CHAPTER 1: INTRODUCTION TO FINANCIAL STATEMENTS © Dan Moore/iStockphoto The Navigator • • • • Scan Learning Objectives Read Feature Story Scan Preview • Read Text and Answer p. 5 Work Using the Decision Toolkit Review Summary of Learning Objectives • Work Comprehensive • Answer Self-Test Questions Complete Assignments Go to WileyPLUS for practice and tutorials • • • • p. 24 Read A Look at IFRS p. 43 LEARNING OBJECTIVES p. 11 p. 18 p. 21 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. 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. Feature Story: KNOWING THE NUMBERS 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?” Well, 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.” 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 businesses agree with this view. They see the value of their employees being able to read financial statements and understand how their actions affect the company’s financial results. For example, consider Clif Bar & Company. The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees and is considered one of the leading Landor’s Breakaway Brands®. Clif Bar is guided by what it calls its Five Aspirations–Sustaining Our Business, Our Brands, Our People, Our Community, and the Planet. Its website documents its efforts and accomplishments in these five areas. Just a few examples include the company’s use of organic products to protect soil, water, and biodiversity; the “smart” solar array (the largest in North America), which provides nearly all the electrical needs for its 115,000square-foot building; and the incentives Clif Bar provides to employees to reduce their personal environmental impact, such as $6,500 toward the purchase of an efficient car or $1,000 per year for eco-friendly improvements toward their homes. One of the company’s proudest moments was the creation of an employee stock ownership plan (ESOP) in 2010. This plan gives its employees 20% ownership of the company (Gary and his wife Kit own the other 80%). The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its finances. Armed with this basic financial knowledge, employees are more aware of the financial impact of their actions, which leads to better decisions. Even in companies that do not practice open-book management, today’s employers generally assume that managers in all areas of the company are “financially literate.” To help prepare you for that, in this textbook you will learn how to read and prepare financial statements, and how to use basic tools to evaluate 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 complete, yet also relatively easy to understand. INSIDE CHAPTER 1... • • • • The Scoop on Accounting (p. 6) Spinning the Career Wheel (p. 7) The Numbers Behind Not-for-Profit Organizations (p. 9) Beyond Financial Statements (p. 16) PREVIEW OF CHAPTER 1 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 banks 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 enjoy working with people, especially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains. LEARNING OBJECTIVE 1 Describe the primary forms of business organization. Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation. 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. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants), often organize as partnerships. As a third alternative, you might organize as a corporation. A business organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can becomestockholders by investing relatively small amounts of money. Therefore, it is easier for corporations to raise funds. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate. For example, in 1896 Leo Hirshfield started Tootsie Roll as a sole proprietorship, and by 1919 the company had incorporated. Alternative Terminology Stockholders are sometimes called shareholders. Alternative Terminology notes present synonymous terms that you may come across in practice. Other factors to consider in deciding which organizational form to choose are taxes and legal liability. If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter. Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. These hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. Probably the most common among these hybrids types are limited liability companies (LLCs) and subchapter S corporations. These forms are discussed extensively in business law classes. The combined number of proprietorships and partnerships in the United States is more than five times the number of corporations. However, the revenue produced by corporations is eight times greater. Most of the largest businesses in the United States— for example, Coca-Cola, ExxonMobil,General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this textbook is on the corporate form of organization. BUSINESS ORGANIZATION FORMS In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated. • • • • • 1. Easier to raise funds. 2. Simple to establish. 3. No personal legal liability. 4. Tax advantages. 5. Easier to transfer ownership. Do it! exercises prompt you to stop and review the key points you have just studied. Action Plans give you tips about how to approach the problem. Action Plan • Know which organizational form best matches the business type, size, and preferences of the owner(s). Solution • • • • • 1. Easier to raise funds: Corporation. 2. Simple to establish: Sole proprietorship and partnership. 3. No personal legal liability: Corporation. 4. Tax advantages: Sole proprietorship and partnership. 5. Easier to transfer ownership: Corporation. Related exercise material: BE1-1 and 1-1. Users and Uses of Financial Information The purpose of financial information is to provide inputs for decisionmaking. Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users. Users of accounting information can be divided broadly into two groups: internal users and external users. LEARNING OBJECTIVE 2 Identify the users and uses of accounting information. 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 inIllustration 1-1. Illustration 1-1: Questions that internal users ask To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized financial information in the form of financial statements. Illustrations help you visualize and apply the ideas as you study. Accounting Across the Organization: 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: © Agnieszka Pastuszak-Maksim/iStockphoto “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 management 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 financial statements available to all employees? (See page 42.) Accounting Across the Organization stories show applications of accounting information in various business functions. EXTERNAL USERS There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1-2. Illustration 1-2: Questions that external users ask The information needs and questions of other external users vary considerably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws. Customers are interested in whether a company like General Motors will continue to honor product warranties and otherwise support its product lines. Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and benefits. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energytrading 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. Accounting Across the Organization: Spinning the Career Wheel How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every field of business. Some examples of how accounting is used in business careers include: Josef Volavka/iStockphoto General management: Managers of Ford Motors, Massachusetts General Hospital, California State University–Fullerton, a McDonald’s franchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions. Marketing: A marketing specialist at Procter & Gamble must be sensitive to costs and benefits, which accounting helps them quantify and understand. Making a sale is meaningless unless it is a profitable sale. Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These fields rely heavily on accounting knowledge to analyze financial statements. In fact, it is difficult to get a good job in a finance function without two or three courses in accounting. Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank—is almost always involved in financing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash flow from an industrial property justify the purchase price? What are the tax benefits of the purchase? How might accounting help you? (See page 42.) ETHICS IN FINANCIAL REPORTING People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t “play” the stock market if they think stock prices are rigged. At one time, the financial press was full of articles about financial scandals at Enron, WorldCom, HealthSouth, and AIG. As more scandals came to light, a mistrust of financial reporting in general seemed to be developing. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.”1 Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting. United States regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting. Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now certify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Also, SOX increased the independence of the outside auditors who review the accuracy of corporate financial statements, and increased the oversight role of boards of directors. Ethics Note Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook. (1) A number of the Feature Stories and other parts of the text discuss the central importance of ethical behavior to financial reporting. (2) Ethics Insight boxes and marginalEthics Notes highlight ethics situations and issues in actual business settings. (3) Many of thePeople, Planet, and Profit Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. (4) At the end of the chapter, an Ethics Casesimulates a business situation and asks you to put yourself in the position of a decision-maker in that case. When analyzing these various ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1-3. Illustration 1-3: Steps in analyzing ethics cases Ethics Insight: The Numbers Behind Notfor-Profit Organizations Accounting plays an important role for a wide range of business organizations worldwide. Just as the integrity of the numbers matters for business, it matters at least as much at 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 organization if they think the organization is subject to waste or theft. The accounting challenges of some large international not-for-profits rival those of the world’s largest businesses. 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. In response, he hired a new accountant and improved the transparency regarding funds raised and spent. Gemunu Amarasinghe/AP Photo What benefits does a sound accounting system provide to a not-for-profit organization? (Seepage 43.) Insights provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Business Activities All businesses are involved in three types of activity—financing, investing, and operating. For example, Leo Hirshfield, the founder of Tootsie Roll, obtained 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 theoperating activities of making and selling candy. LEARNING OBJECTIVE 3 Explain the three principal types of business activity. The accounting information system keeps track of the results of each of the various business activities—financing, investing, and operating. Let’s look at each type of business activity in more detail. FINANCING ACTIVITIES It takes money to make money. The two primary sources of outside funds for corporations are borrowing money (debt financing) and issuing (selling) shares of stock in exchange for cash (equity financing). Tootsie Roll may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom 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 securities sold to investors that must be repaid at a particular date some years in the future are bonds payable. Essential terms are printed in blue. They are defined again in the glossary at the end of the chapter. Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase. The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a payment schedule (e.g., payment at the end of three months). As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may legally force the company to sell property to pay its debts. In the case of financial difficulty, creditor claims must be paid before stockholders’ claims. Stockholders, on the other hand, have no claim to corporate cash until the claims of creditors are satisfied. Suppose you buy a company’s stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company’s creditors are paid. However, many corporations make payments to stockholders on a regular basis as long as there is sufficient cash to cover required payments to creditors. These cash payments to stockholders are called dividends. INVESTING ACTIVITIES Once the company has raised cash through financing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. A growing company purchases many resources, such as computers, delivery trucks, furniture, and buildings. Resources owned by a business are called assets. Different types of assets are given different names. For example, 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 choose to invest in securities (stocks or bonds) of other corporations. Investments are another example of an investing activity. Alternative Terminology Property, plant, and equipment is sometimes called fixed assets. OPERATING ACTIVITIES Once a business has the assets it needs to get started, it begins operations. 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 Apple Pops, Mason Dots, Mason Crows, Sugar Daddy, and Sugar Babies. We call amounts earned on the sale of these products revenues. Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business. For example, 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 interest revenue on debt securities held as investments. Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue. The company purchases its longer-lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operating activities. For example, supplies are assets used in day-to-day operations. Goods available for future sales to customers are assets calledinventory. 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 ingredients, 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 depending 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); administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corporate office);interest expense (amounts of interest paid on various debts); and income taxes (corporate taxes paid to the government). Tootsie Roll may also have liabilities arising from these expenses. For example, it may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable. Additionally, 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. BUSINESS ACTIVITIES Classify each item as an asset, liability, common stock, revenue, or expense. • • • • • • 1. Cost of renting property. 2. Truck purchased. 3. Notes payable. 4. Issuance of ownership shares. 5. Amount earned from performing service. 6. Amounts owed to suppliers. Action Plan • Classify each item based on its economic characteristics. Proper classification of items is critical if accounting is to provide useful information. Solution • • • • • • 1. Cost of renting property: Expense. 2. Truck purchased: Asset. 3. Notes payable: Liabilities. 4. Issuance of ownership shares: Common stock. 5. Amount earned from performing service: Revenue. 6. Amounts owed to suppliers: Liabilities. Related exercise material: BE1-3, 1-2, and E1-3. 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: LEARNING OBJECTIVE 4 Describe the content and purpose of each of the financial statements. • • • • • To show how successfully your business performed during a period of time, you report its revenues and expenses in an income statement. • To indicate how much of previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth, you present a retained earnings statement. • To present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities), you prepare a balance sheet. • To show where your business obtained cash during a period of time and how that cash was used, you present a statement of cash flows. International Note The primary types of financial statements required by International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same. Neither IFRS nor GAAP is very specific regarding format requirements for the primary financial statements. However, in practice, some format differences do exist in presentations commonly employed by IFRS companies as compared to GAAP companies. To introduce you to these statements, we have prepared the financial statements for your outdoor guide service, Sierra Corporation, after your first month of operations. To summarize, you officially started your business in Truckee, California, on October 1, 2014. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe outdoor day trips, such as rafting, snowshoeing, and hiking, as well as multi-day backcountry experiences. To minimize your initial investment, at this point the company has limited outdoor equipment for customer use. Instead, your customers either bring their own equipment or rent equipment through local outfitters. The financial statements for Sierra’s first month of business are provided in the following pages. INCOME STATEMENT The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time. To indicate that its income statement reports the results of operations for aspecific period of time, Sierra dates the income statement “For the Month Ended October 31, 2014.” The income statement lists the company’s revenues followed by its expenses. Finally, Sierra determines the net income (or net loss) by deducting expenses from revenues. Sierra Corporation’s income statement is shown in Illustration 1-4. Congratulations, you are already showing a profit! Illustration 1-4: Sierra Corporation’s income statement SIERRA CORPORATION Income Statement For the Month Ended October 31, 2014 Revenues Service revenue $10,600 Expenses Salaries and wages expense $5,200 Rent expense 900 Supplies expense 1,500 Depreciation expense 40 Interest expense 50 Insurance expense 50 Total expenses 7,740 Net income $ 2,860 Helpful Hint The financial statement heading identifies the company, the type of statement, and the time period covered. Sometimes, another line indicates the unit of measure, e.g., “in thousands” or “in millions.” Why are financial statement users interested in net income? Investors are interested in a company’s past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company’s future performance. If investors believe that Sierra will be successful in the future and that this will result in a higher stock price, they will buy its stock. Creditors also use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn’t think it would be repaid, it wouldn’t loan the money. Therefore, prior to making the loan the bank loan officer uses the income statement as a source of information to predict whether the company will be profitable enough to repay its loan. Thus, reporting a strong profit will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing. 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. Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (seeIllustration 1-7), nor does it regard as a business expense the $500 of dividends paid (seeIllustration 1-5). DECISION TOOLKIT DECISION CHECKPOINTS INFO NEEDED FOR DECISION Are the company’s Income operations profitable? statement TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time. If the company’s revenue exceeds its expenses, it will report net income; otherwise, it will report a net loss. Decision Toolkits summarize the financial decision-making process. 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 current-period profits, but few companies do this. Why? Because they want to retain part of the profits to allow for further expansion. High-growth companies, such as Google and Facebook, often pay no dividends. Retained earnings is the net income retained in the corporation. The retained earnings statement shows the amounts and causes of changes in retained earnings for a specific time period. The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the first line of the statement. Then, the company adds net income and deducts dividends to determine the retained earnings at the end of the period. If a company has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1-5 presents Sierra Corporation’s retained earnings statement. Illustration 1-5: Sierra Corporation’s retained earnings statement SIERRA CORPORATION Retained Earnings Statement For the Month Ended October 31, 2014 Retained earnings, October 1 Add: Net income Less: Dividends Retained earnings, October 31 $ 0 2,860 2,860 500 $2,360 Helpful Hint The heading of this statement identifies the company, the type of statement, and the time period covered by the 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 company’s growth instead of paying dividends. Lenders monitor their corporate customers’ dividend payments because any money paid in dividends reduces a company’s ability to repay its debts. DECISION TOOLKIT DECISION CHECKPOINTS What is the company’s policy toward dividents and growth? INFO NEEDED FOR DECISION Retained earnings statement TOOL TO USE FOR DECISION How much of this year’s income did the company pay out in dividends to shareholders? HOW TO EVALUATE RESULTS A company striving for rapid growth will pay a low (or no) dividend. 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. The owners’ claim to assets is called stockholders’ equity. LEARNING OBJECTIVE 5 Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation. Illustration 1-6 shows the relationship among the categories on the balance sheet in equation form. This equation is referred to as the basic accounting equation. Illustration 1-6: Basic accounting equation Assets = Liabilities + Stockholders’ Equity 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, 2014. It lists assets first, followed by liabilities and stockholders’ equity. Stockholders’ equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the company sells new shares of stock; retained earnings is the net income retained in the corporation. Sierra has common stock of $10,000 and retained earnings of $2,360, for total stockholders’ equity of $12,360. Alternative Terminology Liabilities are also referred to as debt. Illustration 1-7: Sierra Corporation’s balance sheet SIERRA CORPORATION Balance Sheet October 31, 2014 Assets Cash Accounts receivable Supplies Prepaid insurance Equipment, net Total assets Liabilities and Stockholders’ Equity Liabilities Notes payable Accounts payable Unearned service revenue $15,200 200 1,000 550 4,960 $21,910 $ 5,000 2,500 800 SIERRA CORPORATION Balance Sheet October 31, 2014 Salaries and wages payable 1,200 Interest payable 50 Total liabilities $ 9,550 Stockholders’ equity Common stock 10,000 Retained earnings 2,360 Total stockholders’ equity 12,360 Total liabilities and stockholders’ equity $21,910 Helpful Hint The heading of a balance sheet must identify the company, the statement, and the date. 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 immediate cash needs. The balance sheet will also be used to evaluate the relationship between debt and stockholders’ equity to determine whether the company has a satisfactory proportion of debt and common stock financing. DECISION TOOLKIT DECISION CHECKPOINTS Does the company rely primarily on debt or stockholders’ equity to finance its assets? INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION The balance sheet reports the company’s resources and claims to those Balance sheet resources. There are two types of claims: liabilities and stockholders’ equity. HOW TO EVALUATE RESULTS 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. STATEMENT OF CASH FLOWS The primary purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. 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. The statement of cash flows provides answers to these simple but important questions: • • Where did cash come from during the period? • • • How was cash used during the period? • What was the change in the cash balance during the period? Illustration 1-8: Sierra Corporation’s statement of cash flows SIERRA CORPORATION Statement of Cash Flows For the Month Ended October 31, 2014 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 Cash flows from investing activities Purchased office equipment (5,000) Net cash used by investing activities Cash flows from financing activities Issuance of common stock 10,000 Issuance of note payable 5,000 Payment of dividend (500) Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period $ 5,700 (5,000) 14,500 15,200 0 $15,200 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. 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 activities (services to clients) increased cash $5,700, and financing activities increased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment. People, Planet, and Profit Insight: Beyond Financial Statements Should we expand our corporate reports beyond the income statement, retained earnings statement, balance sheet, and statement of cash flows? Some believe we should take into account ecological and social performance, in addition to financial results, in evaluating a company. The argument is that a company’s responsibility lies with anyone who is influenced by its actions. In other words, a company should be interested in benefiting many different parties, instead of only maximizing stockholders’ interests. © Marek Uliasz/iStockphoto A socially responsible business does not exploit or endanger any group of individuals. It follows fair trade practices, provides safe environments for workers, and bears responsibility for environmental damage. Granted, measurement of these factors is difficult. How to report this information is also controversial. But many interesting and useful efforts are underway. Throughout this textbook, we provide additional insights into how companies are attempting to meet the challenge of measuring and reporting their contributions to society, as well as their financial results, to stockholders. Why might a company’s stockholders be interested in its environmental and social performance? (See page 43.) DECISION TOOLKIT INFO DECISION NEEDED TOOL TO USE FOR CHECKPOINTS FOR DECISION DECISION The statement of cash Does the company flows shows the generate sufficient cash Statement of amount of cash from operations to fund cash flows provided or used by its investing activities? operating activities, investing activities, HOW TO EVALUATE RESULTS 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 DECISION CHECKPOINTS INFO NEEDED TOOL TO USE FOR HOW TO EVALUATE FOR DECISION RESULTS DECISION and financing made up with cash from activities. financing activities. 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 2011 is $43,938,000, not $43,938. Because the results on some financial statements become inputs to other statements, the statements are interrelated. These interrelationships can be seen in Tootsie Roll’s financial statements, as follows. • 1. The retained earnings statement uses the results of the income statement. Tootsie Roll reported net income of $43,938,000 for the period. Net income is added to the beginning amount of retained earnings to determine ending retained earnings. Illustration 1-9: Tootsie Roll’s financial statements • • 2. The balance sheet and retained earnings statement are also interrelated. Tootsie Roll reports the ending amount of $114,269,000 on the retained earnings statement as the retained earnings amount on the balance sheet. 3. Finally, the statement of cash flows relates to information on the balance sheet. The statement of cash flows shows how the Cash account changed during the period. It shows the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the $78,612,000 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. FINANCIAL STATEMENTS CSU Corporation began operations on January 1, 2014. The following information is available for CSU Corporation on December 31, 2014: Accounts receivable 1,800 Retained earnings ? Supplies expense 200 Accounts payable Rent expense Notes payable Common stock 2,000 9,000 5,000 10,000 Equipment 16,000 Cash Insurance expense 1,000 Dividends Service revenue 17,000 Supplies 4,000 1,400 600 Prepare an income statement, a retained earnings statement, and a balance sheet. Action Plan • • • Report the revenues and expenses for a period of time in an income statement. Show the amounts and causes (net income and dividends) of changes in retained earnings during the period in the retained earnings statement. Present the assets and claims to those assets (liabilities and equity) at a specific point in time in the balance sheet. Solution CSU CORPORATION Income Statement For the Year Ended December 31, 2014 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, 2014 Retained earnings, January 1 $ 0 Add: Net income 6,800 6,800 Less: Dividends 600 CSU CORPORATION Income Statement For the Year Ended December 31, 2014 Retained earnings, December 31 $6,200 CSU CORPORATION Balance Sheet December 31, 2014 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, BE110, 1-3, E1-4, E1-5, E1-6, E1-7, E1-8, E1-9, E1-10, E1-11, and E1-14. OTHER ELEMENTS OF AN ANNUAL REPORT Publicly traded U.S. companies must provide shareholders with an annual report. The annual report always includes the financial statements introduced in this chapter. The annual report also includes other important information such as a management discussion and analysis section, notes to the financial statements, and an independent auditor’s report. No analysis of a company’s financial situation and performance is complete without a review of these items. LEARNING OBJECTIVE 6 Describe the components that supplement the financial statements in an annual report. Management Discussion and Analysis The management discussion and analysis (MD&A) section presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. Management must highlight favorable or unfavorable trends and identify significant events and uncertainties that affect these three factors. This discussion obviously involves a number of subjective estimates and opinions. A brief excerpt from the MD&A section ofTootsie Roll’s annual report is presented in Illustration 1-10. 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 financing needs, including capital expenditures, in 2012. Notes to the Financial Statements Explanatory notes and supporting schedules accompany every set of financial statements and are an integral part of the statements. The notes to the financial statements clarify the financial statements, and provide additional detail. Information in the notes does not have to be quantifiable (numeric). Examples of notes are descriptions of the significant accounting policies and methods used in preparing the statements, explanations of uncertainties and contingencies, and various statistics and details too voluminous to be included in the statements. The notes are essential to understanding a company’s operating performance and financial position. Illustration 1-11 is an excerpt from the notes to Tootsie Roll’s financial statements. It describes the methods that Tootsie Roll uses to account for revenues. Illustration 1-11: Notes to Tootsie Roll’s financial statements 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 customers based on a customer purchase order, and collectibility is reasonably assured. Auditor’s Report An auditor’s report is prepared by an independent outside auditor. It states the auditor’s opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles. An auditor is an accounting professional who conducts an independent examination of a company’s financial statements. Only accountants who meet certain criteria and thereby attain the designation certified public accountant (CPA) may perform audits. If the auditor is satisfied that the financial statements provide a fair representation of the company’s financial position and results of operations in accordance with generally accepted accounting principles, then the auditor expresses an unqualified opinion. If the auditor expresses anything other than an unqualified opinion, then readers should only use the financial statements with caution. That is, without an unqualified opinion, we cannot have complete confidence that the financial statements give an accurate picture of the company’s financial health. For example, recently 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 2011 annual report. Tootsie Roll received an unqualified opinion from its auditor, 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 position of Tootsie Roll Industries, Inc. and its subsidiaries at December 31, 2011 and December 31, 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011 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, 2011, 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 State whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the financial statements, or the auditor’s report. • • • • • • 1. Descriptions of significant accounting policies. 2. Unqualified opinion. 3. Explanations of uncertainties and contingencies. 4. Description of ability to fund operations and expansion. 5. Description of results of operations. 6. Certified public accountant (CPA). Action Plan • • Realize that financial statements provide information about a company’s performance and financial position. Be familiar with the other elements of the annual report in order to gain a fuller understanding of a company. Solution • 1. Descriptions of significant accounting policies: Notes. • 2. Unqualified opinion: Auditor’s report. 3. Explanations of uncertainties and contingencies: Notes. • • • • 4. Description of ability to fund operations and expansion: MD&A. 5. Description of results of operations: MD&A. 6. Certified public accountant (CPA): Auditor’s report. Related exercise material: BE1-11, 1-4, and E1-17. USING THE DECISION TOOLKIT The Hershey Company, located in Hershey, Pennsylvania, is the leading North American manufacturer of chocolate. Its products include Hershey’s Kisses, Reese’s Peanut Butter Cups, Kit Kat, and Take 5 bars. Imagine that you are considering the purchase of shares of Hershey’s common stock. Instructions Answer these questions related to your decision whether to invest. • (a) What financial statements should you evaluate? • (b) What should these financial statements tell you? (c) Do you care if the financial statements have been audited? Explain. • • (d) Appendix B at the end of this textbook 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? Using the Decision Toolkit exercises ask you to use information from financial statements to make financial decisions. Solution • • (a) Before you invest, you should evaluate the income statement, retained earnings statement, balance sheet, and statement of cash flows. (b) You would probably be most interested in the income statement because it tells about past performance and thus gives an indication of future performance. The retained earnings statement provides a record of the company’s dividend history. The balance sheet reveals the relationship between assets and liabilities. The statement of cash flows reveals where the company is getting and spending its cash. This is especially important for a company that wants to grow. • • (c) You would want audited financial statements. These statements indicate that a CPA (certified public accountant) has examined and expressed an opinion that the statements present fairly the financial position and results of operations of the company. Investors and creditors should not make decisions without studying audited financial statements. (d) Many interesting comparisons can be made between the two companies. Tootsie Roll is smaller, with total assets of $857,856,000 versus $4,412,199,000 for Hershey, and it has lower revenue—$532,505,000 versus $6,080,788,000 for Hershey. In addition, Tootsie Roll’s cash provided by operating activities of $50,390,000 is less than Hershey’s $580,867,000. 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. Summary of Learning Objectives • • • • • 1 Describe the primary forms of business organization. A sole proprietorship is a business owned by one person. A partnership is a business owned by two or more people associated as partners. A corporation is a separate legal entity for which evidence of ownership is provided by shares of stock. 2 Identify the users and uses of accounting information. Internal users are managers who need accounting information to plan, organize, and run business operations. The primary external users are investors and creditors. Investors (stockholders) use accounting information to help them decide whether to buy, hold, or sell shares of a company’s stock. Creditors (suppliers and bankers) use accounting information to assess the risk of granting credit or loaning money to a business. Other groups who have an indirect interest in a business are taxing authorities, customers, labor unions, and regulatory agencies. 3 Explain the three principal types of business activity. Financing activities involve collecting the necessary funds to support the business. Investing activities involve acquiring the resources necessary to run the business. Operating activities involve putting the resources of the business into action to generate a profit. 4 Describe the content and purpose of each of the financial statements. An income statement presents the revenues and expenses of a company for a specific period of time. A retained earnings statement summarizes the changes in retained earnings that have occurred for a specific period of time. A balance sheet reports the assets, liabilities, and stockholders’ equity of a business at a specific date. A statement of cash flows summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time. 5 Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation. Assets are resources owned by a business. Liabilities are the debts and obligations of the business. Liabilities represent claims of creditors on the assets of the • business. Stockholders’ equity represents the claims of owners on the assets of the business. Stockholders’ equity is subdivided into two parts: common stock and retained earnings. The basic accounting equation is Assets = Liabilities + Stockholders’ Equity. 6 Describe the components that supplement the financial statements in an annual report.The management discussion and analysis provides management’s interpretation of the company’s results and financial position as well as a discussion of plans for the future. Notes to the financial statements provide additional explanation or detail to make the financial statements more informative. The auditor’s report expresses an opinion as to whether the financial statements present fairly the company’s results of operations and financial position. DECISION TOOLKIT A SUMMARY DECISION CHECKPOINTS Are the company’s operations profitable? INFO NEEDED FOR DECISION Income statement TOOL TO USE FOR DECISION The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time. HOW TO EVALUATE RESULTS If the company’s revenue exceeds its expenses, it will report net income; otherwise, it will report a net loss. DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION How much of this year’s income did the company pay out in dividends to shareholders? The balance sheet reports the company’s Does the company rely resources and claims to primarily on debt or Balance sheet those resources. There stockholders’ equity to are two types of claims: finance its assets? liabilities and stockholders’ equity. What is the company’s Retained policy toward dividends earnings and growth? statement HOW TO EVALUATE RESULTS A company striving for rapid growth will pay a low (or no) dividend. 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. Compare the amount of cash The statement of cash provided by operating Does the company flows shows the amount activities with the amount of generate sufficient cash Statement of of cash provided or used cash used by investing from operations to fund cash flows by operating activities, activities. Any deficiency in its investing activities? investing activities, and cash from operating activities financing activities. must be made up with cash from financing activities. Glossary Accounting (p. 6) The information system that identifies, 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 including financial statements, a management discussion and analysis section, notes, and an independent auditor’s report. Assets (p. 10) Resources owned by a business. Auditor’s report (p. 20) A report prepared by an independent outside auditor stating the auditor’s opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles. Balance sheet (p. 14) A financial statement that reports the assets and claims to those assets at a specific point in time. Basic accounting equation (p. 14) Assets = Liabilities + Stockholders’ Equity. Certified public accountant (CPA) (p. 20) An individual 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 owned by stockholders. Dividends (p. 10) Payments of cash from a corporation to its stockholders. Expenses (p. 10) The cost of assets consumed or services used in the process of generating revenues. Income statement (p. 12) A financial statement that reports a company’s revenues and expenses and resulting net income or net loss for a specific period of time. Liabilities (p. 9) Amounts owed to creditors in the form of debts and other obligations. Management discussion and analysis (MD&A) (p. 19) A section of the annual report that presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. Net income (p. 11) The amount by which revenues exceed expenses. Net loss (p. 11) The amount by which expenses exceed revenues. Notes to the financial statements (p. 20) Notes clarify information presented in the financial statements and provide additional detail. 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 statement that summarizes the amounts and causes of changes in retained earnings for a specific time period. Revenue (p. 10) The increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business. Sarbanes-Oxley Act (SOX) (p. 8) Regulations passed by Congress 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 receipts and cash payments of a business for a specific period of time. Stockholders’ equity (p. 14) The owners’ claim to assets. 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. The Comprehensive Do it! is a final review before you begin homework. 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 corporate bank account at December 31, 2014, was $49,500. 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.) 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 stockholders’ 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. Solution to Comprehensive ICE CAMP Income Statement For the Year Ended December 31, 2014 Revenues Service revenue $100,000 Expenses Salaries and wages expense $20,000 ICE CAMP Income Statement For the Year Ended December 31, 2014 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, 2014 Retained earnings, January 1, 2014 $ 0 Add: Net income 52,200 52,200 Less: Dividends 5,000 Retained earnings, December 31, 2014 $47,200 ICE CAMP Balance Sheet December 31, 2014 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 ICE CAMP Balance Sheet December 31, 2014 Total liabilities and stockholders’ equity ICE CAMP $83,000 Statement of Cash Flows For the Year Ended December 31, 2014 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 Cash flows from investing activities Purchase of equipment (13,500) Net cash used by investing activities 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 Net increase in cash Cash at beginning of period Cash at end of period $33,000 (13,500) 30,000 49,500 0 $49,500 WileyPLUS Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS. This would be a good time to look at the Preface to this textbook. Knowing the purpose of the different types of homework will help you understand what each contributes to your accounting skills and competencies. Self-Test Questions Answers are on page 43. 1. Which is not one of the three forms of business organization? (LO 1) • • • • (a)Sole proprietorship. (b)Creditorship. (c)Partnership. (d)Corporation. 2. Which is an advantage of corporations relative to partnerships and sole proprietorships? (LO 1) • • • • (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 information is incorrect? (LO 2) • • • (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? (LO 2) • • (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? (LO 3) • • (a)Financing. (b)Operating. (c)Advertising. • (d)Investing. • 6. Which of the following is an example of a financing activity? (LO 3) • • (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: (LO 4) • (a)assets exceed liabilities. • • • (b)assets exceed revenues. (c)expenses exceed revenues. (d)revenues exceed expenses. 8. The financial statements for Joseph Corporation contained the following information. (LO 4) Accounts receivable Sales revenue Cash Salaries and wages expense Rent expense $ 5,000 75,000 15,000 20,000 10,000 What was Joseph Corporation’s net income? • • • • (a)$60,000. (b)$15,000. (c)$65,000. (d)$45,000. 9. What section of a statement of cash flows indicates the cash spent on new equipment during the past accounting period? (LO 4, 5) • (a)The investing activities section. • (b)The operating activities section. • (c)The financing activities section. • (d)The statement of cash flows does not give this information. 10. Which statement presents information as of a specific point in time? (LO 4, 5) • (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? (LO 5) • • (a)Income statement. (b)Retained earnings statement. • (c)Balance sheet. • (d)Statement of cash flows. 12. Stockholders’ equity represents: (LO 5) • (a)claims of creditors. • (b)claims of employees. • (c)the difference between revenues and expenses. • (d)claims of owners. 13. As of December 31, 2014, Stoneland Corporation has assets of $3,500 and stockholders’ equity of $1,500. What are the liabilities for Stoneland Corporation as of December 31, 2014? (LO 5) • (a)$1,500. • (b)$1,000. • (c)$2,500. • (d)$2,000. 14. The element of a corporation’s annual report that describes the corporation’s accounting methods is/are the: (LO 6) • (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: (LO 6) • • • • (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 additional Self-Test Questions. 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 Finzelberg. Indicate in which financial statement(s) each item would appear. • • • • • (a)Service revenue. (b)Equipment. (c)Advertising expense. (d)Accounts receivable. (e)Common stock. • (f)Interest payable. 9. Why would a bank want to monitor the dividend payment practices of the corporations to which it lends money? 10. “A company’s net income appears directly on the income 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 statement 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 stockholders’ equity. • (b)What items affect stockholders’ equity? 16. Which of these items are liabilities of White Glove Cleaning Service? • (a)Cash. • (b)Accounts payable. • (c)Dividends. • (d)Accounts receivable. • (e)Supplies. • (f)Equipment. • (g)Salaries and wages payable. • (h)Service revenue. • (i)Rent expense. 17. How are each of the following financial statements interrelated? (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 textbook, reproduces Tootsie Roll’s financial statements. Replacing words in the equation with dollar amounts, what is Tootsie Roll’s accounting equation at December 31, 2011? The tool icon indicates that an activity employs one of the decision tools presented in the chapter. The indicates that an activity relates to a business function beyond accounting. The pencil icon indicates that an activity requires written communication. Brief Exercises BE1-1 Match each of the following forms of business organization with a set of characteristics: sole proprietorship (SP), partnership (P), corporation (C). Describe forms of business organization. (LO 1), K • • • (a) ____________ Shared control, tax advantages, increased skills and resources. (b) ____________ Simple to set up and maintains control with owner. (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. Identify users of accounting information. (LO 2), K • • • • • • • • 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 advertising 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. (b) ____________ Marketing managers. (c) ____________ Creditors. • • (d) ____________ Chief Financial Officer. (e) ____________ Internal Revenue Service. 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). Classify items by activity. (LO 3), K • • • • • (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 transaction affects common stock (C), dividends (D), revenue (R), expense (E), or does not affect stockholders’ equity (NSE). Provide titles for the revenues and expenses. Determine effect of transactions on stockholders’ equity. (LO 4), C • • • • • • • • • (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) Cash received from investors. BE1-5 In alphabetical order below are balance sheet items for Burnett Company at December 31, 2014. Prepare a balance sheet following the format of Illustration 17 (page 14). Prepare a balance sheet. (LO 4, 5), AP Accounts payable $65,000 Accounts receivable 71,000 Cash 22,000 Common stock 18,000 Retained earnings 10,000 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). Determine where items appear on financial statements. (LO 4, 5), K • (a) ____________ Income tax expense. • (b) ____________ Inventory. (c) ____________ Accounts payable. (d) ____________ Retained earnings. (e) ____________ Equipment. (f) ____________ Sales revenue. (g) ____________ Cost of goods sold. (h) ____________ Common stock. (i) ____________ Accounts receivable. (j) ____________ Interest expense. • • • • • • • • BE1-7 Indicate which statement you would examine to find each of the following items: income statement (IS), balance sheet (BS), retained earnings statement (RES), or statement of cash flows (SCF). Determine proper financial statement. (LO 4), K • • • • (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. Use basic accounting equation. (LO 5), AP • • • (a) The liabilities of Jantz Company are $90,000 and the stockholders’ equity is $230,000. What is the amount of Jantz Company’s total assets? (b) The total assets of Foley Company are $170,000 and its stockholders’ equity is $80,000. What is the amount of its total liabilities? (c) The total assets of Sundberg Co. are $800,000 and its liabilities are equal to one-fourth of its total assets. What is the amount of Sundberg Co.’s stockholders’ equity? BE1-9 At the beginning of the year, Goren Company had total assets of $800,000 and total liabilities of $500,000. (Treat each item independently.) Use basic accounting equation. (LO 5), AP • (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). Identify assets, liabilities, and stockholders’ equity. (LO 5), K • • • • • • (a) Accounts receivable. (b) Salaries and wages payable. (c) Equipment. (d) Supplies. (e) Common stock. (f) Notes payable. BE1-11 Which is not a required part of an annual report of a publicly traded company? Determine required parts of annual report. (LO 6), K • (a) Statement of cash flows. • (b) Notes to the financial statements. (c) Management discussion and analysis. (d) All of these are required. • • Review 1-1 Identify each of the following organizational characteristics with the organizational form or forms with which it is associated. Identify benefits of business organization forms. (LO 1), C • • • • (a) Easier to transfer ownership. (b) Easier to raise funds. (c) More owner control. (d) Tax advantages. • (e) No personal legal liability. 1-2 Classify each item as an asset, liability, common stock, revenue, or expense. Classify business activities. (LO 3), K • (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. • • • • 1-3 Marsh Corporation began operations on January 1, 2014. The following information is available for Marsh Corporation on December 31, 2014. Prepare financial statements. (LO 4, 5), AP Accounts payable $ 5,000 Accounts receivable 2,000 Advertising expense 4,000 Cash 3,100 Common stock 15,000 Dividends 2,500 Equipment 26,800 Notes payable $ 7,000 Rent expense 10,000 Retained earnings ? Service revenue 25,000 Supplies 1,900 Supplies expense 1,700 Prepare an income statement, a retained earnings statement, and a balance sheet for Marsh 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 statements, or the auditor’s report. Identify components of annual reports. (LO 6), C • • • • • • (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. Exercises E1-1 Here is a list of words or phrases discussed in this chapter: Match items with descriptions. (LO 1, 2, 4, 6), K • • • • • • • • 1. Corporation 2. Creditor 3. Accounts receivable 4. Partnership 5. Stockholder 6. Common stock 7. Accounts payable 8. Auditor’s opinion Instructions Match each word or phrase with the best description of it. • • • • • • • • _______ (a) An expression about whether financial statements conform with generally accepted accounting principles. _______ (b) A business 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. Identify business activities. (LO 3), C • 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? E1-3 The Clear View Golf & Country Club details the following accounts in its financial statements. Classify accounts. (LO 3, 4), C (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 Molina Co. for the year 2014. Prepare income statement and retained earnings statement. (LO 4), AP Retained earnings, January 1, 2014 $67,000 Advertising expense 1,800 Dividends 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, 2014. E1-5 Suppose the following information was taken from the 2014 financial statements of pharmaceutical giant Merck and Co. (All dollar amounts are in millions.) Prepare income statement and retained earnings statement. (LO 4), AP Retained earnings, January 1, 2014 $43,698.8 Cost of goods sold 9,018.9 Selling and administrative expenses 8,543.2 Dividends 3,597.7 Sales revenue 38,576.0 Research and development expense 5,845.0 Income tax expense 2,267.6 Instructions • • (a) After analyzing the data, prepare an income statement and a retained earnings statement for the year ending December 31, 2014. (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 implications? How do you think the stock market would react? E1-6 Presented here is information for DeVito Inc. for 2014. Prepare a retained earnings statement. (LO 4), AP Retained earnings, January 1 $130,000 Service revenue 400,000 Total expenses 175,000 Dividends 65,000 Instructions Prepare the 2014 retained earnings statement for DeVito Inc. E1-7 Consider each of the following independent situations. Interpret financial facts. (LO 4), AP • • (a) The retained earnings statement of Grant Corporation shows dividends of $68,000, while net income for the year was $75,000. (b) The statement of cash flows for Remington 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 example, you might discuss the company’s financial health or its apparent growth philosophy. E1-8 The following items and amounts were taken from Motte Inc.’s 2014 income statement and balance sheet. Identify financial statement components and prepare income statement. (LO 4, 5), C ____________ Cash ____________ Retained earnings ____________ Cost of goods sold ____________ Salaries and wages expense $ 84,700 123,192 438,458 ____________ Accounts receivable ____________ Sales revenue ____________ Notes payable $ 88,419 584,951 6,499 115,131 ____________ Accounts payable 49,384 ____________ Prepaid insurance ____________ Inventory 7,818 64,618 ____________ Service revenue ____________ Interest expense 4,806 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 Motte Inc. for the year ended December 31, 2014. E1-9 Here are incomplete financial statements for Riedy, Inc. Calculate missing amounts. (LO 4, 5), AP RIEDY, INC. Balance Sheet Assets Liabilities and Stockholders’ Equity Cash $ 7,000 Liabilities Inventory 10,000 Accounts payable $ 5,000 Buildings 45,000 Stockholders’ equity Total assets $62,000 Common stock (a) Retained earnings (b) Total liabilities and stockholders’ equity $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 Flint Hills Park is a private camping ground near the Lathom Peak Recreation Area. It has compiled the following financial information as of December 31, 2014. Compute net income and prepare a balance sheet. (LO 4, 5), AP Service revenue (from camping fees) $132,000 Sales revenue (from general store) 25,000 Accounts payable 11,000 Cash 8,500 Equipment 114,000 Dividends $ 9,000 Notes payable 50,000 Expenses during 2014 126,000 Supplies 5,500 Common stock 40,000 Retained earnings (1/1/2014) 5,000 Instructions • (a) Determine Flint Hills Park’s net income for 2014. • (b) Prepare a retained earnings statement and a balance sheet for Flint Hills Park as of December 31, 2014. (c) Upon seeing this income statement, Joe Winsor, the campground manager, immediately 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. Suppose the following items were taken from its 2014 income statement and balance sheet. (All dollars are in millions.) Identify financial statement components and prepare an income statement. (LO 4, 5), AP ____ Retained earnings $5,481 ____ Cost of goods sold 7,184 ____ Selling and administrative expenses 3,390 ____ Bonds payable ____ Inventory ____ Sales revenue $ 4,835 910 12,575 ____ Cash ____ Notes payable ____ Interest expense 334 44 295 ____ Accounts payable 1,077 ____ Common stock 105 ____ Income tax expense 498 Instructions Perform each of the following. • (a) In each case, identify whether the item is an asset (A), liability (L), stockholders’ equity • (SE), revenue (R), or expense (E). (b) Prepare an income statement for Kellogg Company for the year ended December 31, 2014. E1-12 This information is for Dyckman Corporation for the year ended December 31, 2014. Prepare a statement of cash flows. (LO 5), AP 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 1/1/14 12,000 Instructions • • (a) Prepare the 2014 statement of cash flows for Dyckman Corporation. (b) Suppose you are one of Dyckman’s creditors. Referring to the statement of cash flows, evaluate Dyckman’s ability to repay its creditors. E1-13 Suppose the following data are derived from the 2014 financial statements of Southwest Airlines. (All dollars are in millions.) Southwest has a December 31 yearend. Prepare a statement of cash flows. (LO 5), AP Cash balance, January 1, 2014 $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, 2014. (b) Discuss whether the company’s net cash provided by operating activities was sufficient to finance its investing activities. If it was not, how did the company finance its investing activities? E1-14 Edward Waltz is the bookkeeper for Edminson Company. Edward has been trying to get the balance sheet of Edminson Company to balance. It finally balanced, but now he’s not sure it is correct. Correct an incorrectly prepared balance sheet. (LO 5), AP EDMINSON COMPANY Balance Sheet Assets Cash $18,000 Supplies 9,500 Equipment 40,000 Dividends 8,000 Total assets $75,500 December 31, 2014 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 Instructions Prepare a correct balance sheet. E1-15 Suppose the following items were taken from the balance sheet of Nike, Inc. (All dollars are in millions.) Classify items as assets, liabilities, and stockholders’ equity and prepare accounting equation. (LO 5), AP 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Cash $2,291.1 Accounts receivable 2,883.9 Common stock 2,874.2 Notes payable 342.9 Buildings 3,759.9 Mortgage payable 1,311.5 Inventory $2,357.0 Income taxes payable 86.3 Equipment 1,957.7 Retained earnings 5,818.9 11. Accounts payable 2,815.8 Instructions Perform each of the following. • • • (a) Classify each of these items as an asset, liability, or stockholders’ equity and determine the total dollar amount for each classification. (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, Colaw Corporation and Hunter Enterprises, are presented on the next page for 2014. Use financial statement relationships to determine missing amounts. (LO 5), AP Colaw Corporation Hunter Enterprises Beginning of year Total assets $110,000 Total liabilities 70,000 Total stockholders’ equity (a) End of year Total assets (b) Total liabilities 120,000 Total stockholders’ equity 60,000 Changes during year in retained earnings Dividends (c) Total revenues 215,000 Total expenses 165,000 $150,000 (d) 70,000 180,000 55,000 (e) 5,000 (f) 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, including the following. Classify various items in an annual report. (LO 6), K • 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 presented. If the item would probably not be found in an annual report, state “Not disclosed.” • • • • • • (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. Determine forms of business organization. (LO 1), C • • • • (a) Three physics professors at MIT have formed a business to improve the speed of information transfer over the Internet for stock exchange transactions. Each has contributed an equal amount of cash and knowledge to the venture. Although their approach looks promising, they are concerned about the legal liabilities that their business might confront. (b) Al Bolt, a college student looking for summer employment, opened a bait shop in a small shed at a local marina. (c) Rita Benedict and Joe Freeze 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) Andrea, Diane, and Steve 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) Jack Yaeger has developed a low-cost GPS device that can be implanted into pets so that they can be easily located when lost. He would like to build a small manufacturing facility to make the devices and then sell them to veterinarians across the country. Jack 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 proprietorship, partnership, or corporation. Give reasons for your choice. P1-2A Financial decisions often place heavier emphasis on one type of financial statement over the others. Consider each of the following hypothetical situations independently. Identify users and uses of financial statements. (LO 2, 4, 5), K • • • (a) The North Face 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) JPMorgan Chase Bank 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 generating 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 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. P1-3A On June 1, Hightower Service Co. was started with an initial investment in the company of $22,100 cash. Here are the assets, liabilities, and common stock of the company at June 30, and the revenues and expenses for the month of June, its first month of operations: Prepare an income statement, retained earnings statement, and balance sheet; discuss results. (LO 4, 5), AP Cash $ 4,600 Accounts receivable 4,000 Service revenue 7,500 Supplies 2,400 Advertising expense 400 Equipment 26,000 Common stock 22,100 Notes payable $12,000 Accounts payable 500 Supplies expense 1,000 Maintenance and repairs expense 600 Utilities expense 300 Salaries and wages expense ...
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