Common stock.
5. Amount earned from providing service: Revenue.
6. Amounts owed to suppliers: Liabilities.
Communicating with Users 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:
• To present a picture at a point in time of what your business owns (its as- sets) and what it owes (its liabilities), you prepare a balance sheet.
• 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 show where your business obtained cash during a period of time and how that cash was used, you present a statement of cash flows.
To introduce you to these statements, we have prepared the financial state- ments 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, 2012. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe out- door 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 cus- tomers either bring their own equipment or you arrange for them to rent equip- ment through local outfitters. The financial statements for Sierra’s first month of business are provided in the following pages.
INCOME STATEMENT
The income statement reports the success or failure of the company’s opera- tions for a period of time. To indicate that its income statement reports the
4 Describe the content and purpose of each of the financial statements.
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 compared to GAAP companies.
study objective
Related exercise material: BE1-3, 1-2, and E1-3.Do it!
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12 chapter 1 Introduction to Financial Statements
results of operations for a period of time, Sierra dates the income statement “For the Month Ended October 31, 2012.” The income statement lists the com- pany’s revenues followed by its expenses. Finally, Sierra determines the net in- come (or net loss) by deducting expenses from revenues. Sierra Corporation’s income statement is shown in Illustration 1-4. Congratulations, you are already showing a profit!
Why are financial statement users interested in net income? Investors are in- terested in a company’s past net income because it provides useful informa- tion 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 re- paid 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 state- ment 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 rev- enue the $10,000 of cash received from issuing new stock, nor does it regard as a business expense the $500 of dividends paid.
RETAINED EARNINGS STATEMENT
If Sierra 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
Illustration 1-4 Sierra Corporation’s income statement
SIERRA CORPORATION Income Statement
For the Month Ended October 31, 2012
Revenues Service revenue $10,600
Expenses Salaries expense $5,200 Supplies expense 1,500 Rent expense 900 Insurance expense 50 Interest expense 50 Depreciation expense 40
Total expenses 7,740
Net income $ 2,860
Helpful Hint The 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.”
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.
Decision Toolkits summarize the financial decision-making process.
DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
Are the company’s operations profitable?
Income statement The income statement reports on the success or failure of the company’s operations by reporting its revenues and expenses.
If the company’s revenue exceeds its expenses, it will report net income; otherwise it will report a net loss.
INFO NEEDED FOR DECISION
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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 Cisco Systems, 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 during the period. The time period is the same as that cov- ered 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 com- pany has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1-5 presents Sierra Corporation’s retained earn- ings statement.
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 com- pany’s growth instead of paying dividends. Lenders monitor their corporate cus- tomers’ dividend payments because any money paid in dividends reduces a company’s ability to repay its debts.
Communicating with Users 13
SIERRA CORPORATION Retained Earnings Statement
For the Month Ended October 31, 2012
Retained earnings, October 1 $ 0 Add: Net income 2,860
2,860 Less: Dividends 500
Retained earnings, October 31 $2,360
Illustration 1-5 Sierra Corporation’s retained earnings statement
DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
What is the company’s policy toward dividends and growth?
Retained earnings statement How much of this year’s income did the company pay out in dividends to shareholders?
A company striving for rapid growth will pay a low (or no) dividend.
INFO NEEDED FOR DECISION
Illustration 1-6 Basic accounting equationAssets � Liabilities � Stockholders’ Equity
5 Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation.
BALANCE SHEET
The balance sheet reports assets and claims to assets at a specific point in time. Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. Claims of owners are called stockholders’ equity.
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.
Helpful Hint The heading of this statement identifies the company, the type of statement, and the time period covered by the statement.
study objective
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14 chapter 1 Introduction to Financial Statements
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’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, 2012. It lists assets first, followed by liabilities and stock- holders’ equity. Stockholders’ equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the com- pany 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.
Illustration 1-7 Sierra Corporation’s balance sheet
SIERRA CORPORATION Balance Sheet
October 31, 2012
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 Salaries payable 1,200 Unearned service revenue 800 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
Helpful Hint The heading of a balance sheet must identify the company, the statement, and the date.
DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
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.
INFO NEEDED FOR DECISION
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 the Sierra Corporation guide service, the balance sheet will be used to determine whether cash on hand is sufficient for immedi- ate 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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STATEMENT OF CASH FLOWS
The primary purpose of a statement of cash flows is to provide financial in- formation about the cash receipts and cash payments of a business for a spe- cific period of time. 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.
Users are interested in the statement of cash flows because they want to know what is happening to a company’s most important resource. In operating Sierra, the statement of cash flows will provide answers to these simple but im- portant 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, in Illustration 1-8, shows that cash increased $15,200 during the month. This increase resulted because operating
Rocking the Bottom Line
What topic has performers such as Tom Waits, Clint Black, Sheryl Crow, and Madonna so concerned that they are pushing for new laws regarding its use? Account- ing. Recording-company accounting to be more precise. Musicians receive royalty pay- ments based on the accounting done by their recording companies. Many performers say that the recording companies—either intentionally or unintentionally—have very poor accounting systems, which, the performers say, has resulted in many inaccurate royalty payments. They would like to see laws created that would hit the recording companies with stiff fines for accounting errors.
Ethics Insight
? What is one way that some of these disputes might be resolved? (See page 41.)
SIERRA CORPORATION Statement of Cash Flows
For the Month Ended October 31, 2012
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 Issued 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
Illustration 1-8 Sierra Corporation’s statement of cash flows
Communicating with Users 15
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.
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16 chapter 1 Introduction to Financial Statements
activities (services to clients) increased cash $5,700, and financing activities in- creased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment.
INTERRELATIONSHIPS OF STATEMENTS
Illustration 1-9 shows simplified financial statements of Tootsie Roll Industries, Inc. (We have simplified the financial statements to assist your learning.) Tootsie Roll’s actual financial statements are presented in Appendix A, at the end of the textbook. Note that the numbers in Tootsie Roll’s statements are presented in thousands—that is, the last three 000s are omitted. Thus, Tootsie Roll’s net income in 2009 is $53,475,000, not $53,475. Because the results on some finan- cial statements become inputs to other statements, the statements are interre- lated. These interrelationships can be seen in Tootsie Roll’s financial statements, as follows.
1. The retained earnings statement depends on the results of the income state- ment. Tootsie Roll reported net income of $53,475,000 for the period. It adds the net income amount to the beginning amount of retained earnings in order to determine ending retained earnings.
2. The balance sheet and retained earnings statement are also interrelated. Tootsie Roll reports the ending amount of $145,928,000 on the retained earn- ings 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 $90,990,000 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.
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.
DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
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 cash provided or used by operating activities, investing activities, and financing activities.
Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities.
INFO NEEDED FOR DECISION
Tootsie Roll Annual Report Walkthrough
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TOOTSIE ROLL INDUSTRIES, INC. Income Statement
For the Year Ended December 31, 2009 (in thousands)
Revenues $499,331 Expenses
Cost of goods sold $319,497 Selling, marketing, and administrative expense and other 115,655 Income tax expense 10,704
Total expenses 445,856 Net income $ 53,475
Illustration 1-9 Tootsie Roll Industries, Inc.’s financial statements
TOOTSIE ROLL INDUSTRIES, INC. Retained Earnings Statement
For the Year Ended December 31, 2009 (in thousands)
Retained earnings, January 1, 2009 $142,872 Add: Net income 53,475
196,347 Less: Dividends and other (net) 50,419
Retained earnings, December 31, 2009 $145,928
TOOTSIE ROLL INDUSTRIES, INC. Statement of Cash Flows
For the Year Ended December 31, 2009 (in thousands)
Cash flows from operating activities Cash receipts from operating activities $491,344 Cash payments for operating activities (416,063)
Net cash provided by operating activities $ 75,281 Cash flows from investing activities
Capital expenditures and acquisitions (20,831) Net purchases/sales of investment securities and other 6,180
Net cash used by investing activities (14,651) Cash flows from financing activities
Repurchase of common stock (20,723) Dividends paid in cash (17,825)
Net cash used by financing activities (38,548)
Net increase (decrease) in cash 22,082 Cash at beginning of year 68,908
Cash at end of year $ 90,990
TOOTSIE ROLL INDUSTRIES, INC. Balance Sheet
December 31, 2009 (in thousands)
Assets
Cash $ 90,990 Investments 8,663 Accounts receivable 45,909 Inventories 56,387 Prepaid expenses 8,562 Property, plant and equipment, net 220,721 Other assets 407,015
Total assets $838,247
Liabilities and Stockholders’ Equity
Liabilities Accounts payable $ 9,140 Dividends payable 4,458 Accrued liabilities 42,468 Deferred income taxes payable 44,582 Bonds payable 7,500 Employee benefits payable and other 77,614 $185,762
Stockholders’ equity Common stock 506,557 Retained earnings 145,928 652,485
Total liabilities and stockholders’ equity $838,247
→
→
1
→
→
→
→
2
3
Helpful Hint Note that final sums are double-underlined, and negative amounts (in the statement of cash flows) are presented in parentheses.
Helpful Hint The arrows in this illustration show interrelationships of the four financial statements.
Communicating with Users 17
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18 chapter 1 Introduction to Financial Statements
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 at a specific point in time in the balance sheet.
CSU Corporation began operations on January 1, 2012. The following information is available for CSU Corporation on December 31, 2012:
Accounts receivable 1,800 Retained earnings ? Supplies expense 200 Accounts payable 2,000 Equipment 16,000 Cash 1,400 Building rental 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.
Solution
FINANCIAL STATEMENTS
before you go on...
Do it!
CSU CORPORATION Income Statement
For the Year Ended December 31, 2012
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
CSU CORPORATION Retained Earnings Statement
For the Year Ended December 31, 2012
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, 2012
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, 1-3, E1-4, E1-5, E1-6, E1-7, E1-8, E1-9, E1-10, E1-11, and E1-14.
Do it!
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OTHER ELEMENTS OF AN ANNUAL REPORT
U.S. companies that are publicly traded must provide shareholders with an annual report. The annual report always includes the financial statements intro- duced in this chapter. The annual report also includes other important informa- tion such as a management discussion and analysis section, notes to the finan- cial statements, and an independent auditor’s report. No analysis of a company’s financial situation and prospects is complete without a review of these items.
Management Discussion and Analysis The management discussion and analysis (MD&A) section covers various finan- cial aspects of a company, including its ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. Man- agement 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 Tootsie Roll’s annual report is presented in Illustration 1-10.
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 finan- cial 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 state- ments. The notes are essential to understanding a company’s operating perform- ance and financial position.
Illustration 1-11 is an excerpt from the notes to Tootsie Roll’s financial state- ments. It describes the methods that Tootsie Roll uses to account for revenues.
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 ac- counting standards.
Communicating with Users 19
6 Describe the components that supplement the financial statements in an annual report.
Illustration 1-10 Tootsie Roll’s management discussion and analysis
TOOTSIE ROLL INDUSTRIES, INC. Management’s Discussion and Analysis of
Financial Condition and Results of Operations
The Company has a relatively straightforward financial structure and has historically maintained a conservative financial position. Except for an immaterial amount of operating leases, the Company has no special financing arrangements or “off-balance sheet” special purpose entities. Cash flows from operations plus maturities of short- term investments are expected to be adequate to meet the Company’s overall financ- ing needs, including capital expenditures, in 2010.
TOOTSIE ROLL INDUSTRIES, INC. Notes to Financial Statements
Revenue recognition Revenue, net of applicable provisions for discounts, returns, allowances, and certain advertising and promotional costs, is recognized when products are delivered to cus- tomers based on a customer purchase order, and collectibility is reasonably assured.
Illustration 1-11 Notes to Tootsie Roll’s financial statements
study objective
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20 chapter 1 Introduction to Financial Statements
An auditor is an accounting professional who conducts an independent ex- amination of a company’s financial statements. Only accountants who meet cer- tain criteria and thereby attain the designation Certified Public Accountant (CPA) may perform audits. If the auditor is satisfied that the financial state- ments provide a fair representation of the company’s financial position and re- sults of operations in accordance with generally accepted accounting principles, then the auditor expresses an unqualified opinion. If the auditor expresses any- thing other than an unqualified opinion, then readers should only use the finan- cial statements with caution. That is, without an unqualified opinion, we can- not have complete confidence that the financial statements give an accurate picture of the company’s financial health. For example, in April 2009 Blockbuster, Inc.’s auditor 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 Tootsie Roll’s 2009 annual report. Tootsie Roll received an unqualified opinion from its audi- tor, PricewaterhouseCoopers.
Illustration 1-12 Excerpt from auditor’s report on Tootsie Roll’s financial statements
TOOTSIE ROLL INDUSTRIES, INC. Excerpt from Auditor’s Report
To the Board of Directors and Shareholders of Tootsie Roll Industries, Inc.
In our opinion, the accompanying consolidated statements of financial position and the related consolidated statements of earnings, comprehensive earnings and retained earnings, and of cash flows present fairly, in all material respects, the financial posi- tion of Tootsie Roll Industries, Inc. and its subsidiaries at December 31, 2009 and December 31, 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
COMPONENTS OF ANNUAL REPORTS
before you go on...
Do it! 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)
Solution
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.
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, 1-4, and E1-17.Do it!
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Summary of Study Objectives 21
The Hershey Company, located in Hershey, Pennsylvania, is the leading North American manufacturer of chocolate—for example, Hershey’s Kisses, Reese’s Peanut Butter Cups, Kit Kat, and Take 5 bars. Imagine that you are considering the pur- chase of shares of Hershey’s common stock.
Instructions
Answer these questions related to your decision whether to invest. (a) What financial statements should you request from the company? (b) What should these financial statements tell you? (c) Should you request audited financial statements? Explain. (d) Appendix B at the end of this book contains financial statements for Hershey.
What comparisons can you make between Tootsie Roll and Hershey in terms of their respective results from operations and financial position?
Solution
(a) Before you invest, you should investigate the income statement, retained earn- ings statement, statement of cash flows, and balance sheet.
(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 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. Finally, the balance sheet reveals the relationship between assets and liabilities.
(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 study- ing audited financial statements.
(d) Many interesting comparisons can be made between the two companies. Tootsie Roll is smaller, with total assets of $838,247,000 versus $3,675,031,000 for Hershey, and it has lower revenue—$499,331,000 versus $5,298,660,000 for Hershey. In addition, Tootsie Roll’s cash provided by operating activities of $75,281,000 is less than Hershey’s $1,065,749,000.
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 of tools that will allow you to compare the relative profitability and financial health of these and other companies.
USING THE DECISION TOOLKIT Using the Decision Toolkit exercises ask you to use information from financial statements to make financial decisions.
Summary of Study Objectives 1 Describe the primary forms of business organization.
A sole proprietorship is a business owned by one per- son. A partnership is a business owned by two or more people associated as partners. A corporation is a sep- arate legal entity for which evidence of ownership is provided by shares of stock.
2 Identify the users and uses of accounting information. Internal users are managers who need accounting in- formation to plan, organize, and run business opera- tions. The primary external users are investors and creditors. Investors (stockholders) use accounting in- formation to help them decide whether to buy, hold,
or sell shares of a company’s stock. Creditors (suppli- ers and bankers) use accounting information to assess the risk of granting credit or loaning money to a busi- ness. Other groups who have an indirect interest in a business are taxing authorities, customers, labor unions, and regulatory agencies.
3 Explain the three principal types of business activity. Financing activities involve collecting the necessary funds to support the business. Investing activities in- volve acquiring the resources necessary to run the busi- ness. Operating activities involve putting the resources of the business into action to generate a profit.
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22 chapter 1 Introduction to Financial Statements
4 Describe the content and purpose of each of the finan- cial statements. An income statement presents the revenues and expenses of a company for a specific pe- riod of time. A retained earnings statement summa- rizes the changes in retained earnings that have oc- curred 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 in- flows (receipts) and outflows (payments) for a specific period of time.
5 Explain the meaning of assets, liabilities, and stockhold- ers’ equity, and state the basic accounting equation. As- sets 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 busi- ness. 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.
6 Describe the components that supplement the financial statements in an annual report. The management dis- cussion and analysis provides management’s interpre- tation of the company’s results and financial position as well as a discussion of plans for the future. Notes to the financial statements provide additional expla- nation 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 CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
Are the company’s operations profitable?
Income statement The income statement reports on the success or failure of the company’s operations by reporting its revenues and expenses.
If the company’s revenue exceeds its expenses, it will report net income; otherwise it will report a net loss.
INFO NEEDED FOR DECISION
What is the company’s policy toward dividends and growth?
Retained earnings statement How much of this year’s income did the company pay 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 cash provided or used by operating activities, investing activities, and financing activities.
Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities.
DECISION TOOLKIT A SUMMARY
Glossary Accounting (p. 5) The information system that identi- fies, records, and communicates the economic events of an organization to interested users.
Annual report (p. 19) A report prepared by corporate management that presents financial information includ- ing financial statements, notes, a management discus-
sion and analysis section, and an independent auditor’s report.
Assets (p. 9) Resources owned by a business.
Auditor’s report (p. 19) A report prepared by an inde- pendent outside auditor stating the auditor’s opinion as
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to the fairness of the presentation of the financial posi- tion and results of operations and their conformance with generally accepted accounting standards.
Balance sheet (p. 13) A financial statement that reports the assets and claims to those assets at a specific point in time.
Basic accounting equation (p. 13) Assets � Liabilities � Stockholders’ Equity.
Certified Public Accountant (CPA) (p. 20) An individ- ual who has met certain criteria and is thus allowed to perform audits of corporations.
Common stock (p. 9) Term used to describe the total amount paid in by stockholders for the shares they purchase.
Corporation (p. 4) A business organized as a separate legal entity having ownership divided into transferable shares of stock.
Dividends (p. 9) Payments of cash from a corporation to its stockholders.
Expenses (p. 10) The cost of assets consumed or ser- vices used in the process of generating revenues.
Income statement (p. 11) A financial statement that presents the revenues and expenses and resulting net in- come or net loss of a company for a specific period of time.
Liabilities (p. 9) The debts and obligations of a busi- ness. Liabilities represent the amounts owed to creditors.
Management discussion and analysis (MD&A) (p. 19) A section of the annual report that presents manage- ment’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 (p. 10) The amount by which revenues ex- ceed expenses.
Net loss (p. 10) The amount by which expenses exceed revenues.
Notes to the financial statements (p. 19) Notes that clarify information presented in the financial statements, as well as expand upon it where additional detail is needed.
Partnership (p. 4) A business owned by two or more persons associated as partners.
Retained earnings (p. 13) The amount of net income retained in the corporation.
Retained earnings statement (p. 13) A financial state- ment that summarizes the amounts and causes of changes in retained earnings for a specific period of time.
Revenue (p. 10) The increase in assets that result from the sale of a product or service in the normal course of business.
Sarbanes-Oxley Act (p. 8) Regulations passed by Con- gress in 2002 to try to reduce unethical corporate behavior.
Sole proprietorship (p. 4) A business owned by one person.
Statement of cash flows (p. 15) A financial statement that provides financial information about the cash re- ceipts and cash payments of a business for a specific pe- riod of time.
Stockholders’ equity (p. 13) The owners’ claim to assets.
Comprehensive Do it! 23
Comprehensive
Jeff Andringa, a former college hockey player, quit his job and started Ice Camp, a hockey camp for kids ages 8 to 18. Eventually, he would like to open hockey camps nationwide. Jeff has asked you to help him prepare financial statements at the end of his first year of operations. He relates the following facts about his business activities.
In order to get the business off the ground, he decided to incorporate. He sold shares of common stock to a few close friends, as well as buying some of the shares himself. He initially raised $25,000 through the sale of these shares. In addition, the company took out a $10,000 loan at a local bank.
Ice Camp purchased, for $12,000 cash, a bus for transporting kids. The company also bought hockey goals and other miscellaneous equipment with $1,500 cash. The company earned camp tuition during the year of $100,000 but had collected only $80,000 of this amount. Thus, at the end of the year its customers still owed $20,000. The company rents time at a local rink for $50 per hour. Total rink rental costs during the year were $8,000, insurance was $10,000, salary expense was $20,000, and supplies used totaled $9,000, all of which were paid in cash. The company incurred $800 in interest expense on the bank loan, which it still owed at the end of the year.
The company paid dividends during the year of $5,000 cash. The balance in the cor- porate bank account at December 31, 2012, was $49,500.
Do it!
The Comprehensive Do it! is a final review before you begin homework.
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24 chapter 1 Introduction to Financial Statements
Instructions
Using the format of the Sierra Corporation statements in this chapter, prepare an income statement, retained earnings statement, balance sheet, and statement of cash flows. (Hint: Prepare the statements in the order stated to take advantage of the flow of information from one statement to the next, as shown in Illustration 1-9 on page 17.)
Solution to Comprehensive
ICE CAMP
Income Statement For the Year Ended December 31, 2012
Revenues Service revenue $100,000
Expenses Salaries and wages expense $20,000 Insurance expense 10,000 Supplies expense 9,000 Rent expense 8,000 Interest expense 800
Total expenses 47,800
Net income $ 52,200
ICE CAMP
Retained Earnings Statement For the Year Ended December 31, 2012
Retained earnings, January 1, 2012 $ 0 Add: Net income 52,200
52,200 Less: Dividends 5,000
Retained earnings, December 31, 2012 $47,200
ICE CAMP
Balance Sheet December 31, 2012
Assets Cash $49,500 Accounts receivable 20,000 Equipment 13,500
Total assets $83,000
Liabilities and Stockholders’ Equity Liabilities
Notes payable $10,000 Interest payable 800
Total liabilities $10,800 Stockholders’ equity
Common stock 25,000 Retained earnings 47,200
Total stockholders’ equity 72,200
Total liabilities and stockholders’ equity $83,000
Do it!
Action Plan
• On the income statement: Show revenues and expenses for a period of time.
• On the retained earnings statement: Show the changes in retained earnings for a period of time.
• On the balance sheet: Report assets, liabilities, and stockhold- ers’ equity at a specific date.
• On the statement of cash flows: Report sources and uses of cash from operating, investing, and financing activities for a period of time.
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Self-Test Questions 25
ICE CAMP
Statement of Cash Flows For the Year Ended December 31, 2012
Cash flows from operating activities Cash receipts from operating activities $80,000 Cash payments for operating activities (47,000)
Net cash provided by operating activities $33,000 Cash flows from investing activities
Purchase of equipment (13,500)
Net cash used by investing activities (13,500) Cash flows from financing activities
Issuance of common stock 25,000 Issuance of notes payable 10,000 Dividends paid (5,000)
Net cash provided by financing activities 30,000
Net increase in cash 49,500 Cash at beginning of period 0
Cash at end of period $49,500
This would be a good time to look at the Student Owner’s Manual in the Preface to the book. Knowing the purpose of the different types of homework will help you understand what each contributes to your accounting skills and competencies.
The tool icon indicates that an activity employs one of the decision tools presented in the chapter. The
Self-Test Questions Answers are on page 42.
1. Which is not one of the three forms of business organization? (a) Sole proprietorship. (c) Partnership. (b) Creditorship. (d) Corporation.
2. Which is an advantage of corporations relative to partnerships and sole proprietorships? (a) Lower taxes. (b) Harder to transfer ownership. (c) Reduced legal liability for investors. (d) Most common form of organization.
3. Which statement about users of accounting infor- mation is incorrect? (a) Management is considered an internal user. (b) Taxing authorities are considered external users. (c) Present creditors are considered external users. (d) Regulatory authorities are considered internal
users.
4. Which of the following did not result from the Sarbanes-Oxley Act?
(a) Top management must now certify the accuracy of financial information.
(b) Penalties for fraudulent activity increased. (c) Independence of auditors increased. (d) Tax rates on corporations increased.
5. Which is not one of the three primary business activities? (a) Financing. (c) Advertising. (b) Operating. (d) Investing.
6. Which of the following is an example of a financing activity? (a) Issuing shares of common stock. (b) Selling goods on account. (c) Buying delivery equipment. (d) Buying inventory.
7. Net income will result during a time period when: (a) assets exceed liabilities. (b) assets exceed revenues. (c) expenses exceed revenues. (d) revenues exceed expenses.
(SO 1)
(SO 1)
(SO 2)
(SO 2)
(SO 3)
(SO 3)
(SO 4)
indicates that an activity relates to a business function beyond accounting. The pencil icon indicates that an activity requires written communication.
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS
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26 chapter 1 Introduction to Financial Statements
8. The financial statements for Joseph Corporation contained the following information. Accounts receivable $ 5,000 Sales revenue 75,000 Cash 15,000 Salaries and wages expense 20,000 Rent expense 10,000 What was Joseph Corporation’s net income? (a) $60,000. (c) $65,000. (b) $15,000. (d) $45,000.
9. What section of a statement of cash flows indicates the cash spent on new equipment during the past accounting period? (a) The investing section. (b) The operating section. (c) The financing section. (d) The cash flow statement does not give this
information.
10. Which statement presents information as of a spe- cific point in time? (a) Income statement. (b) Balance sheet. (c) Statement of cash flows. (d) Retained earnings statement.
11. Which financial statement reports assets, liabilities, and stockholders’ equity? (a) Income statement. (b) Retained earnings statement. (c) Balance sheet. (d) Statement of cash flows.
12. Stockholders’ equity represents: (a) claims of creditors. (b) claims of employees. (c) the difference between revenues and expenses. (d) claims of owners.
13. As of December 31, 2012, Stoneland Corporation has assets of $3,500 and stockholders’ equity of $1,500. What are the liabilities for Stoneland Cor- poration as of December 31, 2012? (a) $1,500. (c) $2,500. (b) $1,000. (d) $2,000.
14. The element of a corporation’s annual re- port that describes the corporation’s accounting methods is the: (a) notes to the financial statements. (b) management discussion and analysis. (c) auditor’s report. (d) income statement.
15. The element of the annual report that presents an opinion regarding the fairness of the presentation of the financial position and results of operations is/are the: (a) income statement. (b) auditor’s opinion. (c) balance sheet. (d) comparative statements.
Go to the book’s companion website, www. wiley.com/college/kimmel, to access addi- tional Self-Test Questions.
1. What are the three basic forms of business organizations?
2. What are the advantages to a business of being formed as a corporation? What are the disadvantages?
3. What are the advantages to a business of being formed as a partnership or sole proprietorship? What are the disadvantages?
4. “Accounting is ingrained in our society and is vital to our economic system.” Do you agree? Explain.
5. Who are the internal users of accounting data? How does accounting provide relevant data to the internal users?
6. Who are the external users of accounting data? Give examples.
7. What are the three main types of business activity? Give examples of each activity.
8. Listed here are some items found in the financial statements of Ellyn Toth, Inc. Indicate in which fi- nancial statement(s) each item would appear. (a) Service revenue. (d) Accounts receivable. (b) Equipment. (e) Common stock. (c) Advertising expense. (f ) Interest payable.
9. Why would a bank want to monitor the dividend payment practices of the corporations it lends money to?
10. “A company’s net income appears directly on the in- come statement and the retained earnings statement, and it is included indirectly in the company’s balance sheet.” Do you agree? Explain.
11. What is the primary purpose of the state- ment of cash flows?
12. What are the three main categories of the statement of cash flows? Why do you think these categories were chosen?
13. What is retained earnings? What items increase the balance in retained earnings? What items decrease the balance in retained earnings?
14. What is the basic accounting equation?
15. (a) Define the terms assets, liabilities, and stockhold- ers’ equity.
(b) What items affect stockholders’ equity?
16. Which of these items are liabilities of White Glove Cleaning Service? (a) Cash. (c) Dividends. (b) Accounts payable. (d) Accounts receivable.
(SO 4)
(SO 4, 5)
(SO 4, 5)
(SO 5)
(SO 5)
(SO 5)
(SO 6)
(SO 6)
Questions
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Brief Exercises 27
(e) Supplies. (h) Service revenue. (f) Equipment. (i) Rent expense. (g) Salaries and wages payable.
17. How are each of the following financial statements in- terrelated? (a) Retained earnings statement and income statement. (b) Retained earnings statement and balance sheet. (c) Balance sheet and statement of cash flows.
18. What is the purpose of the management discussion and analysis section (MD&A)?
19. Why is it important for financial statements to receive an unqualified auditor’s opinion?
20. What types of information are presented in the notes to the financial statements?
21. The accounting equation is: Assets � Liabilities � Stockholders’ Equity. Appendix A, at the end of this book, reproduces Tootsie Roll’s financial statements. Replacing words in the equation with dollar amounts, what is Tootsie Roll’s accounting equation at December 31, 2009?
Brief Exercises BE1-1 Match each of the following forms of business organization with a set of char- acteristics: sole proprietorship (SP), partnership (P), corporation (C). (a) _____ Shared control, tax advantages, increased skills and resources. (b) _____ Simple to set up and maintains control with founder. (c) _____ Easier to transfer ownership and raise funds, no personal liability.
BE1-2 Match each of the following types of evaluation with one of the listed users of accounting information.
1. Trying to determine whether the company complied with tax laws.
2. Trying to determine whether the company can pay its obligations.
3. Trying to determine whether a marketing proposal will be cost effective.
4. Trying to determine whether the company’s net income will result in a stock price increase.
5. Trying to determine whether the company should employ debt or equity financing. (a) _____ Investors in common stock. (d) _____ Chief Financial Officer. (b) _____ Marketing managers. (e) _____ Internal Revenue Service. (c) _____ Creditors.
BE1-3 Indicate in which part of the statement of cash flows each item would appear: operating activities (O), investing activities (I), or financing activities (F). (a) _____ Cash received from customers. (b) _____ Cash paid to stockholders (dividends). (c) _____ Cash received from issuing new common stock. (d) _____ Cash paid to suppliers. (e) _____ Cash paid to purchase a new office building.
BE1-4 Presented below are a number of transactions. Determine whether each trans- action affects common stock (C), dividends (D), revenue (R), expense (E), or does not affect stockholders’ equity (NSE). Provide titles for the revenues and expenses. (a) Costs incurred for advertising. (b) Assets received for services performed. (c) Costs incurred for insurance. (d) Amounts paid to employees. (e) Cash distributed to stockholders. (f) Assets received in exchange for allowing the use of the company’s building. (g) Costs incurred for utilities used. (h) Cash purchase of equipment. (i) Issued common stock for cash.
BE1-5 In alphabetical order below are balance sheet items for Wyoming Company at December 31, 2012. Prepare a balance sheet following the format of Illustration 1-7.
Accounts payable $65,000 Accounts receivable 71,000 Cash 22,000 Common stock 28,000
Describe forms of business organization.
(SO 1), K
Identify users of accounting information.
(SO 2), K
Classify items by activity.
(SO 3, 4), K
Determine effect of transactions on stockholders’ equity.
(SO 4), C
Prepare a balance sheet.
(SO 4, 5), AP
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28 chapter 1 Introduction to Financial Statements
BE1-6 Eskimo Pie Corporation markets a broad range of frozen treats, including its famous Eskimo Pie ice cream bars. The following items were taken from a recent income statement and balance sheet. In each case, identify whether the item would appear on the balance sheet (BS) or income statement (IS). (a) _____ Income tax expense. (f ) _____ Net sales. (b) _____ Inventories. (g) _____ Cost of goods sold. (c) _____ Accounts payable. (h) _____ Common stock. (d) _____ Retained earnings. (i) _____ Receivables. (e) _____ Property, plant, and equipment. (j) _____ Interest expense.
BE1-7 Indicate which statement you would examine to find each of the following items: income statement (I), balance sheet (B), retained earnings statement (R), or statement of cash flows (C). (a) Revenue during the period. (b) Supplies on hand at the end of the year. (c) Cash received from issuing new bonds during the period. (d) Total debts outstanding at the end of the period.
BE1-8 Use the basic accounting equation to answer these questions. (a) The liabilities of Daley Company are $90,000 and the stockholders’ equity is $230,000.
What is the amount of Daley Company’s total assets? (b) The total assets of Laven Company are $170,000 and its stockholders’ equity is
$80,000. What is the amount of its total liabilities? (c) The total assets of Peterman Co. are $800,000 and its liabilities are equal to one-
fourth of its total assets. What is the amount of Peterman Co.’s stockholders’ equity?
BE1-9 At the beginning of the year, Peale Company had total assets of $800,000 and total liabilities of $500,000. (a) If total assets increased $150,000 during the year and total liabilities decreased
$80,000, what is the amount of stockholders’ equity at the end of the year? (b) During the year, total liabilities increased $100,000 and stockholders’ equity decreased
$70,000. What is the amount of total assets at the end of the year? (c) If total assets decreased $80,000 and stockholders’ equity increased $110,000 during
the year, what is the amount of total liabilities at the end of the year?
BE1-10 Indicate whether each of these items is an asset (A), a liability (L), or part of stockholders’ equity (SE). (a) Accounts receivable. (d) Supplies. (b) Salaries and wages payable. (e) Common stock. (c) Equipment. (f ) Notes payable.
BE1-11 Which is not a required part of an annual report of a publicly traded company? (a) Statement of cash flows. (b) Notes to the financial statements. (c) Management discussion and analysis. (d) All of these are required.
Determine where items appear on financial statements.
(SO 4, 5), K
Determine proper financial statement.
(SO 4), K
Use basic accounting equation.
(SO 5), AP
Use basic accounting equation.
(SO 5), AP
Identify assets, liabilities, and stockholders’ equity.
(SO 5), K
Determine required parts of annual report.
(SO 6), K
1-1 Identify each of the following organizational characteristics with the orga- nizational form or forms with which it is associated.
(a) Easier to transfer ownership (d) Tax advantages (b) Easier to raise funds (e) No personal legal liability (c) More owner control
1-2 Classify each item as an asset, liability, common stock, revenue, or expense.
(a) Issuance of ownership shares (b) Land purchased (c) Amounts owed to suppliers (d) Bonds payable (e) Amount earned from selling a product (f) Cost of advertising
Identify benefits of business organization forms.
(SO 1), C
Classify business activities.
(SO 3), K Do it!
Do it!
ReviewDo it!
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Exercises 29
1-3 Gould Corporation began operations on January 1, 2012. The following in- formation is available for Gould Corporation on December 31, 2012.
Accounts payable $ 5,000 Notes payable $ 7,000 Accounts receivable 2,000 Rent expense 10,000 Advertising expense 4,000 Retained earnings ? Cash 3,100 Service revenue 25,000 Common stock 15,000 Supplies 1,900 Dividends 2,500 Supplies expense 1,700 Equipment 26,800
Prepare an income statement, a retained earnings statement, and a balance sheet for Gould Corporation.
1-4 Indicate whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the financial state- ments, or the auditor’s report.
(a) Description of ability to pay near-term obligations (b) Unqualified opinion (c) Details concerning liabilities, too voluminous to be included in the statements (d) Description of favorable and unfavorable trends (e) Certified Public Accountant (CPA) (f) Descriptions of significant accounting policies
Prepare financial statements.
(SO 4), AP
Identify components of annual reports.
(SO 6), C
Do it!
Do it!
Exercises E1-1 Here is a list of words or phrases discussed in this chapter: 1. Corporation 4. Partnership 7. Accounts payable 2. Creditor 5. Stockholder 8. Auditor’s opinion 3. Accounts receivable 6. Common stock
Instructions Match each word or phrase with the best description of it.
______ (a) An expression about whether financial statements conform with generally ac- cepted accounting principles.
______ (b) A business enterprise that raises money by issuing shares of stock. ______ (c) The portion of stockholders’ equity that results from receiving cash from
investors. ______ (d) Obligations to suppliers of goods. ______ (e) Amounts due from customers. ______ (f ) A party to whom a business owes money. ______ (g) A party that invests in common stock. ______ (h) A business that is owned jointly by two or more individuals but does not
issue stock.
E1-2 All businesses are involved in three types of activities—financing, investing, and operating. Listed below are the names and descriptions of companies in several different industries.
Abitibi Consolidated Inc.—manufacturer and marketer of newsprint Cal State–Northridge Stdt Union—university student union Oracle Corporation—computer software developer and retailer Sportsco Investments—owner of the Vancouver Canucks hockey club Grant Thornton LLP—professional accounting and business advisory firm Southwest Airlines—discount airline
Instructions (a) For each of the above companies, provide examples of (1) a financing activity, (2) an
investing activity, and (3) an operating activity that the company likely engages in. (b) Which of the activities that you identified in (a) are common to most businesses?
Which activities are not?
Match items with descriptions.
(SO 1, 2, 4, 6), K
Identify business activities.
(SO 3), C
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30 chapter 1 Introduction to Financial Statements
Classify accounts.
(SO 3, 4), C
Prepare income statement and retained earnings statement.
(SO 4), AP
Prepare income statement and retained earnings statement.
(SO 4), AP
Prepare a retained earnings statement.
(SO 4), AP
Interpret financial facts.
(SO 4), AP
E1-3 The Fair View Golf & Country Club details the following accounts in its financial statements.
(a) (b) Accounts payable _____ _____ Accounts receivable _____ _____ Equipment _____ _____ Sales revenue _____ _____ Service revenue _____ _____ Inventory _____ _____ Mortgage payable _____ _____ Supplies expense _____ _____ Rent expense _____ _____ Salaries and wages expense _____ _____
Instructions (a) Classify each of the above accounts as an asset (A), liability (L), stockholders’ equity
(SE), revenue (R), or expense (E) item. (b) Classify each of the above accounts as a financing activity (F), investing activity (I),
or operating activity (O). If you believe a particular account doesn’t fit in any of these activities, explain why.
E1-4 This information relates to Alexis Co. for the year 2012.
Retained earnings, January 1, 2012 $67,000 Advertising expense 1,800 Dividends paid during 2012 6,000 Rent expense 10,400 Service revenue 58,000 Utilities expense 2,400 Salaries and wages expense 30,000
Instructions
After analyzing the data, prepare an income statement and a retained earnings statement for the year ending December 31, 2012.
E1-5 The following information was taken from the 2009 financial statements of phar- maceutical giant Merck and Co. All dollar amounts are in millions.
Retained earnings, January 1, 2009 $43,698.8 Materials and production expense 9,018.9 Marketing and administrative expense 8,543.2 Dividends 3,597.7 Sales revenue 27,428.3 Research and development expense 5,845.0 Tax expense 2,267.6 Other revenue 11,147.7
Instructions (a) After analyzing the data, prepare an income statement and a retained earnings state-
ment for the year ending December 31, 2009. (b) Suppose that Merck decided to reduce its research and development expense by 50%.
What would be the short-term implications? What would be the long-term implica- tions? How do you think the stock market would react?
E1-6 Presented here is information for Packee Inc. for 2012.
Retained earnings, January 1 $130,000 Revenue from legal services 400,000 Total expenses 175,000 Dividends 65,000
Instructions
Prepare the 2012 retained earnings statement for Packee Inc.
E1-7 Consider each of the following independent situations. (a) The retained earnings statement of Scott Corporation shows dividends of $68,000,
while net income for the year was $75,000.
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Exercises 31
Liabilities and Stockholders’ Equity
Liabilities Accounts payable $ 5,000
Stockholders’ equity Common stock (a) Retained earnings (b)
Total liabilities and stockholders’ equity $62,000
(b) The statement of cash flows for Silberman Corporation shows that cash provided by operating activities was $10,000, cash used in investing activities was $110,000, and cash provided by financing activities was $130,000.
Instructions
For each company provide a brief discussion interpreting these financial facts. For exam- ple, you might discuss the company’s financial health or its apparent growth philosophy.
E1-8 The following items and amounts were taken from Linus Inc.’s 2012 income state- ment and balance sheet.
______ Cash $ 84,700 ______ Accounts receivable 88,419 ______ Retained earnings 123,192 ______ Sales revenue 584,951 ______ Cost of goods sold 438,458 ______ Income taxes payable 6,499 ______ Salaries and wages expense 115,131 ______ Accounts payable 49,384 ______ Prepaid insurance 7,818 ______ Service revenue 4,806 ______ Inventory $ 64,618 ______ Interest expense 1,882
Instructions (a) In each, case, identify on the blank line whether the item is an asset (A), liability (L),
stockholder’s equity (SE), revenue (R), or expense (E) item. (b) Prepare an income statement for Linus Inc. for the year ended December 31, 2012.
E1-9 Here are incomplete financial statements for Liam, Inc.
Identify financial statement components and prepare income statement.
(SO 4), C
Calculate missing amounts.
(SO 4, 5), AP
LIAM, INC. Balance Sheet
Assets
Cash $ 7,000 Inventory 10,000 Buildings 45,000
Total assets $62,000
Income Statement Revenues $85,000 Cost of goods sold (c) Salaries and wages expense 10,000
Net income $ (d)
Retained Earnings Statement Beginning retained earnings $12,000 Add: Net income (e) Less: Dividends 5,000
Ending retained earnings $27,000
Instructions Calculate the missing amounts.
E1-10 Deer Track Park is a private camping ground near the Lathom Peak Recreation Area. It has compiled the following financial information as of December 31, 2012.
Revenues during 2012: camping fees $132,000 Dividends $ 9,000 Revenues during 2012: general store 25,000 Notes payable 50,000 Accounts payable 11,000 Expenses during 2012 126,000 Cash 8,500 Supplies 5,500 Equipment 114,000 Common stock 40,000
Retained earnings (1/1/2012) 5,000
Compute net income and prepare a balance sheet.
(SO 4, 5), AP
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32 chapter 1 Introduction to Financial Statements
Instructions (a) Determine Deer Track Park’s net income for 2012. (b) Prepare a retained earnings statement and a balance sheet for Deer Track Park as of
December 31, 2012. (c) Upon seeing this income statement, Ken Zilber, the campground manager, imme-
diately concluded, “The general store is more trouble than it is worth—let’s get rid of it.” The marketing director isn’t so sure this is a good idea. What do you think?
E1-11 Kellogg Company is the world’s leading producer of ready-to-eat cereal and a leading producer of grain-based convenience foods such as frozen waffles and cereal bars. The following items were taken from its 2009 income statement and balance sheet. All dollars are in millions.
____ Retained earnings $5,481 ____ Long-term debt $ 4,835 ____ Cost of goods sold 7,184 ____ Inventories 910 ____ Selling and ____ Net sales 12,575
administrative expenses 3,390 ____ Accounts payable 1,077 ____ Cash 334 ____ Common stock 105 ____ Notes payable 44 ____ Income tax expense 476 ____ Interest expense 295 ____ Other expense 22
Instructions Perform each of the following. (a) In each case identify whether the item is an asset (A), liability (L), stockholders’ eq-
uity (SE), revenue (R), or expense (E). (b) Prepare an income statement for Kellogg Company for the year ended December 31,
2009.
E1-12 This information is for O’Brien Corporation for the year ended December 31, 2012.
Cash received from lenders $20,000 Cash received from customers 50,000 Cash paid for new equipment 28,000 Cash dividends paid 8,000 Cash paid to suppliers 16,000 Cash balance 1/1/12 12,000
Instructions (a) Prepare the 2012 statement of cash flows for O’Brien Corporation. (b) Suppose you are one of O’Brien’s creditors. Referring to the statement of cash flows,
evaluate O’Brien’s ability to repay its creditors.
E1-13 The following data are derived from the 2009 financial statements of Southwest Airlines. All dollars are in millions. Southwest has a December 31 year-end.
Cash balance, January 1, 2009 $1,390 Cash paid for repayment of debt 122 Cash received from issuance of common stock 144 Cash received from issuance of long-term debt 500 Cash received from customers 9,823 Cash paid for property and equipment 1,529 Cash paid for dividends 14 Cash paid for repurchase of common stock 1,001 Cash paid for goods and services 6,978
Instructions (a) After analyzing the data, prepare a statement of cash flows for Southwest Airlines
for the year ended December 31, 2009. (b) Discuss whether the company’s cash from operations was sufficient to finance
its investing activities. If it was not, how did the company finance its investing activities?
E1-14 Andrew Davis is the bookkeeper for Cheyenne Company. Andrew has been try- ing to get the balance sheet of Cheyenne Company to balance. It finally balanced, but now he’s not sure it is correct.
Identify financial statement components and prepare an income statement.
(SO 4, 5), AP
Prepare a statement of cash flows.
(SO 5), AP
Prepare a statement of cash flows.
(SO 5), AP
Correct an incorrectly prepared balance sheet.
(SO 5), AP
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Exercises 33
Instructions Prepare a correct balance sheet.
E1-15 The following items were taken from the balance sheet of Nike, Inc.
1. Cash $2,291.1 7. Inventories $2,357.0 2. Accounts receivable 2,883.9 8. Income taxes payable 86.3 3. Common stock 2,874.2 9. Property, plant, and equipment 1,957.7 4. Notes payable 342.9 10. Retained earnings 5,818.9 5. Other assets 3,759.9 11. Accounts payable 2,815.8 6. Other liabilities 1,311.5
Instructions Perform each of the following. (a) Classify each of these items as an asset, liability, or stockholders’ equity and deter-
mine the total dollar amount for each classification. (All dollars are in millions.) (b) Determine Nike’s accounting equation by calculating the value of total assets, total
liabilities, and total stockholders’ equity. (c) To what extent does Nike rely on debt versus equity financing?
E1-16 The summaries of data from the balance sheet, income statement, and retained earnings statement for two corporations, Bates Corporation and Wilson Enterprises, are presented below for 2012.
Bates Corporation Wilson Enterprises
Beginning of year Total assets $110,000 $150,000 Total liabilities 70,000 (d) Total stockholders’ equity (a) 70,000
End of year Total assets (b) 180,000 Total liabilities 120,000 55,000 Total stockholders’ equity 60,000 (e)
Changes during year in retained earnings
Dividends (c) 5,000 Total revenues 215,000 (f) Total expenses 165,000 80,000
Instructions Determine the missing amounts. Assume all changes in stockholders’ equity are due to changes in retained earnings.
E1-17 The annual report provides financial information in a variety of formats, includ- ing the following.
Management discussion and analysis (MD&A) Financial statements Notes to the financial statements Auditor’s opinion
Instructions For each of the following, state in what area of the annual report the item would be pre- sented. If the item would probably not be found in an annual report, state “Not disclosed.”
Liabilities and Stockholders’ Equity
Accounts payable $16,000 Accounts receivable (12,000) Common stock 40,000 Retained earnings 31,500 Total liabilities and
stockholders’ equity $75,500
CHEYENNE COMPANY Balance Sheet
December 31, 2012
Assets
Cash $18,000 Supplies 9,500 Equipment 40,000 Dividends 8,000
Total assets $75,500
Classify items as assets, liabilities, and stockholders’ equity and prepare accounting equation.
(SO 5), AP
Use financial statement relationships to determine missing amounts.
(SO 5), AP
Classify various items in an annual report.
(SO 6), K
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34 chapter 1 Introduction to Financial Statements
(a) The total cumulative amount received from stockholders in exchange for common stock.
(b) An independent assessment concerning whether the financial statements present a fair depiction of the company’s results and financial position.
(c) The interest rate that the company is being charged on all outstanding debts. (d) Total revenue from operating activities. (e) Management’s assessment of the company’s results. (f ) The names and positions of all employees hired in the last year.
Exercises: Set B and Challenge Exercises Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
Problems: Set A P1-1A Presented below are five independent situations. (a) Three physics professors at MIT have formed a business to improve the speed of in-
formation transfer over the Internet for stock exchange transactions. Each has con- tributed an equal amount of cash and knowledge to the venture. Although their ap- proach looks promising, they are concerned about the legal liabilities that their business might confront.
(b) Ed Toth, a college student looking for summer employment, opened a bait shop in a small shed at a local marina.
(c) Joan Stuebben and Ron Klinke each owned separate shoe manufacturing businesses. They have decided to combine their businesses. They expect that within the coming year they will need significant funds to expand their operations.
(d) Crystal, Allie, and Harry recently graduated with marketing degrees. They have been friends since childhood. They have decided to start a consulting business focused on marketing sporting goods over the Internet.
(e) Mark Willis wants to rent CD players and CDs in airports across the country. His idea is that customers will be able to rent equipment and CDs at one airport, listen to the CDs on their flights, and return the equipment and CDs at their destination airport. Of course, this will require a substantial investment in equipment and CDs, as well as employees and locations in each airport. Mark has no savings or personal assets. He wants to maintain control over the business.
Instructions In each case, explain what form of organization the business is likely to take—sole pro- prietorship, partnership, or corporation. Give reasons for your choice.
P1-2A Financial decisions often place heavier emphasis on one type of financial state- ment over the others. Consider each of the following hypothetical situations independently. (a) The North Face, Inc. is considering extending credit to a new customer. The terms
of the credit would require the customer to pay within 30 days of receipt of goods. (b) An investor is considering purchasing common stock of Amazon.com. The investor
plans to hold the investment for at least 5 years. (c) Chase Manhattan is considering extending a loan to a small company. The company
would be required to make interest payments at the end of each year for 5 years, and to repay the loan at the end of the fifth year.
(d) The president of Campbell Soup is trying to determine whether the company is gen- erating enough cash to increase the amount of dividends paid to investors in this and future years, and still have enough cash to buy equipment as it is needed.
Instructions In each situation, state whether the decision maker would be most likely to place pri- mary emphasis on information provided by the income statement, balance sheet, or state- ment of cash flows. In each case provide a brief justification for your choice. Choose only one financial statement in each case.
Determine forms of business organization.
(SO 1), C
Identify users and uses of financial statements.
(SO 2, 4, 5), K
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Problems: Set A 35
P1-3A On June 1, Beardsley Service Co. was started with an initial investment in the company of $22,100 cash. Here are the assets and liabilities of the company at June 30, and the revenues and expenses for the month of June, its first month of operations:
Cash $ 4,600 Notes payable $12,000 Accounts receivable 4,000 Accounts payable 500 Service revenue 7,500 Supplies expense 1,000 Supplies 2,400 Maintenance and repairs expense 600 Advertising expense 400 Utilities expense 300 Equipment 26,000 Salaries and wages expense 1,400
In June, the company issued no additional stock, but paid dividends of $1,400.
Instructions (a) Prepare an income statement and a retained earnings statement for the month of
June and a balance sheet at June 30, 2012. (b) Briefly discuss whether the company’s first month of operations was a success. (c) Discuss the company’s decision to distribute a dividend.
P1-4A Presented below is selected financial information for Yvonne Corporation for December 31, 2012.
Inventory $ 25,000 Cash paid to purchase equipment $ 12,000 Cash paid to suppliers 104,000 Equipment 40,000 Building 200,000 Revenues 100,000 Common stock 50,000 Cash received from customers 132,000 Cash dividends paid 7,000 Cash received from issuing
common stock 22,000
Instructions (a) Determine which items should be included in a statement of cash flows and then
prepare the statement for Yvonne Corporation. (b) Comment on the adequacy of net cash provided by operating activities to fund the
company’s investing activities and dividend payments.
P1-5A Gabelli Corporation was formed on January 1, 2012. At December 31, 2012, John Paulus, the president and sole stockholder, decided to prepare a balance sheet, which ap- peared as follows.
GABELLI CORPORATION Balance Sheet
December 31, 2012
Assets Liabilities and Stockholders’ Equity
Cash $20,000 Accounts payable $30,000 Accounts receivable 50,000 Notes payable 15,000 Inventory 36,000 Boat loan 22,000 Boat 24,000 Stockholders’ equity 64,000
John willingly admits that he is not an accountant by training. He is concerned that his balance sheet might not be correct. He has provided you with the following additional information.
1. The boat actually belongs to Paulus, not to Gabelli Corporation. However, because he thinks he might take customers out on the boat occasionally, he decided to list it as an asset of the company. To be consistent, he also listed as a liability of the cor- poration his personal loan that he took out at the bank to buy the boat.
2. The inventory was originally purchased for $25,000, but due to a surge in demand John now thinks he could sell it for $36,000. He thought it would be best to record it at $36,000.
3. Included in the accounts receivable balance is $10,000 that John loaned to his brother 5 years ago. John included this in the receivables of Gabelli Corporation so he wouldn’t forget that his brother owes him money.
Instructions (a) Comment on the proper accounting treatment of the three items above. (b) Provide a corrected balance sheet for Gabelli Corporation. (Hint: To get the balance
sheet to balance, adjust stockholders’ equity.)
(a) Net increase $31,000
Prepare an income statement, retained earnings statement, and balance sheet; discuss results.
(SO 4, 5), AP
Determine items included in a statement of cash flows, prepare the statement, and comment.
(SO 4, 5), AP
Comment on proper accounting treatment and prepare a corrected balance sheet.
(SO 4, 5), AP
Marginal check figures (in blue) provide a key number to let you know you are on the right track. (a) Net income $3,800
Ret. earnings $2,400 Tot. assets $37,000
Tot. assets $85,000
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36 chapter 1 Introduction to Financial Statements
Problems: Set B P1-1B Presented below are five independent situations. (a) Rachel Jackson, a college student looking for summer employment, opened a veg-
etable stand along a busy local highway. Each morning she buys produce from local farmers, then sells it in the afternoon as people return home from work.
(b) Colin Doyle and Jason Elliot each owned separate swing-set manufacturing busi- nesses. They have decided to combine their businesses and try to expand their reach beyond their local market. They expect that within the coming year they will need significant funds to expand their operations.
(c) Three chemistry professors at FIU have formed a business to employ bacteria to clean up toxic waste sites. Each has contributed an equal amount of cash and knowledge to the venture. The use of bacteria in this situation is experimental, and legal obli- gations could result.
(d) Brittany Medler has run a successful, but small cooperative health food store for over 20 years. The increased sales of her store have made her believe that the time is right to open a national chain of health food stores across the country. Of course, this will require a substantial investment in stores, inventory, and employees in each store. Brittany has no savings or personal assets. She wants to maintain control over the business.
(e) Cheryl Lamb and Tom Majors recently graduated with masters degrees in economics. They have decided to start a consulting business focused on teaching the basics of international economics to small business owners interested in international trade.
Instructions In each case, explain what form of organization the business is likely to take—sole pro- prietorship, partnership, or corporation. Give reasons for your choice.
P1-2B Financial decisions often place heavier emphasis on one type of financial state- ment over the others. Consider each of the following hypothetical situations independently. (a) An investor is considering purchasing common stock of the Bally Total Fitness com-
pany. The investor plans to hold the investment for at least 3 years. (b) Boeing is considering extending credit to a new customer. The terms of the credit
would require the customer to pay within 60 days of receipt of goods. (c) The president of Northwest Airlines is trying to determine whether the company is
generating enough cash to increase the amount of dividends paid to investors in this and future years, and still have enough cash to buy new flight equipment as it is needed.
(d) Bank of America is considering extending a loan to a small company. The company would be required to make interest payments at the end of each year for 5 years, and to repay the loan at the end of the fifth year.
Instructions In each of the situations above, state whether the decision maker would be most likely to place primary emphasis on information provided by the income statement, balance sheet, or statement of cash flows. In each case, provide a brief justification for your choice. Choose only one financial statement in each case.
P1-3B Special Delivery was started on May 1 with an investment of $45,000 cash. Fol- lowing are the assets and liabilities of the company on May 31, 2012, and the revenues and expenses for the month of May, its first month of operations.
Accounts receivable $ 6,200 Notes payable $28,000 Service revenue 10,400 Salaries and wages expense 2,000 Advertising expense 800 Equipment 56,000 Accounts payable 2,400 Maintenance and repairs expense 2,900 Cash 15,800 Insurance expense 400
No additional common stock was issued in May, but a dividend of $1,700 in cash was paid.
Instructions (a) Prepare an income statement and a retained earnings statement for the month of
May and a balance sheet at May 31, 2012.
Determine forms of business organization.
(SO 1), C
Identify users and uses of financial statements.
(SO 2, 4, 5), K
Prepare an income statement, retained earnings statement, and balance sheet; discuss results.
(SO 4, 5), AP
(a) Net income $4,300 Ret. earnings $2,600 Tot. assets $78,000
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Continuing Cookie Chronicle 37
(b) Briefly discuss whether the company’s first month of operations was a success. (c) Discuss the company’s decision to distribute a dividend.
P1-4B Presented below are selected financial statement items for Rowe Corporation for December 31, 2012.
Inventory $ 55,000 Cash paid to purchase equipment $ 30,000 Cash paid to suppliers 154,000 Equipment 40,000 Buildings 400,000 Revenues 200,000 Common stock 20,000 Cash received from customers 172,000 Cash dividends paid 6,000 Cash received from issuing
bonds payable 40,000
Instructions (a) Determine which items should be included in a statement of cash flows, and then
prepare the statement for Rowe Corporation. (b) Comment on the adequacy of net cash provided by operating activities to fund the
company’s investing activities and dividend payments.
P1-5B Austin Corporation was formed during 2011 by Joanna Kay. Joanna is the pres- ident and sole stockholder. At December 31, 2012, Joanna prepared an income statement for Austin Corporation. Joanna is not an accountant, but she thinks she did a reasonable job preparing the income statement by looking at the financial statements of other com- panies. She has asked you for advice. Joanna’s income statement appears as follows.
AUSTIN CORPORATION Income Statement
For the Year Ended December 31, 2012
Accounts receivable $17,000 Service revenue 47,000 Rent expense 10,000 Insurance expense 7,000 Vacation expense 4,000
Net income $43,000
Joanna has also provided you with these facts.
1. Included in the service revenue account is $3,000 of revenue that the company earned and received payment for in 2011. She forgot to include it in the 2011 income state- ment, so she put it in this year’s statement.
2. Joanna operates her business out of the basement of her parents’ home. They do not charge her anything, but she thinks that if she paid rent it would cost her about $10,000 per year. Therefore, she included $10,000 of rent expense in the income statement.
3. To reward herself for a year of hard work, Joanna went to Greece. She did not use company funds to pay for the trip, but she reported it as an expense on the income statement since it was her job that made her need the vacation.
Instructions (a) Comment on the proper accounting treatment of the three items above. (b) Prepare a corrected income statement for Austin Corporation.
(a) Net income $37,000
Comment on proper accounting treatment and prepare a corrected income statement.
(SO 4, 5), AP
Determine items included in a statement of cash flows, prepare the statement, and comment.
(SO 4, 5), AP
(a) Net increase $22,000
Problems: Set C Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problem Set C.
Continuing Cookie Chronicle CCC1 Natalie Koebel spent much of her childhood learning the art of cookie-making from her grandmother. They spent many happy hours mastering every type of cookie imaginable and later devised new recipes that were both healthy and delicious. Now at
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38 chapter 1 Introduction to Financial Statements
the start of her second year in college, Natalie is investigating possibilities for starting her own business as part of the entrepreneurship program in which she is enrolled.
A long-time friend insists that Natalie has to include cookies in her business plan. After a series of brainstorming sessions, Natalie settles on the idea of operating a cookie- making school. She will start on a part-time basis and offer her services in people’s homes. Now that she has started thinking about it, the possibilities seem endless. During the fall, she will concentrate on holiday cookies. She will offer group sessions (which will prob- ably be more entertainment than education) and individual lessons. Natalie also decides to include children in her target market. The first difficult decision is coming up with the perfect name for her business. She settles on “Cookie Creations,” and then moves on to more important issues.
Instructions (a) What form of business organization—proprietorship, partnership, or corporation—
do you recommend that Natalie use for her business? Discuss the benefits and weak- nesses of each form that Natalie might consider.
(b) Will Natalie need accounting information? If yes, what information will she need and why? How often will she need this information?
(c) Identify specific asset, liability, revenue, and expense accounts that Cookie Creations will likely use to record its business transactions.
(d) Should Natalie open a separate bank account for the business? Why or why not? (e) Natalie expects she will have to use her car to drive to people’s homes and to pick
up supplies, but she also needs to use her car for personal reasons. She recalls from her first-year accounting course something about keeping business and personal as- sets separate. She wonders what she should do for accounting purposes. What do you recommend?
This serial problem starts in Chapter 1 and continues in every chapter. You can also find this problem at the book’s companion website, www.wiley.com/ college/kimmel.
Financial Reporting and Analysis FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries Inc.
BYP1-1 The 2009 financial statements of Tootsie Roll Industries, Inc. are provided in Appendix A.
Instructions Refer to Tootsie Roll’s financial statements to answer the following questions. (a) What were Tootsie Roll’s total assets at December 31, 2009? At December 31, 2008? (b) How much cash did Tootsie Roll have on December 31, 2009? (c) What amount of accounts payable did Tootsie Roll report on December 31, 2009? On Decem-
ber 31, 2008? (d) What were Tootsie Roll’s total revenues in 2009? In 2008? (e) What is the amount of the change in Tootsie Roll’s net income from 2008 to 2009?
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey
BYP1-2 Tootsie Roll’s financial statements are presented in Appendix A, and the financial state- ments of The Hershey Company are presented in Appendix B.
Instructions (a) Based on the information in these financial statements, determine the following for each
company.
(1) Total assets at December 31, 2009. (2) Net property, plant, and equipment at December 31, 2009. (3) Total revenue for 2009. (4) Net income for 2009.
(b) What conclusions concerning the two companies can you draw from these data?
broadening your perspective
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Broadening Your Perspective 39
RESEARCH CASE
BYP1-3 The September 3, 2009, issue of BusinessWeek includes an article by Lindsey Gerdes entitled “The Best Places to Launch a Career.” It provides interesting information regarding the job opportunities for accounting students.
Instructions Read the article and answer the following questions. (The article can be found at www.businessweek.com/magazine/content/09_37/b4146032027785.htm.) (a) What position did each of the “Big Four” (the four largest international accounting firms) re-
ceive in the survey? (b) To what did the article attribute the accounting firms’ success? (c) What was the starting salary for a new employee at Deloitte and Touche? (d) The accounting firms’ hiring was affected by the recession although not as much as many
of the other employers in the survey. Which one of the Big Four firms had the smallest de- cline in hiring, and which had the largest?
INTERPRETING FINANCIAL STATEMENTS
BYP1-4 Xerox was not having a particularly pleasant year. The company’s stock price had already fallen in the previous year from $60 per share to $30. Just when it seemed things couldn’t get worse, Xerox’s stock fell to $4 per share. The data below were taken from the statement of cash flows of Xerox. All dollars are in millions.
Cash used in operating activities $ (663) Cash used in investing activities (644) Financing activities
Dividends paid $ (587) Net cash received from issuing debt 3,498
Cash provided by financing activities 2,911
Instructions Analyze the information above, and then answer the following questions. (a) If you were a creditor of Xerox, what reaction might you have to the above information? (b) If you were an investor in Xerox, what reaction might you have to the above information? (c) If you were evaluating the company as either a creditor or a stockholder, what other infor-
mation would you be interested in seeing? (d) Xerox decided to pay a cash dividend. This dividend was approximately equal to the amount
paid in the previous year. Discuss the issues that were probably considered in making this decision.
FINANCIAL ANALYSIS ON THE WEB
BYP1-5 Purpose: Identify summary information about companies. This information includes basic descriptions of the company’s location, activities, industry, financial health, and financial performance.
Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/kimmel
Steps 1. Type in a company name, or use the index to find company name. 2. Choose Quote, then choose Profile, then choose Income Statement. Perform instructions
(a) and (b) below. 3. Choose Industry to identify others in this industry. Perform instructions (c)–(e) below.
Instructions Answer the following questions. (a) What was the company’s net income? Over what period was this measured? (b) What was the company’s total sales? Over what period was this measured? (c) What is the company’s industry? (d) What are the names of four companies in this industry? (e) Choose one of the competitors. What is this competitor’s name? What were its sales? What
was its net income?
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Critical Thinking DECISION MAKING ACROSS THE ORGANIZATION
BYP1-6 Kim Walters recently accepted a job in the production department at Tootsie Roll. Before she starts work, she decides to review the company’s annual report to better understand its operations.
Instructions Use the annual report provided in Appendix A to answer the following questions. (a) What CPA firm performed the audit of Tootsie Roll’s financial statements? (b) What was the amount of Tootsie Roll’s earnings per share in 2009? (c) What are the company’s net sales in foreign countries in 2009? (d) What did management suggest as the cause of the decrease in the earnings from operations
in 2009? (e) What were net sales in 2005? (f) How many shares of Class B common stock have been authorized? (g) How much cash was spent on capital expenditures in 2009? (h) Over what life does the company depreciate its buildings? (i) What was the value of raw material and supplies inventory in 2008?
COMMUNICATION ACTIVITY
BYP1-7 Jane Noonan is the bookkeeper for Wilson Company, Inc. Jane has been trying to get the company’s balance sheet to balance. She finally got it to balance, but she still isn’t sure that it is correct.
WILSON COMPANY, INC.
Balance Sheet For the Month Ended December 31, 2012
Assets
Equipment $18,000 Cash 9,000 Supplies 1,000 Accounts payable (4,000)
Total assets $24,000
Instructions Explain to Jane Noonan in a memo (a) the purpose of a balance sheet, and (b) why this balance sheet is incorrect and what she should do to correct it.
ETHICS CASE
BYP1-8 Rules governing the investment practices of individual certified public accountants pro- hibit them from investing in the stock of a company that their firm audits. The Securities and Exchange Commission (SEC) became concerned that some accountants were violating this rule. In response to an SEC investigation, PricewaterhouseCoopers fired 10 people and spent $25 million educating employees about the investment rules and installing an investment tracking system.
Instructions Answer the following questions. (a) Why do you think rules exist that restrict auditors from investing in companies that are
audited by their firms? (b) Some accountants argue that they should be allowed to invest in a company’s stock as long
as they themselves aren’t involved in working on the company’s audit or consulting. What do you think of this idea?
(c) Today a very high percentage of publicly traded companies are audited by only four very large public accounting firms. These firms also do a high percentage of the consulting work that
40 chapter 1 Introduction to Financial Statements
Liabilities and Stockholders’ Equity
Common stock $12,000 Accounts receivable (6,000) Dividends (2,000) Notes payable 10,000 Retained earnings 10,000
Total liabilities and stockholders’ equity $24,000
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is done for publicly traded companies. How does this fact complicate the decision regarding whether CPAs should be allowed to invest in companies audited by their firm?
(d) Suppose you were a CPA and you had invested in IBM when IBM was not one of your firm’s clients. Two years later, after IBM’s stock price had fallen considerably, your firm won the IBM audit contract. You will be involved in working with the IBM audit. You know that your firm’s rules require that you sell your shares immediately. If you do sell immediately, you will sustain a large loss. Do you think this is fair? What would you do?
(e) Why do you think PricewaterhouseCoopers took such extreme steps in response to the SEC investigation?
“ALL ABOUT YOU” ACTIVITY
BYP1-9 Some people are tempted to make their finances look worse to get financial aid. Companies sometimes also manage their financial numbers in order to accomplish certain goals. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. In managing earnings, companies’ actions vary from being within the range of ethical activity, to being both unethical and illegal attempts to mislead investors and creditors.
Instructions Provide responses for each of the following questions. (a) Discuss whether you think each of the following actions (adapted from www.finaid.
org/fafsa/maximize.phtml) to increase the chances of receiving financial aid is ethical. (i) Spend down the student’s assets and income first, before spending parents’ assets and
income. (ii) Accelerate necessary expenses to reduce available cash. For example, if you need a new
car, buy it before applying for financial aid. (iii) State that a truly financially dependent child is independent. (iv) Have a parent take an unpaid leave of absence for long enough to get below the “thresh-
old” level of income. (b) What are some reasons why a company might want to overstate its earnings? (c) What are some reasons why a company might want to understate its earnings? (d) Under what circumstances might an otherwise ethical person decide to illegally overstate or
understate earnings?
FASB CODIFICATION ACTIVITY
BYP1-10 The FASB has developed the Financial Accounting Standards Board Accounting Standards Codification (or more simply “the Codification”). The FASB’s primary goal in develop- ing the Codification is to provide in one place all the authoritative literature related to a particu- lar topic. To provide easy access to the Codification, the FASB also developed the Financial Accounting Standards Board Codification Research System (CRS). CRS is an online, real-time database that provides easy access to the Codification. The Codification and the related CRS pro- vide a topically organized structure, subdivided into topic, subtopics, sections, and paragraphs, using a numerical index system.
You may find this system useful in your present and future studies, and so we have provided an opportunity to use this online system as part of the Broadening Your Perspective section.
Instructions Academic access to the FASB Codification is available through university subscriptions, obtained from the American Accounting Association (at http://aaahq.org/FASB/Access.cfm), for an annual fee of $150. This subscription covers an unlimited number of students within a single institution. Once this access has been obtained by your school, you should login (at http://aaahq.org/ascLogin.cfm) and familiarize yourself with the resources that are accessible at the FASB Codification site.
Answers to Insight and Accounting Across the Organization Questions
p. 6 The Scoop on Accounting Q: What are the benefits to the company and to the employees of making the financial statements available to all employees? A: If employees can read and use financial reports, a company will benefit in the following ways. The marketing department will
Broadening Your Perspective 41
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make better decisions about products to offer and prices to charge. The finance department will make better decisions about debt and equity financing and how much to distribute in divi- dends. The production department will make better decisions about when to buy new equipment and how much inventory to produce. The human resources department will be better able to de- termine whether employees can be given raises. Finally, all employees will be better informed about the basis on which they are evaluated, which will increase employee morale.
p. 7 Spinning the Career Wheel Q: How might accounting help you? A: You will need to under- stand financial reports in any enterprise with which you are associated. Whether you become a manager, a doctor, a lawyer, a social worker, a teacher, an engineer, an architect, or an entrepre- neur, a working knowledge of accounting is relevant.
p. 8 The Numbers Behind Not-for-Profit Organizations Q: What benefits does a sound account- ing system provide to a not-for-profit organization? A: Accounting provides at least two benefits to not-for-profit organizations. First, it helps to ensure that money is used in the way that donors intended. Second, it assures donors that their money is not going to waste and thus increases the likelihood of future donations.
p. 15 Rocking the Bottom Line Q: What is one way that some of these disputes might be re- solved? A: Frequently, when contractual payments depend on accounting-based financial results, interested parties employ outside auditors to evaluate whether the financial information has been prepared fairly and accurately. The musicians would like auditors to have easy access to inven- tory and manufacturing information of the recording companies.
Answers to Self-Test Questions
1. b 2. c 3. d 4. d 5. c 6. a 7. d 8. d 9. a 10. b 11. c 12. d 13. d 14. a 15. b
42 chapter 1 Introduction to Financial Statements
IFRS A Look at IFRS Most agree that there is a need for one set of international accounting standards. Here is why:
Multinational corporations. Today’s companies view the entire world as their market. For exam- ple, Coca-Cola, Intel, and McDonald’s generate more than 50% of their sales outside the United States, and many foreign companies, such as Toyota, Nestlé, and Sony, find their largest market to be the United States.
Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann sug- gest that we will see even more such business combinations in the future.
Information technology. As communication barriers continue to topple through advances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another.
Financial markets. Financial markets are of international significance today. Whether it is cur- rency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.
KEY POINTS • International standards are referred to as International Financial Reporting Standards (IFRS),
developed by the International Accounting Standards Board (IASB).
• Recent events in the global capital markets have underscored the importance of financial dis- closure and transparency not only in the United States but in markets around the world. As a result, many are examining which accounting and financial disclosure rules should be followed. As indicated in the graphic on the next page, much of the world has voted for the standards issued by the IASB. Over 115 countries require or permit use of IFRS.
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• U.S standards, referred to as generally accepted accounting principles (GAAP), are developed by the Financial Accounting Standards Board (FASB). The fact that there are differences between what is in this textbook (which is based on U.S. standards) and IFRS should not be surprising because the FASB and IASB have responded to different user needs. In some coun- tries, the primary users of financial statements are private investors; in others, the primary users are tax authorities or central government planners. It appears that the United States and the international standard-setting environment are primarily driven by meeting the needs of investors and creditors.
• The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is a continuing debate as to whether non-U.S. com- panies should have to comply with this extra layer of regulation. Debate about international companies (non-U.S.) adopting SOX-type standards centers on whether the benefits exceed the costs. The concern is that the higher costs of SOX compliance are making the U.S. securities markets less competitive.
• The textbook mentions a number of ethics violations, such as Enron, WorldCom, and AIG. These problems have also occurred internationally, for example, at Satyam Computer Services (India), Parmalat (Italy), and Royal Ahold (the Netherlands).
• IFRS tends to be simpler in its accounting and disclosure requirements; some people say it is more “principles-based.” GAAP is more detailed; some people say it is more “rules-based.” This difference in approach has resulted in a debate about the merits of “principles-based” versus “rules-based” standards.
• U.S. regulators have recently eliminated the need for foreign companies that trade shares in U.S. markets to reconcile their accounting with GAAP.
• The three most common forms of business organization, proprietorships, partnerships, and corporations, are also found in countries that use IFRS. Because the choice of business organ- ization is influenced by factors such as legal environment, tax rates and regulations, and degree of entrepreneurism, the relative use of each form will vary across countries.
• The conceptual framework that underlies IFRS is very similar to that used to develop GAAP. The basic definitions provided in this textbook for the key elements of financial statements, that is, assets, liabilities, equity, revenues, and expenses, are simplified versions of the official defi- nitions provided by the FASB. The more substantive definitions, using the IASB definitional structure, are as follows.
Assets. A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
A Look at IFRS 43
Countries that require or permit IFRS or have fixed dates for adoption
Countries seeking conver- gence with the IASB or pursuing adoption of IFRS
Source: http://www.pwc.com/us/en/issues/ifrs-reporting/country-adoption/index.jhtml.
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Liabilities. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law, but need not be, i.e., they can arise due to normal business practice or customs.
Equity. A residual interest in the assets of the entity after deducting all its liabilities.
Income. Increases in economic benefits that result in increases in equity (other than those related to contributions from shareholders). Income includes both revenues (resulting from ordinary activities) and gains.
Expenses. Decreases in economic benefits that result in decreases in equity (other than those related to distributions to shareholders). Expenses includes losses that are not the result of ordinary activities.
LOOKING TO THE FUTURE Both the IASB and the FASB are hard at work developing standards that will lead to the elimi- nation of major differences in the way certain transactions are accounted for and reported. In fact, at one time the IASB stated that no new major standards would become effective until 2009. The major reason for this policy was to provide companies the time to translate and imple- ment IFRS into practice, as much has happened in a very short period of time. Consider, for example, that as a result of a joint project on the conceptual framework, the definitions of the most fundamental elements (assets, liabilities, equity, revenues, and expenses) may actually change. However, whether the IASB adopts internal control provisions similar to those in SOX remains to be seen.
IFRS Self-Test Questions 1. Which of the following is not a reason why a single set of high-quality international account-
ing standards would be beneficial? (a) Mergers and acquisition activity. (b) Financial markets. (c) Multinational corporations. (d) GAAP is widely considered to be a superior reporting system.
2. The Sarbanes-Oxley Act determines: (a) international tax regulations. (b) internal control standards as enforced by the IASB. (c) internal control standards of U.S. publicly traded companies. (d) U.S. tax regulations.
3. IFRS is considered to be more: (a) principles-based and less rules-based than GAAP. (b) rules-based and less principles-based than GAAP. (c) detailed than GAAP. (d) None of the above.
4. Which of the following statements is false? (a) IFRS is based on a conceptual framework that is similar to that used to develop GAAP. (b) Assets are defined by the IASB as resources controlled by the entity as a result of past
events and from which future economic benefits are expected to flow to the entity. (c) Non-U.S. companies that trade shares in U.S. markets must reconcile their accounting with
GAAP. (d) Proprietorships, partnerships, and corporations are also found in countries that use IFRS.
5. Which of the following statements is true? (a) Under IFRS, the term income refers to what would be called revenues and gains under
GAAP. (b) The term income is not used under IFRS. (c) The term income refers only to gains on investments. (d) Under IFRS, expenses include distributions to owners.
IFRS Concepts and Application IFRS1–1 Who are the two key international players in the development of international account- ing standards? Explain their role.
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IFRS1-2 What might explain the fact that different accounting standard-setters have developed accounting standards that are sometimes quite different in nature?
IFRS1-3 What is the benefit of a single set of high-quality accounting standards?
IFRS1-4 Discuss the potential advantages and disadvantages that countries outside the United States should consider before adopting regulations, such as those in the Sarbanes-Oxley Act, that increase corporate internal control requirements.
INTERNATIONAL FINANCIAL REPORTING PROBLEM: Zetar plc IFRS1-5 The financial statements of Zetar plc are presented in Appendix C. The company’s complete annual report, including the notes to its financial statements, is available at www.zetarplc.com.
Instructions Visit Zetar’s corporate website and answer the following questions from Zetar’s 2009 annual report.
(a) What accounting firm performed the audit of Zetar’s financial statements? (b) Over what life does the company depreciate its buildings? (c) What is the address of the company’s corporate headquarters? (d) What is the company’s reporting currency? (e) What two segments does the company operate in, and what were the sales for each segment
in the year ended April 30, 2009?
Answers to IFRS Self-Test Questions
1. d 2. c 3. a 4. c 5. a
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