FINANCIAL ACCOUNTING Tools for Business Decision Making
E IGHTH EDIT ION
CHART OF ACCOUNTS
The following is a sample chart of accounts. It does not represent a comprehensive chart of all the accounts used in this textbook but rather those accounts that are commonly used. This sample chart of accounts is for a company that generates both service revenue as well as sales revenue. It uses the perpetual approach to inventory. If a periodic system was used, the following temporary accounts would be needed to record inventory purchases: Purchases, Freight-In, Purchase Returns and Allowances, and Purchase Discounts.
Assets Cash
Accounts Receivable
Allowance for Doubtful Accounts
Interest Receivable
Inventory
Supplies
Prepaid Insurance
Prepaid Rent
Land
Equipment
Accumulated Depreciation— Equipment
Buildings
Accumulated Depreciation— Buildings
Copyrights
Goodwill
Patents
Liabilities Notes Payable
Accounts Payable
Unearned Service Revenue
Salaries and Wages Payable
Interest Payable
Dividends Payable
Income Taxes Payable
Bonds Payable
Discount on Bonds Payable
Premium on Bonds Payable
Mortgage Payable
Stockholders’ Equity Common Stock
Paid-in Capital in Excess of Par Value—Common Stock
Preferred Stock
Paid-in Capital in Excess of Par Value—Preferred Stock
Treasury Stock
Retained Earnings
Dividends
Income Summary
Revenues Service Revenue
Sales Revenue
Sales Discounts
Sales Returns and Allowances
Interest Revenue
Gain on Disposal of Plant Assets
Expenses Administrative Expenses
Amortization Expense
Bad Debt Expense
Cost of Goods Sold
Depreciation Expense
Freight-Out
Income Tax Expense
Insurance Expense
Interest Expense
Loss on Disposal of Plant Assets
Maintenance and Repairs Expense
Rent Expense
Salaries and Wages Expense
Selling Expenses
Supplies Expense
Utilities Expense
ACCOUNT CLASSIFICATION AND PRESENTATION
Account Title Classification Financial Statement Normal Balance
A Accounts Payable Current Liability Balance Sheet Credit
Accounts Receivable Current Asset Balance Sheet Debit
Accumulated Depreciation—Buildings Plant Asset—Contra Balance Sheet Credit
Accumulated Depreciation—Equipment Plant Asset—Contra Balance Sheet Credit
Administrative Expenses Operating Expense Income Statement Debit
Allowance for Doubtful Accounts Current Asset—Contra Balance Sheet Credit
Amortization Expense Operating Expense Income Statement Debit
B Bad Debt Expense Operating Expense Income Statement Debit
Bonds Payable Long-Term Liability Balance Sheet Credit
Buildings Plant Asset Balance Sheet Debit
C Cash Current Asset Balance Sheet Debit
Common Stock Stockholders’ Equity Balance Sheet Credit
Copyrights Intangible Asset Balance Sheet Debit
Cost of Goods Sold Cost of Goods Sold Income Statement Debit
D Debt Investments Current Asset/
Long-Term Investment Balance Sheet Debit
Depreciation Expense Operating Expense Income Statement Debit
Discount on Bonds Payable Long-Term Liability—Contra Balance Sheet Debit
Dividend Revenue Other Income Income Statement Credit Dividends Temporary account closed
to Retained Earnings Retained Earnings Statement
Debit
Dividends Payable Current Liability Balance Sheet Credit
E Equipment Plant Asset Balance Sheet Debit
F Freight-Out Operating Expense Income Statement Debit
G Gain on Disposal of Plant Assets Other Income Income Statement Credit
Goodwill Intangible Asset Balance Sheet Debit
I Income Summary Temporary account closed
to Retained Earnings Not Applicable (1)
Income Tax Expense Income Tax Expense Income Statement Debit
Income Taxes Payable Current Liability Balance Sheet Credit
Insurance Expense Operating Expense Income Statement Debit
Interest Expense Other Expense Income Statement Debit
Interest Payable Current Liability Balance Sheet Credit
Interest Receivable Current Asset Balance Sheet Debit
Interest Revenue Other Income Income Statement Credit
Inventory Current Asset Balance Sheet (2) Debit
Account Title Classification Financial Statement Normal Balance
L Land Plant Asset Balance Sheet Debit
Loss on Disposal of Plant Assets Other Expense Income Statement Debit
M Maintenance and Repairs Expense Operating Expense Income Statement Debit
Mortgage Payable Long-Term Liability Balance Sheet Credit
N Notes Payable Current Liability/
Long-Term Liability Balance Sheet Credit
P Patents Intangible Asset Balance Sheet Debit
Paid-in Capital in Excess of Par Value—Common Stock
Stockholders’ Equity Balance Sheet Credit
Paid-in Capital in Excess of Par Value—Preferred Stock
Stockholders’ Equity Balance Sheet Credit
Preferred Stock Stockholders’ Equity Balance Sheet Credit
Premium on Bonds Payable Long-Term Liability—Contra Balance Sheet Credit
Prepaid Insurance Current Asset Balance Sheet Debit
Prepaid Rent Current Asset Balance Sheet Debit
R Rent Expense Operating Expense Income Statement Debit Retained Earnings Stockholders’ Equity Balance Sheet and Retained
Earnings Statement Credit
S Salaries and Wages Expense Operating Expense Income Statement Debit
Salaries and Wages Payable Current Liability Balance Sheet Credit
Sales Discounts Revenue—Contra Income Statement Debit
Sales Returns and Allowances Revenue—Contra Income Statement Debit
Sales Revenue Revenue Income Statement Credit
Selling Expenses Operating Expense Income Statement Debit
Service Revenue Revenue Income Statement Credit
Stock Investments Current Asset/Long-Term Investment
Balance Sheet Debit
Supplies Current Asset Balance Sheet Debit
Supplies Expense Operating Expense Income Statement Debit
T Treasury Stock Stockholders’ Equity Balance Sheet Debit
U Unearned Service Revenue Current Liability Balance Sheet Credit
Utilities Expense Operating Expense Income Statement Debit
(1) The normal balance for Income Summary will be credit when there is a net income, debit when there is a net loss. The Income Summary account does not appear on any financial statement.
(2) If a periodic system is used, Inventory also appears on the income statement in the calculation of cost of goods sold.
FINANCIAL ACCOUNTING Tools for Business Decision Making
E IGHTH EDIT ION
Paul D. Kimmel PhD, CPA University of Wisconsin—Milwaukee
Milwaukee, Wisconsin
Jerry J. Weygandt PhD, CPA University of Wisconsin—Madison
Madison, Wisconsin
Donald E. Kieso PhD, CPA Northern Illinois University
DeKalb, Illinois
Vice President and Director George Hoffman Executive Editor Michael McDonald Development Editor Ed Brislin Editorial Supervisor Terry Ann Tatro Editorial Associate Margaret Thompson Senior Content Manager Dorothy Sinclair Senior Production Editor Suzie Pfister Executive Marketing Manager Karolina Zarychta Hons Product Design Manager Allison Morris Product Designer Matt Origoni Media Specialist Elena Santa Maria Design Director Harry Nolan Cover Design Maureen Eide Interior Design Maureen Eide Senior Photo Editor Mary Ann Price Market Solutions Assistant Elizabeth Kearns Cover Credit Susanna Price/Getty Images, Inc.
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1 Introduction to Financial Statements 2 2 A Further Look at Financial Statements 44 3 The Accounting Information System 90 4 Accrual Accounting Concepts 150 5 Merchandising Operations and the
Multiple-Step Income Statement 214 6 Reporting and Analyzing Inventory 266 7 Fraud, Internal Control, and Cash 316 8 Reporting and Analyzing Receivables 374 9 Reporting and Analyzing Long-Lived Assets 422 10 Reporting and Analyzing Liabilities 478 11 Reporting and Analyzing Stockholders’
Equity 536 12 Statement of Cash Flows 590 13 Financial Analysis: The Big Picture 646
APPENDICES A Specimen Financial Statements:
Apple Inc. A-1 B Specimen Financial Statements:
Columbia Sportswear Company B-1 C Specimen Financial Statements:
VF Corporation C-1 D Specimen Financial Statements: Amazon.com, Inc. D-1 E Specimen Financial Statements: Wal-Mart Stores, Inc. E-1 F Specimen Financial Statements: Louis Vuitton F-1 G Time Value of Money G-1 H Reporting and Analyzing Investments H-1
COMPANY INDEX I-1 SUBJECT INDEX I-5
iii
Brief Contents
iv
Dear Student,
Why This Course? Remember your biology course in high school? Did you have one of those “invisible man” models (or maybe something more high-tech than that) that gave you the opportunity to look “inside” the human body? This accounting course offers something similar. To understand a business, you have to understand the financial insides of a business organization. A financial accounting course will help you understand the essential financial components of businesses. Whether you are looking at a large multinational company like Apple or Starbucks or a single- owner software consulting business or coffee shop, knowing the fundamentals of financial accounting will help you understand what is happening. As an employee, a manager, an investor,a business owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you will make better decisions for having taken this course.
Why This Book? Hundreds of thousands of students have used this textbook. Your instructor has chosen it for you because of its trusted reputation. The authors have worked hard to keep the book fresh, timely, and accurate.
How to Succeed? We’ve asked many students and many instructors whether there is a secret for success in this course. The nearly unanimous answer turns out to be not much of a secret: “Do the homework.” This is one course where doing is learn- ing. The more time you spend on the homework assignments—using the various tools that this textbook provides—the more likely you are to learn the essential concepts, techniques, and methods of accounting. Besides the textbook itself, WileyPLUS and the book’s companion website also offer various support resources.
Good luck in this course. We hope you enjoy the experience and that you put to good use throughout a lifetime of success the knowledge you obtain in this course. We are sure you will not be disappointed.
Paul D. Kimmel Jerry J. Weygandt
Donald E. Kieso
“Whether you are looking at a large multinational company like Apple or Starbucks or a single-owner software consulting business or coffee shop, knowing the fundamentals of financial accounting will help you understand what is happening.”
From the Authors
Jerry Weygandt JERRY J. WEYGANDT, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin— Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in the Accounting Review, Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional journals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation. Professor Weygandt has received the Chancellor’s Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award. He is on the board of directors of M & I Bank of Southern Wisconsin. He is the recipient of the Wisconsin Institute of CPA’s Outstanding Educator’s Award and the Lifetime Achievement Award. In 2001 he received the American Accounting Association’s Outstanding Educator Award.
Paul Kimmel PAUL D. KIMMEL, PhD, CPA, received his bachelor’s degree from the University of Minnesota and his doctorate in account- ing from the University of Wisconsin. He is an Associate Professor at the University of Wisconsin—Milwaukee, and has pub- lic accounting experience with Deloitte & Touche (Minneapolis). He was the recipient of the UWM School of Business Advisory Council Teaching Award, the Reggie Taite Excellence in Teaching Award and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin. He is also a recipient of the Elijah Watts Sells Award for Honorary Distinction for his results on the CPA exam. He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting Education, Journal of Accounting Education, as well as other journals. His research interests include accounting for financial instruments and innovation in accounting education. He has published papers and given numerous talks on incorporating critical thinking into accounting education, and helped prepare a catalog of critical thinking resources for the Federated Schools of Accountancy.
Don Kieso DONALD E. KIESO, PhD, CPA, received his bachelor’s degree from Aurora University and his doctorate in accounting from the University of Illinois. He has served as chair- man of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University. He has public accounting experience with Price Waterhouse & Co. (San Francisco and Chicago) and Arthur Andersen & Co. (Chicago) and research experience with the Research Division of the American Institute of Certified Public Accountants (New York). He has done postdoctoral work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU’s Teaching Excellence Award and four Golden Apple Teaching Awards. Professor Kieso is the author of other accounting and business books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Illinois CPA Society. He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Committees, the State of Illinois Comptroller’s Commission, as Secretary- Treasurer of the Federation of Schools of Accountancy, and as Secretary-Treasurer of the American Accounting Association. Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital. From 1989 to 1993 he served as a charter member of the national Accounting Education Change Commission. He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA’s Joseph A. Silvoso Award of Merit, the NIU Foundation’s Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorate from Aurora University.
Author Commitment
Quickly identify areas of strength and weakness before the first exam, and use the information to build a learning path to success.
A little time with ORION goes a long way. Based on usage data, students who engage in ORION adaptive practice—just a few minutes per week—get better outcomes. In fact, students who used ORION five or more times over the course of a semester reported the following results:
Developing effective problem solving skills requires practice, relevant feedback, and insightful examples.
Solutions to practice multiple-choice questions, exercises, and problems are now available at the end of each chapter.
LEARNING OBJECTIVES REVIEW
REVIEW AND PRACTICE
1 Discuss how to classify and determine inventory. Merchandisers need only one inventory classifi cation, merchandise inventory, to describe the different items that make up total inventory. Manufacturers, on the other hand, usually classify inventory into three catego- ries: fi nished goods, work in process, and raw materi- als. To determine inventory quantities, manufactur- ers (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.
2 Apply inventory cost fl ow methods and discuss their fi nancial effects. The primary basis of accounting for inventories is cost. Cost includes all expenditures neces- sary to acquire goods and place them in a condition ready for sale. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost fl ow methods are specifi c identifi cation and three assumed cost fl ow methods—FIFO, LIFO, and average-cost. The cost of goods available for sale may be allocated to cost of goods sold and ending inventory by specifi c identifi cation or by a method based on an assumed cost fl ow. When prices are rising, the fi rst-in, fi rst-out (FIFO) method results in lower cost of goods sold and higher net income than the average-cost and the last-in, fi rst-out (LIFO) methods. The reverse is true when prices are fall- ing. In the balance sheet, FIFO results in an ending inven- tory that is closest to current value, whereas the inven- tory under LIFO is the farthest from current value. LIFO
lt i th l t i t (b f l t
Inventory turnover is calculated as cost of goods sold divided by average inventory. It can be converted to average days in inventory by dividing 365 days by the inventory turnover. A higher inventory turnover or lower average days in inventory suggests that management is trying to keep inventory levels low relative to its sales level. The LIFO reserve represents the difference between ending inventory using LIFO and ending inventory if FIFO were employed instead. For some companies this differ- ence can be signifi cant, and ignoring it can lead to inappro- priate conclusions when using the current ratio or inven- tory turnover.
*4 Apply inventory cost fl ow methods to perpetual inven- tory records. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. Under the average- cost method, a new average cost is computed after each purchase.
*5 Indicate the effects of inventory errors on the fi nan- cial statements. In the income statement of the current year: (1) An error in beginning inventory will have a reverse effect on net income (e.g., overstatement of inventory results in understatement of net income, and vice versa). (2) An error in ending inventory will have a similar effect on net income (e.g., overstatement of inventory results in overstatement of net income). If ending inventory errors are not corrected in the follow-
▼
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SOLUTION
1. Ending inventory—as reported $650,000
1. Subtract from inventory: The goods belong to Bosnia Corporation. Sergei is merely holding them for Bosnia. (200,000)
2. Add to inventory: The goods belong to Sergei when they were shipped. 40,000
3. Subtract from inventory: Offi ce supplies should be carried in a separate account. They are not considered inventory held for resale. (15,000)
4. Add to inventory: The goods belong to Sergei until they are shipped (Jan. 1). 30,000
p p
INSTRUCTIONS
Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, saying why you did or did not make an adjustment for each item.
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SOLUTIONS 1. (d) A physical inventory is usually taken when a limited number of goods are being sold or received, and at the end
of the company’s fi scal year. Choice (a) is incorrect because a physical inventory count is usually taken when the com- pany has the least, not greatest, amount of inventory. Choices (b) and (c) are correct, but (d) is the better answer.
2. (a) Goods held on consignment should not be included because another company has title (ownership) to the goods. The other choices are incorrect because (b) goods shipped on consignment to another company and (c) goods in transit from another company shipped FOB shipping point should be included in a company’s ending inventory. Choice (d) is incorrect because (a) is not included in the physical inventory.
3. (b) The inventory held on consignment by Rogers should be included in Railway’s inventory balance at cost ($35,000). The purchased goods of $13,000 should not be included in inventory until January 3 because the goods are shipped FOB destination. Therefore, the correct amount of inventory is $215,000 ($180,000 + $35,000), not (a) $230,000, (c) $228,000, or (d) $193,000.
4. (c) Under FIFO, ending inventory will consist of 5,000 units from the Nov. 8 purchase and 4,000 units from the June 19 purchase. Therefore, ending inventory is (5,000 × $13) + (4,000 × $12) = $113,000, not (a) $99,000, (b) $108,000, or (d) $117,000.
5. (d) Under LIFO, ending inventory will consist of 8,000 units from the inventory at Jan. 1 and 1,000 units from the June 19 purchase. Therefore, ending inventory is (8,000 × $11) + (1,000 × $12) = $100,000, not (a) $113,000, (b) $108,000, or (c) $99,000.
6 (d) Under the average-cost method total cost of goods available for sale needs to be calculated in order to deter-
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S l ti t ti lti l
New PRACTICE QUESTIONS WITH SOLUTIONS include:
• BRIEF EXERCISES
• EXERCISES
• DO IT! Exercises
• PROBLEMS
All new practice questions provide
assessment, helping students see what
they understand and where they can
improve.
Algorithmic versions of the questions
allow students to revisit practice
questions until they understand a
topic completely.
Focus on the Accounting Cycle To help students master accounting cycle concepts, we added (1) new, recurring illustrations that show students the big picture of the accounting cycle, (2) new comprehensive accounting cycle exercises and problems, and (3) new accounting cycle questions in the Test Bank and .
Student Practice and Solutions New practice opportunities with solutions are integrated throughout the textbook and WileyPLUS course. Each textbook chapter now provides students with a Review and Practice section that includes learning objective sum- maries, multiple-choice questions with feedback for each answer choice, practice exercises with solutions, and a prac- tice problem with a solution. Also, all learning objective modules in the textbook are followed by a DO IT! exercise with an accompanying solution.
In WileyPLUS, two brief exercises, two DO IT! exercises, two exercises, and a new problem are available for practice with each chapter. All of the new practice questions are algorithmic, providing students with multiple opportunities for advanced practice. WileyPLUS assessment now includes new narrative student feedback.
Over 3,500 questions, including new medium-level, computational, and accounting-cycle-based questions, are avail- able for practice and review. is an adaptive study and practice tool that helps students build proficiency in course topics.
Updated Content and Design We scrutinized all content to find new ways to engage students and help them learn accounting concepts. A new learning objective structure helps students practice their understanding of concepts with DO IT! exercises before they move on to different topics in other learning objectives. Coupled with a new interior design, revised infographics, and the newly designed interactive chapter tutorials, the new outcomes-oriented approach motivates students and helps them make the best use of their time.
WileyPLUS Videos Over 150 videos are available in WileyPLUS. More than 80 of the videos are new to the Eighth Edition. The videos walk students through relevant homework problems and solutions, review important concepts, provide overviews of Excel skills, and explore topics in a real-world context.
Real World Context: Feature Stories and Comprehensive Problems New feature stories frame chapter topics in a real-world company example. Also, the feature stories now closely cor- relate with the Using Decision Tools problem at the end of each chapter. In WileyPLUS, real-world Insight boxes now have questions that can be assigned as homework.
More information about the Eighth Edition is available on the book’s website at www.wiley.com/college/kimmel.
viii
What’s New?
2Introduction to FinancialStatements1
Knowing the Numbers 3 LO 1: Study the forms of business organization and
the uses of accounting information. 4 Forms of Business Organization 4 Users and Uses of Financial Information 5 Ethics in Financial Reporting 7
LO 2: Explain the three principal types of business activity. 8
Financing Activities 9 Investing Activities 9 Operating Activities 9
LO 3: Describe the four financial statements and how they are prepared. 11
Income Statement 11 Retained Earnings Statement 12 Balance Sheet 13 Statement of Cash Flows 14 Interrelationships of Statements 15 Other Elements of an Annual Report 18
A Look at IFRS 42
46A Further Look at Financial Statements2
Just Fooling Around? 45 LO 1: Identity the sections of a classified
balance sheet. 46 Current Assets 46 Long-Term Investments 48 Property, Plant, and Equipment 48 Intangible Assets 48 Current Liabilities 50 Long-Term Liabilities 50 Stockholders’ Equity 50
LO 2: Use ratios to evaluate a company’s profitability, liquidity, and solvency. 51
Ratio Analysis 51 Using the Income Statement 52 Using a Classified Balance Sheet 53 Using the Statement of Cash Flows 57
LO 3: Discuss financial reporting concepts. 58 The Standard-Setting Environment 58 Qualities of Useful Information 59 Assumptions in Financial Reporting 60 Principles in Financial Reporting 61 Cost Constraint 62
A Look at IFRS 87
90The Accounting InformationSystem 3
Accidents Happen 91 LO 1: Analyze the effect of business transactions
on the basic accounting equation. 92 Accounting Transactions 92 Analyzing Transactions 93 Summary of Transactions 99
LO 2: Explain how accounts, debits, and credits are used to record business transactions. 100
Debits and Credits 101 Debit and Credit Procedures 101 Stockholders’ Equity Relationships 104 Summary of Debit/Credit Rules 105
LO 3: Indicate how a journal is used in the recording process. 106
The Recording Process 106 The Journal 106
LO 4: Explain how a ledger and posting help in the recording process. 109
The Ledger 109 Chart of Accounts 109 Posting 110 The Recording Process Illustrated 111 Summary Illustration of Journalizing and
Posting 117 LO 5: Prepare a trial balance. 119
Limitations of a Trial Balance 119 A Look at IFRS 148
46Accrual Accounting Concepts4 Keeping Track of Groupons 151 LO 1: Explain the accrual basis of accounting and
the reasons for adjusting entries. 152 The Revenue Recognition Principle 152 The Expense Recognition Principle 152 Accrual versus Cash Basis of Accounting 153 The Need for Adjusting Entries 154 Types of Adjusting Entries 155
LO 2: Prepare adjusting entries for deferrals. 156 Prepaid Expenses 156 Unearned Revenues 160
LO 3: Prepare adjusting entries for accruals. 163 Accrued Revenues 163 Accrued Expenses 164 Summary of Basic Relationships 167
ix
Table of Contents
LO 4: Prepare an adjusted trial balance and closing entries. 170
Preparing the Adjusted Trial Balance 170 Preparing Financial Statements 171 Quality of Earnings 172 Closing the Books 175 Summary of the Accounting Cycle 177
LO *5: APPENDIX 4A: Describe the purpose and the basic form of a worksheet. 182
A Look at IFRS 212
150 Merchandising Operations and the Multiple-Step Income Statement
5
Buy Now, Vote Later 215 LO 1: Describe merchandising operations and
inventory systems. 216 Operating Cycles 216 Flow of Costs 217
LO 2: Record purchases under a perpetual inventory system. 219
Freight Costs 221 Purchase Returns and Allowances 221 Purchase Discounts 222 Summary of Purchasing Transactions 223
LO 3: Record sales under a perpetual inventory system. 224
Sales Returns and Allowances 225 Sales Discounts 226
LO 4: Prepare a multiple-step income statement and a comprehensive income statement. 227
Single-Step Income Statement 227 Multiple-Step Income Statement 228 Comprehensive Income Statement 231
LO 5: Determine cost of goods sold under a periodic inventory system. 233
LO 6: Compute and analyze gross profit rate and profit margin. 234
Gross Profit Rate 234 Profit Margin 235
LO *7: APPENDIX 5A: Record purchases and sales of inventory under a periodic inventory system. 239
Recording Merchandise Transactions 239 Recording Purchases of Merchandise 239 Freight Costs 240 Recording Sales of Merchandise 240 Comparison of Entries—Perpetual vs.
Periodic 241 A Look at IFRS 264
266Reporting and Analyzing Inventory6
“Where Is That Spare Bulldozer Blade?” 267 LO 1: Discuss how to classify and
determine inventory. 268 Classifying Inventory 268 Determining Inventory Quantities 269
LO 2: Apply inventory cost flow methods and discuss their financial effects. 271
Specific Identification 272 Cost Flow Assumptions 273 Financial Statement and Tax Effects of Cost Flow
Methods 277 Using Inventory Cost Flow Methods
Consistently 280 LO 3: Explain the statement presentation and
analysis of inventory. 281 Presentation 281 Lower-of-Cost-or-Market 281 Analysis 283 Analysts’ Adjustments for LIFO Reserve 284
LO *4: APPENDIX 6A: Apply inventory cost flow methods to perpetual inventory records. 287
First-In, First-Out (FIFO) 287 Last-In, First-Out (LIFO) 288 Average-Cost 289
LO *5: APPENDIX 6B: Indicate the effects of inventory errors on the financial statements. 289
Income Statement Effects 289 Balance Sheet Effects 290
A Look at IFRS 314
316Fraud, Internal Control, and Cash7
Minding the Money in Madison 317 LO 1: Define fraud and the principles of
internal control. 318 Fraud 318 The Sarbanes-Oxley Act 318 Internal Control 319 Principles of Internal Control Activities 320 Limitations of Internal Control 326
LO 2: Apply internal control principles to cash. 327
Cash Receipts Controls 328 Cash Disbursements Controls 330
LO 3: Apply the control features of a bank account. 333
Electronic Funds Transfer (EFT) System 333 Bank Statements 333 Reconciling the Bank Account 334
x
LO 4: Explain the reporting of cash and the basic principles of cash management. 340
Reporting Cash 340 Managing and Monitoring Cash 341 Cash Budgeting 344
LO *5: APPENDIX 7A: Explain the operation of a petty cash fund. 347
Establishing the Petty Cash Fund 347 Making Payments from Petty Cash 347 Replenishing the Petty Cash Fund 348
A Look at IFRS 371
374Reporting and Analyzing Receivables8
What’s Cooking? 375 LO 1: Explain how companies recognize
accounts receivable. 376 Types of Receivables 376 Recognizing Accounts Receivable 376
LO 2: Describe how companies value accounts receivable and record their disposition. 378
Valuing Accounts Receivable 378 Disposing of Accounts Receivable 385
LO 3: Explain how companies recognize, value, and dispose of notes receivable. 387
Determining the Maturity Date 388 Computing Interest 388 Recognizing Notes Receivable 388 Valuing Notes Receivable 389 Disposing of Notes Receivable 389
LO 4: Describe the statement presentation of receivables and the principles of receivables management. 391
Financial Statement Presentation of Receivables 391
Managing Receivables 392 Evaluating Liquidity of Receivables 394 Accelerating Cash Receipts 396
A Look at IFRS 419
422Reporting and Analyzing Long-Lived Assets9
A Tale of Two Airlines 423 LO 1: Explain the accounting for plant
asset expenditures. 424 Determining the Cost of Plant Assets 424 Expenditures During Useful Life 427 To Buy or Lease? 428
LO 2: Apply depreciation methods to plant assets. 429
Factors in Computing Depreciation 430 Depreciation Methods 430
Revising Periodic Depreciation 435 Impairments 436
LO 3: Explain how to account for the disposal of plant assets. 437
Sale of Plant Assets 437 Retirement of Plant Assets 438
LO 4: Identity the basic issues related to reporting intangible assets. 439
Accounting for Intangible Assets 440 Types of Intangible Assets 440
LO 5: Discuss how long-lived assets are reported and analyzed. 443
Presentation 443 Analysis 444
LO *6: APPENDIX 9A: Compute periodic depreciation using the declining-balance method and the units-of-activity method. 449
Declining-Balance Method 449 Units-of-Activity Method 450
A Look at IFRS 475
478Reporting and Analyzing Liabilities10
And Then There Were Two 479 LO 1: Explain how to account for current
liabilities. 480 What Is a Current Liability? 480 Notes Payable 480 Sales Taxes Payable 481 Unearned Revenues 481 Current Maturities of Long-Term Debt 482 Payroll and Payroll Taxes Payable 483
LO 2: Describe the major characteristics of bonds. 485
Types of Bonds 486 Issuing Procedures 486 Determining the Market Price of Bonds 486
LO 3: Explain how to account for bond transactions. 489
Issuing Bonds at Face Value 489 Discount or Premium on Bonds 489 Issuing Bonds at a Discount 490 Issuing Bonds at a Premium 492 Redeeming Bonds at Maturity 493 Redeeming Bonds before Maturity 493
LO 4: Discuss how liabilities are reported and analyzed. 495
Presentation 495 Analysis 496
LO *5: APPENDIX 10A: Apply the straight-line method of amortizing bond discount and bond premium. 502
Amortizing Bond Discount 502 Amortizing Bond Premium 503
xi
LO *6: APPENDIX 10B: Apply the effective-interest method of amortizing bond discount and bond premium. 504
Amortizing Bond Discount 505 Amortizing Bond Premium 506
LO *7: APPENDIX 10C: Describe the accounting for long-term notes payable. 507
A Look at IFRS 534
536Reporting and Analyzing Stockholders’ Equity11
Oh Well, I Guess I’ll Get Rich 537 LO 1: Discuss the major characteristics of a
corporation. 538 Characteristics of a Corporation 538 Forming a Corporation 541 Stockholder Rights 541 Stock Issue Considerations 542 Corporate Capital 544
LO 2: Explain how to account for the issuance of common and preferred stock, and the purchase of treasury stock. 545
Accounting for Common Stock 545 Accounting for Preferred Stock 546 Treasury Stock 547
LO 3: Explain how to account for cash dividends and describe the effect of stock dividends and stock splits. 549
Cash Dividends 549 Dividend Preferences 552 Stock Dividends 553 Stock Splits 555
LO 4: Discuss how stockholders’ equity is reported and analyzed. 557
Retained Earnings 557 Retained Earnings Restrictions 558 Balance Sheet Presentation of Stockholders’
Equity 558 Analysis of Stockholders’ Equity 560 Debt versus Equity Decision 562
LO *5: APPENDIX 11A: Prepare entries for stock dividends. 565
A Look at IFRS 587
590Statement of Cash Flows12 Got Cash? 591 LO 1: Discuss the usefulness and format of the
statement of cash flows. 592 Usefulness of the Statement of Cash Flows 592 Classification of Cash Flows 592
Significant Noncash Activities 593 Format of the Statement of
Cash Flows 594 LO 2: Prepare a statement of cash flows using
the indirect method. 595 Indirect and Direct Methods 596 Indirect Method—Computer Services
Company 596 Step 1: Operating Activities 598 Summary of Conversion to Net Cash
Provided by Operating Activities– Indirect Method 601
Step 2: Investing and Financing Activities 603
Step 3: Net Change in Cash 604 LO 3: Use the statement of cash flows to
evaluate a company. 607 The Corporate Life Cycle 607 Free Cash Flow 609
LO *4: APPENDIX 12A: Prepare a statement of cash flows using the direct method. 611
Step 1: Operating Activities 613 Step 2: Investing and Financing Activities 617 Step 3: Net Change in Cash 618
LO *5: APPENDIX 12B: Use the T-account approach to prepare a statement of cash flows. 618
A Look at IFRS 643
646Financial Analysis: The Big Picture13
It Pays to Be Patient 647 LO 1: Apply the concept of sustainable income
and quality of earnings. 648 Sustainable Income 648 Quality of Earnings 652
LO 2: Apply horizontal analysis and vertical analysis. 654
Horizontal Analysis 655 Vertical Analysis 657
LO 3: Analyze a company’s performance using ratio analysis. 660
Price-Earnings Ratio 660 Liquidity Ratios 660 Solvency Ratios 661 Profitability Ratios 661
LO *4: APPENDIX 13A: Evaluate a company comprehensively using ratio analysis. 666
Liquidity Ratios 668 Solvency Ratios 670 Profitability Ratios 672
A Look at IFRS 699
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A-1Specimen Financial Statements: Apple Inc.A
B-1 Specimen Financial Statements: Columbia Sportswear Company
B
C-1 Specimen Financial Statements: VF Corporation
C
D-1 Specimen Financial Statements: Amazon.com, Inc.
D
E-1 Specimen Financial Statements: Wal-Mart Stores, Inc.
E
F-1Specimen Financial Statements: Louis VuittonF
G-1Time Value of MoneyG LO 1: Compute interest and future values. G-1
Nature of Interest G-1 Future Value of a Single Amount G-3 Future Value of an Annuity G-4
LO 2: Compute present values. G-7 Present Value Variables G-7
Present Value of a Single Amount G-7 Present Value of an Annuity G-9 Time Periods and Discounting G-11 Present Value of a Long-Term Note or Bond G-11
LO 3: Use a financial calculator to solve time value of money problems. G-13
Present Value of a Single Sum G-14 Present Value of an Annuity G-15 Useful Applications of the Financial
Calculator G-15
H-1Reporting and Analyzing InvestmentsH
LO 1: Explain how to account for debt investments. H-1
Why Corporations Invest H-1 Accounting for Debt Investments H-3
LO 2: Explain how to account for stock investments. H-4
Holdings of Less than 20% H-4 Holdings Between 20% and 50% H-5 Holdings of More than 50% H-6
LO 3: Discuss how debt and stock investments are reported in the financial statements. H-7
Categories of Securities H-7 Balance Sheet Presentation H-10 Presentation of Realized and Unrealized Gain
or Loss H-11 Statement of Cash Flows Presentation H-12
Company Index I-1 Subject Index I-5
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Eighth Edition
Dennis Avola Northeastern University Thomas Bednarcik Robert Morris University Illinois Martin Blaine Columbus State Community College Bradley Blaylock Oklahoma State University Gary Bower Community College of Rhode Island Robert Braun Southeastern Louisiana University Lou Bravo North Lake College Myra Bruegger Southeastern Community College Barry Buchoff Towson University Matthew Calderisi Fairleigh Dickinson University Julia Camp Providence College Marian Canada Ivy Tech Community College at Franklin Bea Chiang The College of New Jersey Colleen Chung Miami Dade College Shifei Chung Rowan University Tony Cioffi Lorain County Community College Leslie Cohen University of Arizona Jim Coughlin Robert Morris University Patricia Crenny Villanova University Dori Danko Grand Valley State University Mingcherng Deng Baruch College Kathy Dunne Rider University Barbara Durham University of Central Florida David Emerson Salisbury University Caroline Falconetti Nassau Community College
Nancy Fan California State Polytechnic University, Pomona Magdy Farag California State Polytechnic University, Pomona Linda Flaming Monmouth University Joseph Fournier University of Rhode Island Amy Geile University of Arizona Alan Glaser Franklin & Marshall College J. D. Golub Northeastern University Rita Grant Grand Valley State University Steve Groves Ivy Tech Community College Konrad Gunderson Missouri Western State University Marcye Hampton University of Central Florida Qian Hao Wilkes University Huong Higgins Worcester Polytechnic Institute Yongtao Hong North Dakota State University Robert Hurst Franklin University Wayne Ingalls University of Maine Jennifer Joe University of Delaware James B. Johnson Community College of Philadelphia Patricia Johnson Canisius College Jordan Kanter University of Rhode Island Ann Galligan Kelley Providence College Robert Kenny The College of New Jersey Emil Koren Saint Leo University Faith Lamprey Providence College Gary Laycock Ivy Tech Community College
Charles Leflar University of Arkansas Jennifer LeSure Ivy Tech Community College Claudia Lubaski Lorain County Community College Yuanyuan Ma University of Minnesota Don McFall Hiram College Allison McLeod University of North Texas Maha Mitrelis Providence College Louella Moore Washburn University Sia Nassiripour William Paterson University Joseph Nesi Monmouth University Glenn Pate Palm Beach State College Suzy Pearse Clemson University Rachel Pernia Essex County College George Psaras Aurora University Patrick Reihing Nassau Community College John Ribezzo Community College of Rhode Island Vernon Richardson University of Arkansas Patrick Rogan Consumnes River College Juan Roman Saint Leo University John Rude Bloomsburg University Martin Rudnick William Paterson University August Saibeni Consumnes River College Barbara Sandler Queens College Barbara Scofield Washburn University Chris Severson Franklin University Suzanne Seymoure Saint Leo University
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Acknowledgments Financial Accounting has benefitted greatly from the input of focus group participants, manuscript reviewers, those who have sent comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancillary authors and checkers.
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Abdus Shahid The College of New Jersey Mike Shapeero Bloomsburg University Todd Shawver Bloomsburg University Eileen Shifflett James Madison University Ladd Simms Mississippi Valley State University
Doug Stives Monmouth University Karen Tower Ivy Tech Community College Daniel Tschopp Saint Leo University Mark Ulrich St. John’s University Nancy Wilburn Northern Arizona University
Wayne W. Williams Community College of Philadelphia Hannah Wong William Paterson University Kenneth Zheng University at Buffalo
Prior Editions
Thanks to the following reviewers and focus group participants of prior editions of Financial Accounting: Dawn Addington, Central New Mexico Community College; Gilda Agacer, Monmouth University; Solochidi Ahiarah, Buffalo State College; C. Richard Aldridge, Western Kentucky University; Sylvia Allen, Los Angeles Valley College; Sheila Ammons, Austin Community College; Thomas G. Amyot, College of Santa Rose; Juanita Ardavany, Los Angeles Valley College; Brian Baick, Montgomery College; Timothy Baker, California State University—Fresno; Cheryl Bartlett, Central New Mexico Community College; Benjamin Bean, Utah Valley State College.
Victoria Beard, University of North Dakota; Angela H. Bell, Jacksonville State University; Charles Bokemeier, Michigan State University; John A. Booker, Tennessee Technological University; Duane Brandon, Auburn University; Gary Braun, University of Texas—El Paso; Jerold K. Braun, Daytona State College; Robert L. Braun, Southeastern Louisiana University; Daniel Brickner, Eastern Michigan University; Evangelie Brodie, North Carolina State University; Sarah Ruth Brown, University of North Alabama; Charles Bunn, Wake Technical Community College; Thane Butt, Champlain College; Sandra Byrd, Missouri State University; James Byrne, Oregon State University.
Judy Cadle, Tarleton State University; Julia Camp, University of Massachusetts—Boston; David Carr, Austin Community College; Jack Cathey, University of North Carolina—Charlotte; Andy Chen, Northeast Illinois University; Jim Christianson, Austin Community College; Siu Chung, Los Angeles Valley College; Laura Claus, Louisiana State University; Leslie A. Cohen, University of Arizona; Teresa L. Conover, University of North Texas; Rita Kingery Cook, University of Delaware; Cheryl Corke, Genesee Community College; Sue Counte, St. Louis Community College—Meramec; Janet Courts, San Bernardino Valley College; Samantha Cox, Wake Technical Community College; Cheryl Crespi, Central Connecticut State University; Dori Danko, Grand Valley State University; Brent W. Darwin, Allan Hancock College; Helen Davis, Johnson and Wales University; Paquita Davis-Friday, Baruch College; Michael Deschamps, Mira Costa College; Cheryl Dickerson, Western Washington University; Gadis Dillon, Oakland University; George M. Dow, Valencia Community College—West; Kathy J. Dow, Salem State College; Lola Dudley, Eastern Illinois University.
Mary Emery, St. Olaf College; Martin L. Epstein, Central New Mexico Community College; Ann Escaro, McHenry County College; Larry R. Falcetto, Emporia State University; Alan Falcon, Loyola Marymount University; Scott Fargason, Louisiana State University; Janet Farler, Pima Community College; Lance Fisher, Oklahoma State University; Sheila D. Foster, The Citadel; Jessica J. Frazier, Eastern Kentucky University; Roger Gee, San Diego Mesa College; Lisa Gillespie, Loyola University—Chicago; Hubert Glover, Drexel University; Norman H. Godwin, Auburn University; David Gotlob, Indiana University—Purdue University—Fort Wayne; Lisa Gray, Seminole State College and Valencia Community College; Emmett Griner, Georgia State University; Leon J. Hanouille, Syracuse University; Hassan Hefzi, California State PolyTech University— Pomona; Kenneth M. Hiltebeitel, Villanova University; Harry Hooper, Santa Fe Community College; Judith A. Hora, University of San Diego; Carol Olson Houston, San Diego State University; Ryan Huldah, Iona College; Sam Isley, Wake Technical Community College.
Norma Jacobs, Austin Community College; Marianne L. James, California State University—Los Angeles; Stanley Jenne, University of Montana; Christopher Jones, George Washington University; Siriyama Kanthi Herath, Georgia Institute of Technology; Jane Kaplan, Drexel University; John E. Karayan, California State University—Pomona; Susan Kattelus, Eastern Michigan University; Ann Kelly, Providence College; Dawn Kelly, Texas Tech University; Robert Kenny, The College of New Jersey; Cindi Khanlarian, University of North Carolina—Greensboro; Robert Kiddoo, California State University—Northridge; Marinilka Kimbro, Gonzaga University; Robert J. Kirsch, Southern Connecticut State University; Frank Korman, Mountain View College; Jerry G. Kreuze, Western Michigan University.
John Lacey, California State University—Long Beach; Joseph Larkin, Saint Joseph’s University; Doulas Larson, Salem State College; Doug Laufer, Metropolitan State College of Denver; Keith Leeseberg, Manatee Community College; Glenda Levendowski, Arizona State University; Seth Levine, DeVry University; Lihon Liang, Syracuse University; James Lukawitz, University of Memphis; Nancy Lynch, West Virginia University; P. Merle Maddocks, University of Alabama—Huntsville; Janice Mardon, Green River Community College; Sal Marino, Westchester Community College; John Marts, University of North Carolina—Wilmington; Alan Mayer- Sommer, Georgetown University; Florence McGovern, Bergen Community College; Noel McKeon, Florida Community College at Jacksonville; Sara Melendy, Gonzaga University; Barbara Merino, University of North Texas; Paul Mihalek, Central Connecticut State University; Jeanne Miller, Cypress College; Robert Miller, California State University—Fullerton; Elizabeth Minbiole, Northwood University; Sherry Mirbod, Montgomery College; Andrew Morgret, University of Memphis; Michelle Moshier, SUNY Albany; Marguerite Muise, Santa Ana College; Kathy Munter, Pima Community College; William J. Nealon, Schenectady County Community College; James Neurath, Central Michigan University; Gale E. Newell, Western Michigan University; Garth Novack, Utah State University; Rosemary Nurre, San Mateo Community College.
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Suzanne Ogilby, Sacramento State University; Sarah N. Palmer, University of North Carolina—Charlotte; Patricia Parker, Columbus State Community College; Terry Patton, Midwestern State University; Charles Pier, Appalachian State University; Ronald Pierno, Florida State University; Janice Pitera, Broome Community College; Franklin J. Plewa, Idaho State University; Meg Pollard, American River College; John Purisky, Salem State College; Donald J. Raux, Siena College; Ray Reisig, Pace University, Pleasantville; Judith Resnick, Borough of Manhattan Community College; Mary Ann Reynolds, Western Washington University; Ruthie G. Reynolds, Howard University; Carla Rich, Pensacola Junior College; Rod Ridenour, Montana State University—Bozeman; Ray Rigoli, Ramapo College of New Jersey; Larry Rittenberg, University of Wisconsin; Jeff Ritter, St. Norbert College; Cecile M. Roberti, Community College of Rhode Island; Brandi Roberts, Southeastern Louisiana University; Patricia A. Robinson, Johnson and Wales University; Nancy Rochman, University of Arizona; Lawrence Roman, Cuyahoga Community College; Marc A. Rubin, Miami University; John A. Rude, Bloomsburg University; Robert Russ, Northern Kentucky University.
Alfredo Salas, El Paso Community College; Christine Schalow, California State University—San Bernardino; Michael Schoderbek, Rutgers University; Richard Schroeder, University of North Carolina—Charlotte; Bill N. Schwartz, Stevens Institute of Technology; Jerry Searfoss, University of Utah; Cindy Seipel, New Mexico State University; Anne E. Selk, University of Wisconsin—Green Bay; William Seltz, University of Massachusetts; Suzanne Sevalstad, University of Nevada; Mary Alice Seville, Oregon State University; Donald Smillie, Southwest Missouri State University; Aileen Smith, Stephen F. Austin State University; Gerald Smith, University of Northern Iowa; Pam Smith, Northern Illinois University; Talitha Smith, Auburn University; William E. Smith, Xavier University; Will Snyder, San Diego State University; Naomi Soderstrom, University of Colorado—Boulder; Chris Solomon, Trident Technical College; Teresa A. Speck, St. Mary’s University of Minnesota; Charles Stanley, Baylor University; Vic Stanton, University of California, Berkeley; Ron Stone, California State University—Northridge; Gary Stout, California State University—Northridge; Gracelyn Stuart, Palm Beach Community College; Paul Swanson, Illinois Central College; Ellen L. Sweatt, Georgia Perimeter College.
William Talbot, Montgomery College; Diane Tanner, University of North Florida; Pamadda Tantral, Fairleigh Dickinson University; Steve Teeter, Utah Valley State College; Michael Tydlaska, Mountain View College; Michael F. van Breda, Texas Christian University; Joan Van Hise, Fairfi eld University; Richard Van Ness, Schenectady County Community College; Christopher Wallace, California State University—Sacramento; Barbara Warschawski, Schenectady County Community College; Andrea B. Weickgenannt, Northern Kentucky University; David P. Weiner, University of San Francisco; Frederick Weis, Claremont McKenna College; T. Sterling Wetzel, Oklahoma State University; Wendy Wilson, Southern Methodist University; Allan Young, DeVry University; Linda G. Wade, Tarleton State University; Stuart K. Webster, University of Wyoming; Kathryn Yarbrough, University of North Carolina—Charlotte; V. Joyce Yearley, New Mexico State University; Judith Zander, Grossmont College
Ancillary Authors, Contributors, Proofers, and Accuracy Checkers
We sincerely thank the following individuals for their hard work in preparing the content that accompanies this textbook: Ellen Bartley St. Joseph’s College LuAnn Bean Florida Institute of Technology Jack Borke University of Wisconsin—Platteville Melanie Bunting Edgewood College Sandra Cohen Columbia College—Chicago James M. Emig Villanova University Larry R. Falcetto Emporia State University Heidi Hansel Kirkwood Community College
Coby Harmon University of California, Santa Barbara DeAnna Kirchen Golden West College Laura McNally Black Hills State University Jill Mitchell Northern Virginia Community College Barb Muller Arizona State University George Psarsas Aurora University Laura Prosser Black Hills State University Alice Sineath Forsyth Technical Community College Teresa Speck Saint Mary’s University of Minnesota Mark Ulrich St. John’s University Sheila Viel University of Wisconsin—Milwaukee Dick D. Wasson Southwestern College
Andrea Weickgenannt Xavier University Melanie Yon
Advisory Board
Robert Braun Southeastern Louisiana University Rita Grant Grand Valley State University Marcye Hampton University of Central Florida Michelle Moshier State University of New York—Albany Courtney Naismith Collin College Michael Newman University of Houston Pamela Rouse Butler University Chris Solomon Trident Technical College
We appreciate the exemplary support and commitment given to us by executive editor Michael McDonald, executive marketing manager Karolina Zarychta Honsa, development editor Ed Brislin, market solutions assistant Elizabeth Kearns, development editors Terry Ann Tatro and Margaret Thompson, product design manager Allie Morris, product designer Matt Origoni, designer Maureen Eide, photo editor Mary Ann Price, and Jackie Henry at Aptara. All of these professionals provided innumerable services that helped the textbook take shape.
Finally, our thanks to George Hoffman, Tim Stookesberry, Douglas Reiner, Joe Heider, Brent Gordon, and Mark Allin for their support and leadership at Wiley. We will appreciate sug- gestions and comments from users—instructors and students alike. You can send your thoughts and ideas about the text- book to us via email at: AccountingAuthors@yahoo.com.
Paul D. Kimmel Jerry J. Weygandt Donald E. Kieso Milwaukee, Wisconsin Madison, Wisconsin DeKalb, Illinois
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How do you start a business? How do you determine whether your business is making or losing
money? How should you fi nance 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 fi nancial
information.
The purpose of this chapter is to show you what role accounting plays in providing fi nancial
information.
Introduction to Financial Statements 1
Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.
Visit for additional tutorials and practice opportunities.
The Chapter Preview describes the purpose of the chapter and highlights major topics.
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CHAPTER PREVIEW
The Chapter Outline presents the chapter’s topics and subtopics, as well as practice opportunities.
LEARNING OBJECTIVES PRACTICE
CHAPTER OUTLINE
• Forms of business organization
• Users and uses of fi nancial information
• Ethics in fi nancial reporting
▼1 Identify the forms of business organization and the uses of accounting information.
DO IT!
1 Business Organization Forms
▼3 Describe the four fi nancial statements and how they are prepared.
• Income statement • Retained earnings statement • Balance sheet • Statement of cash fl ows • Interrelationships of statements • Other annual report elements
DO IT!
3 3a Financial Statements 3b Components of Annual
Reports
▼2 Explain the three principal types of business activity.
• Financing activities • Investing activities • Operating activities
DO IT!
2 Business Activities
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 fi nancial statements are the means for communicating the numbers. If you don’t know how to read fi nancial statements, you can’t really know your business.
Knowing the numbers is sometimes even a matter of corporate survival. Consider the story of Columbia Sportswear Company, headquartered in Portland, Oregon. Gert Boyle’s family fl ed Nazi Germany when she was 13 years old and then purchased a small hat company in Oregon, Columbia Hat Company. In 1971, Gert’s husband, who was then running the company, died suddenly of a heart attack. The company was in the midst of an aggressive expansion, which had taken its sales above $1 million for the fi rst time but which had also left the company fi nancially stressed. Gert took over the small, struggling company with help from her son Tim, who was then a senior at the University of Oregon. Somehow, they kept the company afl oat.
Today, Columbia has more than 4,000 employees and annual sales in excess of $1 billion. Its brands include Columbia, Mountain Hardwear, Sorel, and Montrail.
Gert still heads up the Board of Directors, and Tim is the company’s President and CEO.
Columbia doesn’t just focus on fi nancial success. The company is very committed to corporate, social, and environmental responsibility. For example, several of its factories have participated in a project to increase
health awareness of female factory workers in developing countries. Columbia was also a founding member of the Sustainable Apparel Coalition, which is a group that strives to reduce the environmental and social impact of the apparel industry. In addition, it monitors all of the independent factories that produce its products to ensure that they comply with the company’s Standards of Manufacturing Practices. These standards address issues including forced labor, child labor, harassment, wages and benefi ts, health and safety, and the environment.
Employers such as Columbia Sportswear generally assume that managers in all areas of the company are “fi nancially literate.” To help prepare you for that, in this textbook you will learn how to read and prepare fi nancial statements, and how to use basic tools to evaluate fi nancial results.
Knowing the Numbers
The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business.
© My Good Images/Shutterstock
FEATURE STORY
4 1 Introduction to Financial Statements
LEARNING OBJECTIVE 1 Identify the forms of business organization and the uses of accounting information.▼
-Simple to establish -Owner controlled -Tax advantages
Sole Proprietorship
-Simple to establish -Shared control -Broader skills and resources -Tax advantages
Partnership
-Easier to transfer ownership -Easier to raise funds -No personal liability
Corporation
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, espe- cially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.
FORMS OF BUSINESS ORGANIZATION
Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation.
SOLE PROPRIETORSHIP You might choose the sole proprietorship form for your outdoor guide service. A business owned by one person is a sole proprietorship. It is simple to set up and gives you control over the business. Small owner- operated businesses such as barber shops, law offi ces, and auto repair shops are often sole proprietorships, as are farms and small retail stores.
PARTNERSHIP Another possibility is for you to join forces with other individuals to form a partnership. A business owned by two or more persons associated as partners is a partnership. Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certifi ed public accountants), often organize as partnerships.
CORPORATION As a third alternative, you might organize as a corporation. A busi- ness organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money. There- fore, 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 pro- prietorships or partnerships and eventually incorporate. 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 stock- holders 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 fi ve times the number of corporations. However, the revenue
ALTERNATIVE TERMINOLOGY Stockholders are sometimes called shareholders.
Alternative Terminology notes present synonymous terms that you may come across in practice.
Business Organization and Accounting Information Uses 5
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.
USERS AND USES OF FINANCIAL INFORMATION
The purpose of fi nancial information is to provide inputs for decision-making. Accounting is the information system that identifi es, 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.
Internal Users Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, fi nance directors, and company offi cers. In running a business, managers must answer many important questions, as shown in Illustration 1-1.
To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as fi nancial 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 fi nancial information in the form of fi nancial statements.
Accounting Across the Organization boxes show applications of accounting information in various business functions.
Owning a Piece of the Bar
The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees and is considered one of the leading Landor’s Breakaway Brands®. One of Clif Bar & 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. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its fi nances. Armed with basic accounting knowledge, employees are more aware of the fi nancial impact of their actions, which leads to better decisions.
What are the benefi ts to the company and to the employees of making the fi nancial statements available to all employees? (Go to WileyPLUS for this answer and additional questions.)
ACCOUNTING ACROSS THE ORGANIZATION Clif Bar & Company
© Dan Moore/iStockphoto
STOCK
ON STRIKEON
STRIKE
ON STRIKE
Snack chips Beverages
C O
LA
Questions Asked by Internal Users
Is cash sufficient to pay dividends to
Microsoft stockholders?
Finance Can General Motors afford to give its employees pay
raises this year?
Human Resources Which PepsiCo product line is the most profitable? Should any
product lines be eliminated?
Management What price should Apple charge
for an iPad to maximize the company’s net income?
Marketing
ILLUSTRATION 1-1 Questions that internal users ask
6 1 Introduction to Financial Statements
External Users There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to 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.
What do we do if they catch us?
BILL COLLECTOR
Yeah!
Questions Asked by External Users
Is General Electric earning satisfactory income?
Investors How does Disney compare in size and profitability with Time Warner?
Investors Will United Airlines be able
to pay its debts as they come due?
Creditors
ILLUSTRATION 1-2 Questions that external users ask
The information needs and questions of other external users vary consider- ably. 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 warran- ties 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 benefi ts. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record profi ts at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to inves- tigate the energy traders to make sure that the profi ts were earned by legitimate and fair practices.
Spinning the Career Wheel
How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every fi eld of business. Some examples of how account- ing is used in business careers include the following. General management: Managers of Ford Motors, Massachusetts General Hospital, California State University–Fullerton, a McDonald’s franchise, and a Trek bike shop all need to understand
accounting data in order to make wise business decisions. Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and benefi ts, which accounting helps
them quantify and understand. Making a sale is meaningless unless it is a profi table sale. Finance: Do you want to be a banker for Citicorp, an invest- ment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These fi elds rely heavily on accounting knowledge to an- alyze fi nancial statements. In fact, it is diffi cult to get a good job in a fi nance 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 fi nancing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash fl ow from an industrial property justify the purchase price? What are the tax benefi ts of the purchase?
How might accounting help you? (Go to WileyPLUS for this answer and additional questions.)
ACCOUNTING ACROSS THE ORGANIZATION
© Josef Volavka/iStockphoto
Business Organization and Accounting Information Uses 7
Solving an Ethical Dilemma
#1 ALT
#2 ALT
2. Identify and analyze the principal elements in the situation. Identify the stakeholders— persons or groups who may be harmed or benefited. Ask the question: What are the responsibilities and obligations of the parties involved?
3. Identify the alternatives, and weigh the impact of each alternative on various stakeholders. Select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one right solution; these situations require you to evaluate each alternative and select the best one.
1. Recognize an ethical situation and the ethical issues involved. Use your personal ethics to identify ethical situations and issues. Some businesses and professional organizations provide written codes of ethics for guidance in some business situations.
ILLUSTRATION 1-3 Steps in analyzing ethics cases
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 fi nancial press was full of articles about fi nancial scandals at Enron, WorldCom, HealthSouth, and AIG. As more scandals came to light, a mistrust of fi nancial reporting in general seemed to be developing. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting prac- tices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the fi nancial statements to be hon- estly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable fi nan- cial reporting. United States regulators and lawmakers were very concerned that the econ- omy would suffer if investors lost confi dence in corporate accounting because of unethical fi nancial 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 fi nancial information. In addition, penalties for fraudulent fi nancial activity are much more severe. Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate fi nancial statements and the oversight role of boards of directors. Effective fi nancial reporting depends on sound ethical behavior. To sensi- tize you to ethical situations and to give you practice at solving ethical dilem- mas, 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 fi nancial reporting. (2) Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings. (3) Many of the People, Planet, and Profi t Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. (4) At the end of each chapter, an Ethics Case simulates a business situa tion and asks you to put yourself in the position of a decision-maker in that case. When analyzing these various ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1-3.
Ethics Notes help sensitize you to some of the ethical issues in accounting.
ETHICS NOTE Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.
▼
8 1 Introduction to Financial Statements
Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers to the critical thinking questions are available in WileyPLUS and at www.wiley.com/college/weygandt. Additional questions are offered in WileyPLUS.
I Felt the Pressure— Would You?
“I felt the pressure.” That’s what some of the employees of the now-defunct law fi rm of Dewey & LeBoeuf LLP indicated when they helped to over- state revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former fi nance director and for- mer chief fi nancial offi cer (CFO) of the fi rm. Here are some of their comments:
• “I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”
• “I intentionally gave the auditors incorrect information in the course of the audit.”
What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their fi nancial manipulations as accounting tricks, cooking the books, and fake income.
Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014).
Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to WileyPLUS for this answer and additional questions.)
ETHICS INSIGHT Dewey & LeBoeuf LLP
Alliance/Shutterstock
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.
1▼ Business Organization FormsDO IT! In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated.
1. Easier to raise funds.
2. Simple to establish.
3. No personal legal liability.
4. Tax advantages.
5. Easier to transfer ownership.
Action Plan ✔ Know which organiza-
tional form best matches the business type, size, and preferences of the owner(s).
Related exercise material: BE1-1 and DO IT! 1-1.
DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.
All businesses are involved in three types of activity—fi nancing, investing, and operating. For example, Gert Boyle’s parents, the founders of Columbia Sports- wear, obtained cash through fi nancing to start and grow their business. Some of
Explain the three principal types of business activity. LEARNING OBJECTIVE 2▼
The Three Types of Business Activity 9
this fi nancing came from personal savings, and some likely came from outside sources like banks. The family then invested the cash in equipment to run the business, such as sewing equipment and delivery vehicles. Once this equipment was in place, they could begin the operating activities of making and selling clothing. The accounting information system keeps track of the results of each of the various business activities—fi nancing, 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 fi nancing) and issuing (selling) shares of stock in exchange for cash (equity fi nancing). Columbia Sportswear may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom Columbia owes money are its creditors. Amounts owed to creditors—in the form of debt and other obligations— are called liabilities. Specifi c names are given to different types of liabilities, depending on their source. Columbia may have a note payable to a bank for the money borrowed to purchase delivery trucks. Debt securities sold to investors that must be repaid at a particular date some years in the future are bonds payable. Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase. The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a pay- ment 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 fi nancial diffi culty, 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 satisfi ed. Suppose you buy a company’s stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company’s creditors are paid amounts currently due. However, many corporations make payments to stockholders on a regular basis as long as there is suffi cient cash to cover required payments to creditors. These cash payments to stockholders are called dividends.
INVESTING ACTIVITIES
Once the company has raised cash through fi nancing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. A growing company purchases many resources, such as computers, delivery trucks, furniture, and buildings. Resources owned by a business are called assets. Different types of assets are given different names. For example, Columbia Sportswear’s sewing equipment is a type of asset referred to as property, plant, and equipment. Cash is one of the more important assets owned by Columbia or any other business. If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations. Invest- ments are another example of an investing activity.
OPERATING ACTIVITIES
Once a business has the assets it needs to get started, it begins operations. Columbia Sportswear is in the business of selling outdoor clothing and footwear. It sells TurboDown jackets, Millenium snowboard pants, Sorel® snow boots,
Mountain Sportswear Mountain
Sportswear
Mountain Sportswear
Investing
Operating
Financing
BONDSTOCK
ALTERNATIVE TERMINOLOGY Property, plant, and equipment is sometimes called fi xed assets.
10 1 Introduction to Financial Statements
SOLUTION 1. Cost of renting property: Expense.
2. Truck purchased: Asset.
2▼ Business ActivitiesDO IT! Classify each item as an asset, liability, common stock, revenue, or expense.
1. Cost of renting property.
2. Truck purchased.
3. Notes payable.
4. Issuance of ownership shares.
5. Amount earned from performing service.
6. Amounts owed to suppliers.
Bugaboots™, rainwear, and anything else you might need to protect you from the elements. 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, Columbia records revenue when it sells a footwear product. Revenues arise from different sources and are identifi ed by various names depending on the nature of the business. For instance, Columbia’s primary source of revenue is the sale of sportswear. However, it also generates interest revenue on debt securities held as investments. Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue. The company purchases its longer-lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operat- ing activities. For example, supplies are assets used in day-to-day operations. Goods available for future sales to customers are assets called inventory. Also, if Columbia sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future. This right to receive money in the future is called an account receivable. Before Columbia can sell a single Sorel® boot, it must purchase wool, rubber, leather, metal lace loops, laces, and other materials. It then must process, wrap, and ship the fi nished 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 identifi ed by various names depending on the type of asset consumed or service used. For example, Columbia keeps track of these types of expenses: cost of goods sold (such as the cost of materials), sell- ing 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 corpo- rate offi ce), interest expense (amounts of interest paid on various debts), and income taxes (corporate taxes paid to the government). Columbia may also have liabilities arising from these expenses. For example, it may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable. Additionally, Columbia may have interest payable on the outstanding amounts owed to the bank. It may also have wages payable to its employees and sales taxes payable, property taxes payable, and income taxes payable to the government. Columbia compares the revenues of a period with the expenses of that period to determine whether it earned a profi t. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.
Action Plan ✔ Classify each item based
on its economic charac- teristics. Proper classifi ca- tion of items is critical if accounting is to provide useful information.
The Four Financial Statements 11
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, DO IT! 1-2, and E1-3.
LEARNING OBJECTIVE 3 Describe the four fi nancial statements and how they are prepared.▼
Assets, liabilities, expenses, and revenues are of interest to users of accounting information. This information is arranged in the format of four different fi nan- cial statements, which form the backbone of fi nancial accounting:
• 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 fl ows.
To introduce you to these statements, we have prepared the fi nancial state- ments for your outdoor guide service, Sierra Corporation, after your fi rst month of operations. To summarize, you offi cially started your business in Truckee, California, on October 1, 2017. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe out- door day trips, such as rafting, snowshoeing, and hiking, as well as multi-day backcountry experiences. To minimize your initial investment, at this point the company has limited outdoor equipment for customer use. Instead, your cus- tomers either bring their own equipment or rent equipment through local outfi t- ters. The fi nancial statements for Sierra’s fi rst month of business are provided in the following pages.
INCOME STATEMENT
The income statement reports a company’s revenues and expenses and result- ing net income or loss for a period of time. To indicate that its income statement reports the results of operations for a specifi c period of time, Sierra dates the income statement “For the Month Ended October 31, 2017.” 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 Corpora- tion’s income statement is shown in Illustration 1-4 (page 12). Congratulations, you are already showing a profi t! Why are fi nancial 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
International Notes highlight differences between U.S. and international accounting standards.
INTERNATIONAL NOTE The primary types of fi nancial statements required by Inter- national Financial Reporting Stan- dards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same. Neither IFRS nor GAAP is very specifi c regarding format requirements for the primary fi nancial state- ments. However, in practice, some format differences do exist in presentations commonly employed by IFRS companies as compared to GAAP companies.
Decision Tools that are useful for business decision- making are highlighted throughout the textbook. A summary of the Decision Tools, such as the one on page 21, is provided in each chapter.
DECISION TOOLS
The income statement helps users determine if the company’s operations are profi table.
12 1 Introduction to Financial Statements
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. There- fore, prior to making the loan the bank loan offi cer uses the income statement as a source of information to predict whether the company will be profi table enough to repay its loan. Thus, reporting a strong profi t will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing. Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (see Illustration 1-7), nor does it regard as a business expense the $500 of dividends paid (see Illustration 1-5).
RETAINED EARNINGS STATEMENT
If Sierra is profi table, at the end of each period it must decide what portion of profi ts to pay to shareholders in dividends. In theory, it could pay all of its current-
period profi ts, but few companies do this. Why? Because they want to retain part of the profi ts 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 specifi c time period. The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the fi rst line of the statement. Then, the com-
pany 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 Corpora- tion’s retained earnings statement.
▼ HELPFUL HINT The fi nancial statement heading identifi es the company, the type of statement, and the time period covered. Sometimes, another line indicates the unit of measure, e.g., “in thousands” or “in millions.”
ETHICS NOTE When companies fi nd errors
in previously released income statements, they restate those numbers. Perhaps because of the increased scrutiny shortly
after Sarbanes-Oxley was implemented, companies fi led a
record 1,195 restatements.
▼
ILLUSTRATION 1-4 Sierra Corporation’s income statement
ILLUSTRATION 1-5 Sierra Corporation’s retained earnings statement
Retained earnings, October 1 $ 0 Add: Net income 2,860
2,860 Less: Dividends 500
Retained earnings, October 31 $2,360
SIERRA CORPORATION Retained Earnings Statement
For the Month Ended October 31, 2017
▼ HELPFUL HINT The heading of this statement identifi es the company, the type of statement, and the time period covered by the statement.
DECISION TOOLS The retained earnings statement helps users determine the com- pany’s policy toward dividends and growth.
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
SIERRA CORPORATION Income Statement
For the Month Ended October 31, 2017
The Four Financial Statements 13
By monitoring the retained earnings statement, fi nancial 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.
BALANCE SHEET
The balance sheet reports assets and claims to assets at a specifi c 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. 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.
This relationship is where the name “balance sheet” comes from. Assets must bal- ance 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 fi nancial position as of a specifi c date—in this case, October 31, 2017. It lists assets fi rst, followed by liabilities and stockhold- ers’ equity. Stockholders’ equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the company
ALTERNATIVE TERMINOLOGY Liabilities are also referred to as debt.
ILLUSTRATION 1-6 Basic accounting equationAssets = Liabilities + Stockholders’ Equity
▼ HELPFUL HINT The heading of a balance sheet must identify the company, the statement, and the date.
ILLUSTRATION 1-7 Sierra Corporation’s balance sheet
Assets
Cash $15,200 Accounts receivable 200 Supplies 1,000 Prepaid insurance 550 Equipment, net 4,960
Total assets $21,910
Liabilities and Stockholders’ Equity
Liabilities Notes payable $ 5,000 Accounts payable 2,500 Unearned service revenue 800 Salaries and wages payable 1,200 Interest payable 50
Total liabilities $ 9,550
Stockholders’ equity Common stock 10,000 Retained earnings 2,360
Total stockholders’ equity 12,360
Total liabilities and stockholders’ equity $21,910
SIERRA CORPORATION Balance Sheet
October 31, 2017
DECISION TOOLS
The balance sheet helps users determine if the company relies on debt or stockholders’ equity to fi nance its assets.
14 1 Introduction to Financial Statements
sells new shares of stock; retained earnings is the net income retained in the cor- poration. Sierra has common stock of $10,000 and retained earnings of $2,360, for total stockholders’ equity of $12,360. 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 suffi cient for immedi- ate cash needs. The balance sheet will also be used to evaluate the relationship between debt and stockholders’ equity to determine whether the company has a satisfactory proportion of debt and common stock fi nancing.
STATEMENT OF CASH FLOWS
The primary purpose of a statement of cash fl ows is to provide fi nancial infor- mation about the cash receipts and cash payments of a business for a specifi c
period of time. To help investors, creditors, and others in their analysis of a company’s cash position, the statement of cash fl ows reports the cash effects of a company’s operating, investing, and fi nancing activi- ties. 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 fl ows because they want to know what is happening to a company’s most important
resource. The statement of cash fl ows provides answers to these simple but important questions:
• Where did cash come from during the period?
• How was cash used during the period?
• What was the change in the cash balance during the period?
The statement of cash fl ows 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 fi nancing activities increased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment.
Cash fl ows from operating activities Cash receipts from operating activities $11,200 Cash payments for operating activities (5,500)
Net cash provided by operating activities $ 5,700
Cash fl ows from investing activities Purchased offi ce equipment (5,000)
Net cash used by investing activities (5,000)
Cash fl ows from fi nancing activities Issuance of common stock 10,000 Issuance of note payable 5,000 Payment of dividend (500)
Net cash provided by fi nancing activities 14,500
Net increase in cash 15,200 Cash at beginning of period 0
Cash at end of period $15,200
SIERRA CORPORATION Statement of Cash Flows
For the Month Ended October 31, 2017
ILLUSTRATION 1-8 Sierra Corporation’s statement of cash fl ows
▼ HELPFUL HINT The heading of this statement identifi es the company, the type of statement, and the time period covered by the statement. Negative numbers are shown in parentheses.
DECISION TOOLS The statement of cash fl ows helps users determine if the company generates enough cash from opera- tions to fund its investing activities.
INTERRELATIONSHIPS OF STATEMENTS
Illustration 1-9 (page 16) shows the fi nancial statements of Sierra Corporation. Because the results on some fi nancial statements become inputs to other state- ments, the statements are interrelated. These interrelationships can be seen in Sierra’s fi nancial statements, as follows.
1. The retained earnings statement uses the results of the income statement. Sierra reported net income of $2,860 for the period. Net income is added to the beginning amount of retained earnings to determine ending retained earnings.
2. The balance sheet and retained earnings statement are also interrelated. Sierra reports the ending amount of $2,360 on the retained earnings statement as the retained earnings amount on the balance sheet.
3. Finally, the statement of cash fl ows relates to information on the balance sheet. The statement of cash fl ows shows how the Cash account changed dur- ing the period. It shows the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the $15,200 of cash at the end of the period. The ending amount of cash shown on the statement of cash fl ows must agree with the amount of cash on the balance sheet.
Study these interrelationships carefully. To prepare fi nancial statements, you must understand the sequence in which these amounts are determined and how each statement impacts the next.
The Four Financial Statements 15
PEOPLE, PLANET, AND PROFIT INSIGHT
Beyond Financial Statements
Should we expand our corporate reports beyond the income state- ment, retained earnings statement, balance sheet, and statement of cash fl ows? Some believe we should take into account ecological and
social performance, in addition to fi nancial results, in evaluat- ing a company. The argument is that a company’s responsibil- ity lies with anyone who is infl uenced by its actions. In other words, a company should be interested in benefi ting many different parties, instead of only maximizing stockholders’ interests.
A socially responsible business does not exploit or endan- ger any group of individuals. It follows fair trade practices, provides safe environments for workers, and bears respon- sibility for environmental damage. Granted, measurement of these factors is diffi cult. 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 chal- lenge of measuring and reporting their contributions to society, as well as their fi nancial results, to stockholders.
Why might a company’s stockholders be interested in its environmental and social performance? (Go to WileyPLUS for this answer and additional questions.)
© Marek Uliasz/iStockphoto
Assets
Cash $15,200 Accounts receivable 200 Advertising supplies 1,000 Prepaid insurance 550 Equipment, net 4,960
Total assets $21,910
Liabilities and Stockholders’ Equity
Liabilities Notes payable $ 5,000 Accounts payable 2,500 Unearned service revenue 800 Salaries and wages payable 1,200 Interest payable 50
Total liabilities $ 9,550
Stockholders’ equity Common stock 10,000 Retained earnings 2,360
Total stockholders’ equity 12,360
Total liabilities and stockholders’ equity $21,910
SIERRA CORPORATION Balance Sheet
October 31, 2017
Revenues Service revenue $10,600 Expenses Salaries 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
SIERRA CORPORATION Income Statement
For the Month Ended October 31, 2017
Cash fl ows from operating activities Cash receipts from operating activities $11,200 Cash payments for operating activities (5,500)
Net cash provided by operating activities $ 5,700
Cash fl ows from investing activities Purchased offi ce equipment (5,000)
Net cash used by investing activities (5,000)
Cash fl ows from fi nancing activities Issuance of common stock 10,000 Issued note payable 5,000 Payment of dividend (500)
Net cash provided by fi nancing activities 14,500
Net increase in cash 15,200 Cash at beginning of period 0
Cash at end of period $15,200
SIERRA CORPORATION Statement of Cash Flows
For the Month Ended October 31, 2017
Retained earnings, October 1 $ 0 Add: Net income 2,860
2,860 Less: Dividends 500
Retained earnings, October 31 $ 2,360
SIERRA CORPORATION Retained Earnings Statement
For the Month Ended October 31, 2017
ILLUSTRATION 1-9 Sierra Corporation’s fi nancial statements
▼ HELPFUL HINT Note that fi nal sums are double-underlined.
▼ HELPFUL HINT The arrows in this illustration show interrelationships of the four fi nancial statements.
▼ HELPFUL HINT Negative amounts are presented in parentheses.
16
SOLUTION
3a▼ Financial StatementsDO IT! CSU Corporation began operations on January 1, 2017. The following information is avail- able for CSU on December 31, 2017:
Accounts receivable 1,800 Retained earnings ? Supplies expense 200 Accounts payable 2,000 Equipment 16,000 Cash 1,400 Rent expense 9,000 Insurance expense 1,000 Dividends 600 Notes payable 5,000 Service revenue 17,000 Common stock 10,000 Supplies 4,000
Prepare an income statement, a retained earnings statement, and a balance sheet.
Action Plan ✔ Report the revenues and
expenses for a period of time in an income statement.
✔ Show the amounts and causes (net income and dividends) of changes in retained earnings during the period in the retained earnings statement.
✔ Present the assets and claims to those assets (liabilities and equity) at a specifi c point in time in the balance sheet.
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 Income Statement
For the Year Ended December 31, 2017
Retained earnings, January 1 $ 0 Add: Net income 6,800 6,800 Less: Dividends 600 Retained earnings, December 31 $6,200
CSU CORPORATION Retained Earnings Statement
For the Year Ended December 31, 2017
Related exercise material: BE1-5, BE1-6, BE1-7, BE1-8, BE1-9, BE1-10, DO IT! 1-3a, E1-4, E1-5, E1-6, E1-7, E1-8, E1-9, E1-10, E1-11, and E1-14.
17
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
CSU CORPORATION Balance Sheet
December 31, 2017
18 1 Introduction to Financial Statements
OTHER ELEMENTS OF AN ANNUAL REPORT
Publicly traded U.S. companies must provide shareholders with an annual report. The annual report always includes the fi nancial statements introduced in this chapter. The annual report also includes other important information such as a management discussion and analysis section, notes to the fi nancial state- ments, and an independent auditor’s report. No analysis of a company’s fi nancial situation and performance is complete without a review of these items.
Management Discussion and Analysis The management discussion and analysis (MD&A) section presents manage- ment’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. Management must highlight favorable or unfavorable trends and identify signifi cant events and uncertainties that affect these three factors. This discussion obviously involves a number of subjective estimates and opinions. A brief excerpt from the MD&A section of Columbia Sportswear’s annual report, which addresses its liquidity requirements, is presented in Illustration 1-10.
ILLUSTRATION 1-10 Columbia Sportswear’s management discussion and analysis
Our operations are affected by seasonal trends typical in the outdoor apparel and footwear industry and have historically resulted in higher sales and profi ts in the third and fourth calendar quarters. This pattern has resulted primarily from the timing of shipments of fall season products to wholesale customers in the third and fourth quarters and proportionally higher sales in our direct-to-consumer op- erations in the fourth quarter, combined with an expense base that is spread more evenly throughout the year. We believe that our liquidity requirements for at least the next 12 months will be adequately covered by existing cash, cash provided by operations and existing short-term borrowing arrangements.
COLUMBIA SPORTSWEAR COMPANY Management’s Discussion and Analysis of
Seasonality and Variability of Business
ILLUSTRATION 1-11 Notes to Columbia Sportswear’s fi nancial statements
We record wholesale, distributor, e-commerce and licensed product revenues when title passes and the risks and rewards of ownership have passed to the customer. Title generally passes upon shipment to, or upon receipt by, the customer depend- ing on the terms of sale with the customer. Retail store revenues are recorded at the time of sale.
COLUMBIA SPORTSWEAR COMPANY Notes to Financial Statements
Revenue Recognition
Notes to the Financial Statements Explanatory notes and supporting schedules accompany every set of fi nancial statements and are an integral part of the statements. The notes to the fi nancial statements clarify the fi nancial statements and provide additional detail. Infor- mation in the notes does not have to be quantifi able (numeric). Examples of notes are descriptions of the signifi cant 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 fi nancial position. Illustration 1-11 is an excerpt from the notes to Columbia Sportswear’s fi nan- cial statements. It describes the methods that the company uses to account for revenues.
Real World
Real World
The Four Financial Statements 19
Auditor’s Report An auditor’s report is prepared by an independent outside auditor. It states the audi- tor’s opinion as to the fairness of the presentation of the fi nancial position and results of operations and their conformance with generally accepted accounting principles. An auditor is an accounting professional who conducts an independent exami- nation of a company’s fi nancial statements. Only accountants who meet certain cri- teria and thereby attain the designation certifi ed public accountant (CPA) may perform audits. If the auditor is satisfi ed that the fi nancial statements provide a fair representation of the company’s fi nancial position and results of operations in accor- dance with generally accepted accounting principles, then the auditor expresses an unqualifi ed opinion. If the auditor expresses anything other than an unqualifi ed opinion, then readers should only use the fi nancial statements with caution. That is, without an unqualifi ed opinion, we cannot have complete confi dence that the fi nancial statements give an accurate picture of the company’s fi nancial health. For example, recently Blockbuster, Inc.’s auditor stated that its fi nancial situation raised “substantial doubt about the Company’s ability to continue as a going concern.” Illustration 1-12 is an excerpt from the auditor’s report from Columbia Sportswear’s 2014 annual report. Columbia received an unqualifi ed opinion from its auditor, Deloitte & Touche.
3b▼ Components of Annual ReportsDO IT! State whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the fi nancial statements, or the auditor’s report.
1. Descriptions of signifi cant accounting policies.
2. Unqualifi ed opinion.
3. Explanations of uncertainties and contingencies.
4. Description of ability to fund operations and expansion.
5. Description of results of operations.
6. Certifi ed public accountant (CPA).
SOLUTION 1. Descriptions of signifi cant accounting policies: Notes.
2. Unqualifi ed 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. Certifi ed public accountant (CPA): Auditor’s report.
Action Plan ✔ Realize that fi nancial
statements provide information about a company’s performance and fi nancial position.
✔ Be familiar with the other elements of the annual report in order to gain a fuller understanding of a company.
Related exercise material: BE1-11, DO IT! 1-3b, and E1-17.
ILLUSTRATION 1-12 Excerpt from auditor’s report on Columbia Sportswear’s fi nancial statements
In our opinion, such consolidated fi nancial statements present fairly, in all ma terial respects, the fi nancial position of Columbia Sportswear Company and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash fl ows for each of the three years in the period ended December 31, 2014, in confor- mity with accounting principles generally accepted in the United States of America. Also, in our opinion, such fi nancial statement schedules, when considered in relation to the basic consolidated fi nancial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
COLUMBIA SPORTSWEAR COMPANY Excerpt from Auditor’s Report
Real World
20 1 Introduction to Financial Statements
Using Decision Tools comprehensive exercises ask you to apply business information and the decision tools presented in the chapter. Most of these exercises are based on the companies highlighted in the Feature Story.
There is a good chance that you may have never heard of VF Corporation. There is also a very good chance that you are wearing one of VF’s products right now. VF owns North Face, Lee, Vans, Nautica, Wrangler, Timberland, and numerous other brands. VF is a direct competitor to Columbia Sportswear. Suppose that you are considering investing in shares of VF’s common stock.
INSTRUCTIONS
Answer these questions related to your decision whether to invest.
(a) What fi nancial statements should you evaluate? (b) What should these fi nancial statements tell you? (c) Do you care if the fi nancial statements have been audited? Explain. (d) Appendix B at the end of this textbook contains fi nancial statements for Columbia, and Appendix C contains those
for VF. You can make many comparisons between Columbia and VF in terms of their respective results from operations and fi nancial position. Compare their respective total assets, total revenues, and net cash provided by operating activities.
SOLUTION (a) Before you invest, you should evaluate the income statement, retained earnings statement, balance sheet, and state-
ment of cash fl ows. (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 divi- dend history. The balance sheet reveals the relationship between assets and liabilities. The statement of cash fl ows 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 fi nancial statements. These statements indicate that a CPA (certifi ed public accountant) has examined and expressed an opinion that the statements present fairly the fi nancial position and results of operations of the company. Investors and creditors should not make decisions without studying audited fi nancial statements.
(d) Many interesting comparisons can be made between the two companies (all numbers are in thousands). Columbia is smaller, with total assets of $1,792,209 versus $9,980,140 for VF, and it has lower revenue—$2,100,590 versus $12,282,161 for VF. In addition, Columbia’s net cash provided by operating activities of $185,783 is less than VF’s $1,697,629. However, while useful, these basic measures are not enough to determine whether one company is a better investment than the other. In later chapters, you will learn tools that will allow you to compare the relative profi tability and fi nancial health of these and other companies.
USING DECISION TOOLS—VF CORPORATION
LEARNING OBJECTIVES REVIEW
REVIEW AND PRACTICE
1 Identify the forms of business organization and the uses of accounting information. A sole proprietorship is a business owned by one person. A partnership is a business owned by two or more people associated as partners. A corporation is a separate legal entity for which evidence of ownership is provided by shares of stock.
Internal users are managers who need accounting infor- mation to plan, organize, and run business operations. The primary external users are investors and creditors. Investors (stockholders) use accounting information to decide whether to buy, hold, or sell shares of a company’s stock. Creditors (suppliers and bankers) use accounting
▼
The Review and Practice section provides opportunities for students to review key concepts and terms as well as complete multiple-choice questions, exercises, and a comprehensive problem. Detailed solutions are also included.
Glossary Review 21
information to assess the risk of granting credit or loaning money to a business. Other groups who have an indirect interest in a business are taxing authorities, customers, labor unions, and regulatory agencies.
2 Explain the three principal types of business activity. Financing activities involve collecting the necessary funds to support the business. Investing activities involve acquir- ing the resources necessary to run the business. Operating activities involve putting the resources of the business into action to generate a profi t.
3 Describe the four fi nancial statements and how they are prepared. An income statement presents the revenues and expenses of a company for a specifi c period of time. A retained earnings statement summarizes the changes in retained earnings that have occurred for a specifi c period of time. A balance sheet reports the assets, liabilities, and stockholders’ equity of a business at a specifi c date. A state- ment of cash fl ows summarizes information concerning
the cash infl ows (receipts) and outfl ows (payments) for a specifi c period of time. Assets are resources owned by a business. Liabilities are the debts and obligations of the business. Liabilities represent claims of creditors on the assets of the business. Stockholders’ equity represents the claims of owners on the assets of the business. Stockholders’ equity is subdi- vided into two parts: common stock and retained earnings. The basic accounting equation is Assets = Liabilities + Stockholders’ Equity. Within the annual report, the management discussion and analysis provides management’s interpretation of the company’s results and fi nancial position as well as a discussion of plans for the future. Notes to the fi nan- cial statements provide additional explanation or detail to make the fi nancial statements more informative. The auditor’s report expresses an opinion as to whether the fi nancial statements present fairly the company’s results of operations and fi nancial position.
Accounting The information system that identifi es, records, and communicates the economic events of an organiza- tion to interested users. (p. 5).
Annual report A report prepared by corporate management that presents fi nancial information including fi nancial statements, a management discussion and analysis section, notes, and an independent auditor’s report. (p. 18).
Assets Resources owned by a business. (p. 9).
Auditor’s report A report prepared by an independent outside auditor stating the auditor’s opinion as to the fairness of the presentation of the fi nancial position and results of operations and their conformance with gener- ally accepted accounting principles. (p. 19).
GLOSSARY REVIEW▼
DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
Are the company’s opera- tions profi table?
Income statement The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time.
What is the company’s policy toward dividends and growth?
Retained earnings statement
The retained earnings statement reports how much of this year’s income the company paid out in dividends to shareholders.
A company striving for rapid growth will pay a low (or no) dividend.
Does the company rely primarily on debt or stock- holders’ equity to fi nance its assets?
Balance sheet The balance sheet reports the company’s resources and claims to those resources. There are two types of claims: liabilities and stockholders’ equity.
Compare the amount of debt versus the amount of stockholders’ equity to determine whether the company relies more on creditors or owners for its fi nancing.
Does the company gener- ate suffi cient cash from operations to fund its investing activities?
Statement of cash fl ows The statement of cash fl ows shows the amount of net cash provided or used by operating activities, investing activities, and fi nancing activities.
Compare the amount of net cash provided by operating activities with the amount of net cash used by investing activities. Any defi ciency in cash from operating activities must be made up with cash from fi nancing activities.
If the company’s revenues exceed its expenses, it will report net income; other- wise, it will report a net loss.
22 1 Introduction to Financial Statements
Balance sheet A fi nancial statement that reports the assets and claims to those assets at a specifi c point in time. (p. 13).
Basic accounting equation Assets = Liabilities + Stock- holders’ Equity. (p. 13).
Certifi ed public accountant (CPA) An individual who has met certain criteria and is thus allowed to perform audits of corporations. (p. 19).
Common stock Term used to describe the total amount paid in by stockholders for the shares they purchase. (p. 9).
Corporation A business organized as a separate legal entity owned by stockholders. (p. 4).
Dividends Payments of cash from a corporation to its stockholders. (p. 9).
Expenses The cost of assets consumed or services used in the process of generating revenues. (p. 10).
Income statement A fi nancial statement that reports a company’s revenues and expenses and resulting net income or net loss for a specifi c period of time. (p. 11).
Liabilities Amounts owed to creditors in the form of debts and other obligations. (p. 9).
Management discussion and analysis (MD&A) A section of the annual report that presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. (p. 18).
Net income The amount by which revenues exceed ex- penses. (p. 10).
Net loss The amount by which expenses exceed revenues. (p. 10).
Notes to the fi nancial statements Notes clarify informa- tion presented in the fi nancial statements and provide additional detail. (p. 18).
Partnership A business owned by two or more persons as- sociated as partners. (p. 4).
Retained earnings The amount of net income retained in the corporation. (p. 12).
Retained earnings statement A fi nancial statement that summarizes the amounts and causes of changes in re- tained earnings for a specifi c time period. (p. 12).
Revenue 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. (p. 10).
Sarbanes-Oxley Act (SOX) Regulations passed by Congress to reduce unethical corporate behavior. (p. 7).
Sole proprietorship A business owned by one person. (p. 4).
Statement of cash fl ows A fi nancial statement that provides fi nancial information about the cash receipts and cash payments of a business for a specifi c period of time. (p. 14).
Stockholders’ equity The owners’ claim to assets. (p. 13).
PRACTICE MULTIPLE-CHOICE QUESTIONS▼
1. Which is not one of the three forms of business organization? (a) Sole proprietorship. (c) Partnership. (b) Creditorship. (d) Corporation.
2. Which is an advantage of corporations relative to partnerships and sole proprietorships? (a) Lower taxes. (b) Harder to transfer ownership. (c) Reduced legal liability for investors. (d) Most common form of organization.
3. Which statement about users of accounting informa- tion is incorrect? (a) Management is considered an internal user. (b) Taxing authorities are considered external users. (c) Present creditors are considered external users. (d) Regulatory authorities are considered internal users.
4. Which of the following did not result from the Sarbanes-Oxley Act? (a) Top management must now certify the accuracy
of fi nancial information. (b) Penalties for fraudulent activity increased. (c) Independence of auditors increased. (d) Tax rates on corporations increased.
5. Which is not one of the three primary business activities? (a) Financing. (c) Advertising. (b) Operating. (d) Investing.
6. Which of the following is an example of a fi nancing activity? (a) Issuing shares of common stock. (b) Selling goods on account. (c) Buying delivery equipment. (d) Buying inventory.
(LO 1)
(LO 1)
(LO 1)
(LO 1)
(LO 2)
(LO 2)
7. Net income will result during a time period when: (a) assets exceed liabilities. (b) assets exceed revenues. (c) expenses exceed revenues. (d) revenues exceed expenses.
8. The fi nancial statements for Macias Corporation contained the following information.
Accounts receivable $ 5,000 Sales revenue 75,000 Cash 15,000 Salaries and wages expense 20,000 Rent expense 10,000 What was Macias Corporation’s net income?
(a) $60,000. (c) $65,000. (b) $15,000. (d) $45,000.
9. What section of a statement of cash fl ows indicates the cash spent on new equipment during the past accounting period? (a) The investing activities section. (b) The operating activities section. (c) The fi nancing activities section. (d) The statement of cash fl ows does not give this
information. 10. Which statement presents information as of a spe-
cifi c point in time? (a) Income statement. (b) Balance sheet. (c) Statement of cash fl ows. (d) Retained earnings statement.
11. Which fi nancial statement reports assets, liabilities, and stockholders’ equity? (a) Income statement. (b) Retained earnings statement.
(LO 2)
(LO 3)
(LO 3)
(LO 3)
(LO 3)
Practice Multiple-Choice Questions 23
SOLUTIONS 1. (b) Creditorship is not a form of business organization. The other choices are incorrect because (a) sole proprietorship,
(c) partnership, and (d) corporation are all forms of business organization.
2. (c) An advantage of corporations is that investors are not personally liable for debts of the business. The other choices are incorrect because (a) lower taxes, (b) harder to transfer ownership, and (d) most common form of organization are not true of corporations.
3. (d) Regulatory authorities are considered external, not internal, users. The other choices are true statements.
4. (d) The Sarbanes-Oxley Act (SOX) was created to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals, not to address tax rates. The other choices are incorrect because (a) top management must now certify the accuracy of fi nancial information, (b) penalties for fraudulent activity increased, and (c) increased independence of auditors all resulted from SOX.
5. (c) Advertising is a type of operating activity. The other choices are incorrect because (a) fi nancing, (b) operating, and (d) investing are the three primary business activities.
6. (a) Issuing shares of common stock is a fi nancing activity. The other choices are incorrect because (b) selling goods on account is an operating activity, (c) buying delivery equipment is an investing activity, and (d) buying inventory is an operating activity.
7. (d) When a company earns more revenues than expenses, it will report net income during a time period. The other choices are incorrect because (a) assets and liabilities are on the balance sheet, not the income statement; (b) assets are on the balance sheet, not the income statement; and (c) net income results when revenues exceed expenses, not when expenses exceed revenues.
8. (d) Net income = Sales revenue ($75,000) − Salaries and wages expense ($20,000) − Rent expense ($10,000) = $45,000. The other choices are therefore incorrect.
9. (a) The investing activities section of the statement of cash fl ows provides information about property, plant, and equipment accounts, not (b) the operating activities section or (c) the fi nancing activities section. Choice (d) is incor- rect as the statement of cash fl ows does provide this information.
10. (b) The balance sheet presents information as of a specifi c point in time. The other choices are incorrect because the (a) income statement, (c) statement of cash fl ows, and (d) retained earnings statement all cover a period of time.
11. (c) The balance sheet is a formal presentation of the accounting equation, such that Assets = Liabilities + Stockholders’ Equity, not the (a) income statement, (b) retained earnings statement, or (d) statement of cash fl ows.
12. (d) Stockholders’ equity represents claims of owners. The other choices are incorrect because (a) claims of credi- tors and (b) claims of employees are liabilities. Choice (c) is incorrect because the difference between revenues and expenses is net income.
13. (d) Using the accounting equation, liabilities can be computed by subtracting stockholders’ equity from assets, or $3,500 − $1,500 = $2,000, not (a) $1,500, (b) $1,000, or (c) $2,500.
14. (a) The corporation’s accounting methods are described in the notes to the fi nancial statements, not in the (b) manage- ment discussion and analysis, (c) auditor’s report, or (d) income statement.
15. (b) The element of the annual report that presents an opinion regarding the fairness of the presentation of the fi – nancial position and results of operations is the auditor’s opinion, not the (a) income statement, (c) balance sheet, or (d) comparative statements.
14. The element of a corporation’s annual report that de- scribes the corporation’s accounting methods is/are the: (a) notes to the fi nancial statements. (b) management discussion and analysis. (c) auditor’s report. (d) income statement.
15. The element of the annual report that presents an opin- ion regarding the fairness of the presentation of the fi nancial position and results of operations is/are the: (a) income statement. (b) auditor’s opinion. (c) balance sheet. (d) comparative statements.
(LO 3)
(LO 3)
(c) Balance sheet. (d) Statement of cash fl ows.
12. Stockholders’ equity represents: (a) claims of creditors. (b) claims of employees. (c) the difference between revenues and expenses. (d) claims of owners.
13. As of December 31, 2017, Rockford Corporation has assets of $3,500 and stockholders’ equity of $1,500. What are the liabilities for Rockford Corporation as of December 31, 2017? (a) $1,500. (c) $2,500. (b) $1,000. (d) $2,000.
(LO 3)
(LO 3)
24 1 Introduction to Financial Statements
1. The following items and amounts were taken from Ricardo Inc.’s 2017 income state- ment and balance sheet.
Cash $ 84,700 Inventory $ 64,618 Retained earnings 123,192 Accounts receivable 88,419 Cost of goods sold 483,854 Sales revenue 693,485 Salaries and wages expense 125,000 Income taxes payable 6,499 Prepaid insurance 7,818 Accounts payable 49,384 Interest expense 994 Service revenue 8,998
INSTRUCTIONS
Prepare an income statement for Ricardo Inc. for the year ended December 31, 2017.
PRACTICE EXERCISES▼
Prepare an income statement.
(LO 3)
2. Cozy Bear is a private camping ground near the Mountain Home Recreation Area. It has compiled the following fi nancial information as of December 31, 2017.
Service revenue (from camping fees) $148,000 Dividends $ 9,000 Sales revenue (from general store) 35,000 Notes payable 50,000 Accounts payable 16,000 Expenses during 2017 135,000 Cash 18,500 Supplies 12,500 Equipment 129,000 Common stock 40,000 Retained earnings (1/1/2017) 15,000
INSTRUCTIONS
(a) Determine net income from Cozy Bear for 2017.
(b) Prepare a retained earnings statement and a balance sheet for Cozy Bear as of December 31, 2017.
Compute net income and prepare a balance sheet.
(LO 3)
SOLUTION
2. (a) Service revenue $148,000 Sales revenue 35,000
Total revenue 183,000 Expenses 135,000
Net income $ 48,000
SOLUTION
1.
Revenues Sales revenue $693,485 Service revenue 8,998
Total revenues $702,483 Expenses Cost of goods sold 483,854 Salaries and wages expense 125,000 Interest expense 994
Total expenses 609,848
Net income $ 92,635
RICARDO INC. Income Statement
For the Year Ended December 31, 2017
Practice Problem 25
(b)
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 fi nancial statements at the end of his fi rst year of operations. He relates the following facts about his business activities.
In order to get the business off the ground, Jeff decided to incorporate. He sold shares of common stock to a few close friends, as well as bought 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, 2017, was $49,500.
Prepare fi nancial statements.
(LO 3)
PRACTICE PROBLEM▼
Retained earnings, January 1 $15,000 Add: Net income 48,000
63,000 Less: Dividends 9,000
Retained earnings, December 31 $54,000
COZY BEAR Retained Earnings Statement
For the Year Ended December 31, 2017
Assets
Cash $ 18,500 Supplies 12,500 Equipment 129,000
Total assets $160,000
Liabilities and Stockholders’ Equity
Liabilities Notes payable $50,000 Accounts payable 16,000
Total liabilities $ 66,000 Stockholders’ equity Common stock 40,000 Retained earnings 54,000
Total stockholders’ equity 94,000
Total liabilities and stockholders’ equity $160,000
COZY BEAR Balance Sheet
December 31, 2017
26 1 Introduction to Financial Statements
SOLUTION
Revenues Service revenue $100,000 Expenses Salaries and wages expense $20,000 Insurance expense 10,000 Supplies expense 9,000 Rent expense 8,000 Interest expense 800
Total expenses 47,800
Net income $ 52,200
ICE CAMP Income Statement
For the Year Ended December 31, 2017
Retained earnings, January 1, 2017 $ 0 Add: Net income 52,200
52,200 Less: Dividends 5,000
Retained earnings, December 31, 2017 $ 47,200
ICE CAMP Retained Earnings Statement
For the Year Ended December 31, 2017
Assets
Cash $ 49,500 Accounts receivable 20,000 Equipment ($12,000 + $1,500) 13,500 Total assets $ 83,000
Liabilities and Stockholders’ Equity
Liabilities Notes payable $10,000 Interest payable 800
Total liabilities $ 10,800 Stockholders’ equity Common stock 25,000 Retained earnings 47,200
Total stockholders’ equity 72,200
Total liabilities and stockholders’ equity $ 83,000
ICE CAMP Balance Sheet
December 31, 2017
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 fl ows. (Hint: Prepare the statements in the order stated to take advantage of the fl ow of information from one statement to the next, as shown in Illustration 1-9 on page 16.)
1. What are the three basic forms of business orga- nizations?
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 fi nancial statements of Finzelberg. Indicate in which fi nancial 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 in- come statement and the retained earnings statement, and it is included indirectly in the company’s balance sheet.” Do you agree? Explain.
11. What is the primary purpose of the statement of cash fl ows?
12. What are the three main categories of the statement of cash fl ows? 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) Defi ne the terms assets, liabilities, and stockholders’ equity.
(b) What items affect stockholders’ equity?
Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.
QUESTIONS▼
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.
(b)
Cash fl ows from operating activities Cash receipts from operating activities $80,000 Cash payments for operating activities (47,000)
Net cash provided by operating activities $33,000
Cash fl ows from investing activities Purchase of equipment (13,500)
Net cash used by investing activities (13,500)
Cash fl ows from fi nancing activities Issuance of common stock 25,000 Issuance of notes payable 10,000 Dividends paid (5,000)
Net cash provided by fi nancing activities 30,000
Net increase in cash 49,500 Cash at beginning of period 0
Cash at end of period $49,500
ICE CAMP Statement of Cash Flows
For the Year Ended December 31, 2017
Questions 27
28 1 Introduction to Financial Statements
16. Which of these items are liabilities of White Glove Cleaning Service? (a) Cash. (f) Equipment. (b) Accounts payable. (g) Salaries and wages (c) Dividends. payable. (d) Accounts receivable. (h) Service revenue. (e) Supplies. (i) Rent expense.
17. How are each of the following fi nancial statements interrelated? (a) Retained earnings statement and in- come statement. (b) Retained earnings statement and balance sheet. (c) Balance sheet and statement of cash fl ows.
18. What is the purpose of the management dis- cussion and analysis section (MD&A)?
19. Why is it important for fi nancial statements to receive an unqualifi ed auditor’s opinion?
20. What types of information are presented in the notes to the fi nancial statements?
21. The accounting equation is Assets = Liabilities + Stock- holders’ Equity. Appendix A, at the end of this textbook, reproduces Apple’s fi nancial statements. Replacing words in the equation with dollar amounts, what is Apple’s accounting equation at September 27, 2014?
BE1-1 Match each of the following forms of business organization with a set of character- istics: sole proprietorship (SP), partnership (P), corporation (C). (a) _____ Shared control, tax advantages, increased skills and resources. (b) _____ Simple to set up and maintains control with 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. 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 an 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. (d) _____ Chief Financial Offi cer. (b) _____ Marketing managers. (e) _____ Internal Revenue Service. (c) _____ Creditors.
BE1-3 Indicate in which part of the statement of cash fl ows each item would appear: operating activities (O), investing activities (I), or fi nancing activities (F). (a) _____ Cash received from customers. (b) _____ Cash paid to stockholders (dividends). (c) _____ Cash received from issuing new common stock. (d) _____ Cash paid to suppliers. (e) _____ Cash paid to purchase a new offi ce building.
BE1-4 Presented below are a number of transactions. Determine whether each transac- tion affects common stock (C), dividends (D), revenues (R), expenses (E), or does not affect stockholders’ equity (NSE). Provide titles for the revenues and expenses. (a) Costs incurred for advertising. (b) Cash received for services performed. (c) Costs incurred for insurance. (d) Amounts paid to employees. (e) Cash distributed to stockholders. (f) Cash 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 Karol Company at December 31, 2017. Prepare a balance sheet following the format of Illustration 1-7 (page 13).
Accounts payable $65,000 Accounts receivable 71,000 Cash 22,000 Common stock 18,000 Retained earnings 10,000
Describe forms of business organization.
(LO 1), K
Identify users of accounting information.
(LO 1), K
Classify items by activity.
(LO 2), K
Determine effect of transactions on stockholders’ equity.
(LO 3), C
Prepare a balance sheet.
(LO 3), AP
BRIEF EXERCISES▼
DO IT! Exercises 29
Identify each of the following organizational characteristics with the business organizational form or forms with which it is associated.
(a) Easier to transfer ownership. (d) Tax advantages. (b) Easier to raise funds. (e) No personal legal liability. (c) More owner control.
Classify each item as an asset, liability, common stock, revenue, or expense.
(a) Issuance of ownership shares. (b) Land purchased. (c) Amounts owed to suppliers. (d) Bonds payable. (e) Amount earned from selling a product. (f) Cost of advertising.
DO IT! 1-1 Identify benefi ts of business organization forms.
(LO 1), C
DO IT! 1-2 Classify fi nancial statement elements.
(LO 2), K
EXERCISES▼DO IT!
BE1-6 Eskimo Pie Corporation markets a broad range of frozen treats, including its famous Eskimo Pie ice cream bars. The following items were taken from a recent income statement and balance sheet. In each case, identify whether the item would appear on the balance sheet (BS) or income statement (IS). (a) _____ Income tax expense. (f) _____ Sales revenue. (b) _____ Inventory. (g) _____ Cost of goods sold. (c) _____ Accounts payable. (h) _____ Common stock. (d) _____ Retained earnings. (i) _____ Accounts receivable. (e) _____ Equipment. (j) _____ Interest expense.
BE1-7 Indicate which statement you would examine to fi nd each of the following items: income statement (IS), balance sheet (BS), retained earnings statement (RES), or state- ment of cash fl ows (SCF). (a) Revenue during the period. (b) Supplies on hand at the end of the year. (c) Cash received from issuing new bonds during the period. (d) Total debts outstanding at the end of the period.
BE1-8 Use the basic accounting equation to answer these questions. (a) The liabilities of Lantz Company are $90,000 and the stockholders’ equity is $230,000.
What is the amount of Lantz Company’s total assets? (b) The total assets of Salley Company are $170,000 and its stockholders’ equity is
$80,000. What is the amount of its total liabilities? (c) The total assets of Brandon Co. are $800,000 and its liabilities are equal to one-fourth
of its total assets. What is the amount of Brandon Co.’s stockholders’ equity?
BE1-9 At the beginning of the year, Morales Company had total assets of $800,000 and total liabilities of $500,000. (Treat each item independently.) (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 stock- holders’ equity (SE). (a) Accounts receivable. (d) Supplies. (b) Salaries and wages payable. (e) Common stock. (c) Equipment. (f) Notes payable.
BE1-11 Which is not a required part of an annual report of a publicly traded company? (a) Statement of cash fl ows. (c) Management discussion and analysis. (b) Notes to the fi nancial statements. (d) All of these are required.
Determine where items appear on fi nancial statements.
(LO 3), K
Determine proper fi nancial statement.
(LO 3), K
Use basic accounting equation.
(LO 3), AP
Use basic accounting equation.
(LO 3), AP
Identify assets, liabilities, and stockholders’ equity.
(LO 3), K
Determine required parts of annual report.
(LO 3), K
E1-1 Here is a list of words or phrases discussed in this chapter: 1. Corporation 4. Partnership 7. Accounts payable 2. Creditor 5. Stockholder 8. Auditor’s opinion 3. Accounts receivable 6. Common stock
Instructions Match each word or phrase with the best description of it. ______ (a) An expression about whether fi nancial 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—fi nancing, investing, and operating. Listed below are the names and descriptions of companies in several different industries.
Abitibi Consolidated Inc.—manufacturer and marketer of newsprint Cal State–Northridge Stdt Union—university student union Oracle Corporation—computer software developer and retailer Sportsco Investments—owner of the Vancouver Canucks hockey club Grant Thornton LLP—professional accounting and business advisory firm Southwest Airlines—low-cost airline
Instructions (a) For each of the above companies, provide examples of (1) a fi nancing activity, (2) an
investing activity, and (3) an operating activity that the company likely engages in. (b) Which of the activities that you identifi ed in (a) are common to most businesses?
Which activities are not?
Match items with descriptions.
(LO 1, 2, 3), K
Identify business activities.
(LO 2), C
EXERCISES▼ Gray Corporation began operations on January 1, 2017. The following infor- mation is available for Gray Corporation on December 31, 2017.
Accounts payable $ 5,000 Notes payable $ 7,000 Accounts receivable 2,000 Rent expense 10,000 Advertising expense 4,000 Retained earnings ? Cash 3,100 Service revenue 25,000 Common stock 15,000 Supplies 1,900 Dividends 2,500 Supplies expense 1,700 Equipment 26,800
Prepare an income statement, a retained earnings statement, and a balance sheet for Gray Corporation.
Indicate whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the fi nancial statements, or the auditor’s report.
(a) Description of ability to pay near-term obligations. (b) Unqualifi ed opinion. (c) Details concerning liabilities, too voluminous to be included in the statements. (d) Description of favorable and unfavorable trends. (e) Certifi ed public accountant (CPA). (f) Descriptions of signifi cant accounting policies.
DO IT! 1-3aPrepare fi nancial statements.
(LO 3), AP
DO IT! 1-3bIdentify components of annual reports.
(LO 3), K
30 1 Introduction to Financial Statements
Exercises 31
E1-3 The Bonita Vista Golf & Country Club details the following accounts in its fi nancial statements.
Accounts payable _____ Accounts receivable _____ Equipment _____ Sales revenue _____ Service revenue _____ Inventory _____ Mortgage payable _____ Supplies expense _____ Rent expense _____ Salaries and wages expense _____
Instructions Classify each of the above accounts as an asset (A), liability (L), stockholders’ equity (SE), revenue (R), or expense (E) item.
E1-4 This information relates to Benser Co. for the year 2017.
Retained earnings, January 1, 2017 $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, 2017.
E1-5 Suppose the following information was taken from the 2017 fi nancial statements of pharmaceutical giant Merck and Co. (All dollar amounts are in millions.)
Retained earnings, January 1, 2017 $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 state-
ment for the year ending December 31, 2017. (b) Suppose that Merck decided to reduce its research and development expense by 50%.
What would be the short-term implications? What would be the long-term implica- tions? How do you think the stock market would react?
E1-6 Presented here is information for Zheng Inc. for 2017.
Retained earnings, January 1 $130,000 Service revenue 400,000 Total expenses 175,000 Dividends 65,000
Instructions Prepare the 2017 retained earnings statement for Zheng Inc.
E1-7 Consider each of the following independent situations. (a) The retained earnings statement of Lee Corporation shows dividends of $68,000,
while net income for the year was $75,000. (b) The statement of cash fl ows for Steele Corporation shows that cash provided by oper-
ating activities was $10,000, cash used in investing activities was $110,000, and cash provided by fi nancing activities was $130,000.
Classify accounts.
(LO 2, 3), C
Prepare income statement and retained earnings statement.
(LO 3), AP
Prepare a retained earnings statement.
(LO 3), AP
Interpret fi nancial facts.
(LO 3), AP
Prepare income statement and retained earnings statement.
(LO 3), AP
32 1 Introduction to Financial Statements
Instructions Calculate the missing amounts.
E1-10 Otay Lakes Park is a private camping ground near the Mount Miguel Recreation Area. It has compiled the following fi nancial information as of December 31, 2017.
Service revenue (from camping fees) $132,000 Dividends $ 9,000 Sales revenue (from general store) 25,000 Notes payable 50,000 Accounts payable 11,000 Expenses during 2017 126,000 Cash 8,500 Supplies 5,500 Equipment 114,000 Common stock 40,000 Retained earnings (1/1/2017) 5,000
Instructions (a) Determine Otay Lakes Park’s net income for 2017. (b) Prepare a retained earnings statement and a balance sheet for Otay Lakes Park as of
December 31, 2017.
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
DONAVAN, INC. Balance Sheet
Liabilities and Stockholders’ Equity
Liabilities Accounts payable $ 5,000 Stockholders’ equity Common stock (a) Retained earnings (b)
Total liabilities and stockholders’ equity $62,000
Assets
Cash $ 7,000 Inventory 10,000 Buildings 45,000
Total assets $62,000
Instructions For each company, provide a brief discussion interpreting these fi nancial facts. For example, you might discuss the company’s fi nancial health or its apparent growth philosophy.
E1-8 The following items and amounts were taken from Lonyear Inc.’s 2017 income state- ment and balance sheet. ______ Cash $ 84,700 ______ Accounts receivable $ 88,419 ______ Retained earnings 123,192 ______ Sales revenue 584,951 ______ Cost of goods sold 438,458 ______ Notes payable 6,499 ______ Salaries and wages expense 115,131 ______ Accounts payable 49,384 ______ Prepaid insurance 7,818 ______ Service revenue 4,806 ______ Inventory 64,618 ______ Interest expense 1,882
Instructions (a) In each, case, identify on the blank line whether the item is an asset (A), liability (L),
stockholders’ equity (SE), revenue (R), or expense (E) item. (b) Prepare an income statement for Lonyear Inc. for the year ended December 31, 2017.
E1-9 Here are incomplete fi nancial statements for Donavan, Inc.
Identify fi nancial statement components and prepare income statement.
(LO 3), C
Calculate missing amounts.
(LO 3), AN
Compute net income and prepare a balance sheet.
(LO 3), AP
Exercises 33
(c) Upon seeing this income statement, Walt Jones, the campground manager, im- mediately 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 lead- ing producer of grain-based convenience foods such as frozen waffl es and cereal bars. Suppose the following items were taken from its 2017 income statement and balance sheet. (All dollars are in millions.)
____ Retained earnings $5,481 ____ Bonds payable $ 4,835 ____ Cost of goods sold 7,184 ____ Inventory 910 ____ Selling and ____ Sales revenue 12,575
administrative expenses 3,390 ____ Accounts payable 1,077 ____ Cash 334 ____ Common stock 105 ____ Notes payable 44 ____ Income tax expense 498 ____ Interest expense 295
Instructions (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,
2017.
E1-12 This information is for Williams Corporation for the year ended December 31, 2017.
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 1/1/17 12,000
Instructions (a) Prepare the 2017 statement of cash fl ows for Williams Corporation. (b) Suppose you are one of Williams’ creditors. Referring to the statement of cash fl ows,
evaluate Williams’ ability to repay its creditors.
E1-13 Suppose the following data are derived from the 2017 fi nancial statements of Southwest Airlines. (All dollars are in millions.) Southwest has a December 31 year-end.
Cash balance, January 1, 2017 $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 fl ows for Southwest Airlines for
the year ended December 31, 2017. (b) Discuss whether the company’s net cash provided by operating activities was suffi –
cient to fi nance its investing activities. If it was not, how did the company fi nance its investing activities?
E1-14 Wayne Holtz is the bookkeeper for Beeson Company. Wayne has been trying to get the balance sheet of Beeson Company to balance. It fi nally balanced, but now he’s not sure it is correct.
Identify fi nancial statement components and prepare an income statement.
(LO 3), AP
Prepare a statement of cash fl ows.
(LO 3), AP
Correct an incorrectly prepared balance sheet.
(LO 3), AP
Prepare a statement of cash fl ows.
(LO 3), AP
34 1 Introduction to Financial Statements
Walco Corporation Gunther Enterprises Beginning of year Total assets $110,000 $150,000 Total liabilities 70,000 (d) Total stockholders’ equity (a) 70,000 End of year Total assets (b) 180,000 Total liabilities 120,000 55,000 Total stockholders’ equity 60,000 (e) Changes during year in retained earnings Dividends (c) 5,000 Total revenues 215,000 (f) Total expenses 165,000 80,000
Instructions Determine the missing amounts. Assume all changes in stockholders’ equity are due to changes in retained earnings.
E1-17 The annual report provides fi nancial information in a variety of formats, including the following.
Management discussion and analysis (MD&A) Financial statements Notes to the financial statements Auditor’s opinion
Classify various items in an annual report.
(LO 3), K
BEESON COMPANY Balance Sheet
December 31, 2017
Assets
Cash $18,000 Supplies 9,500 Equipment 40,000 Dividends 8,000
Total assets $75,500
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.)
1. Cash $2,291.1 7. Inventory $2,357.0 2. Accounts receivable 2,883.9 8. Income taxes payable 86.3 3. Common stock 2,874.2 9. Equipment 1,957.7 4. Notes payable 342.9 10. Retained earnings 5,818.9 5. Buildings 3,759.9 11. Accounts payable 2,815.8 6. Mortgage payable 1,311.5
Instructions Perform each of the following. (a) Classify each of these items as an asset, liability, or stockholders’ equity, and deter-
mine the total dollar amount for each classifi cation. (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 fi nancing?
E1-16 The summaries of data from the balance sheet, income statement, and retained earnings statement for two corporations, Walco Corporation and Gunther Enterprises, are presented as follows for 2017.
Use fi nancial statement relationships to determine missing amounts.
(LO 3), AN
Classify items as assets, liabilities, and stockholders’ equity and prepare accounting equation.
(LO 3), AP
Problems: Set A 35
Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.
EXERCISES: SET B AND CHALLENGE EXERCISES
▼
P1-1A Presented below are fi ve independent situations.
(a) Three physics professors at MIT have formed a business to improve the speed of infor- mation transfer over the Internet for stock exchange transactions. Each has contrib- uted 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) Bob Colt, a college student looking for summer employment, opened a bait shop in a small shed at a local marina.
(c) Alma Ortiz and Jaime Falco each owned separate shoe manufacturing businesses. They have decided to combine their businesses. They expect that within the coming year they will need signifi cant funds to expand their operations.
(d) Alice, Donna, and Sam 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) Don Rolls 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 manufac- turing facility to make the devices and then sell them to veterinarians across the country. Don 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 propri- etorship, partnership, or corporation. Give reasons for your choice.
P1-2A Financial decisions often place heavier emphasis on one type of fi nancial statement over the others. Consider each of the following hypothetical situations independently.
(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 com- pany 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 fi fth year.
(d) The president of Campbell Soup is trying to determine whether the company is gener- ating 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.
Determine forms of business organization.
(LO 1), C
Identify users and uses of fi nancial statements.
(LO 3), C
PROBLEMS: SET A▼
Instructions For each of the following, state in what area of the annual report the item would be pre- sented. If the item would probably not be found in an annual report, state “Not disclosed.” (a) The total cumulative amount received from stockholders in exchange for common
stock. (b) An independent assessment concerning whether the fi nancial statements present a
fair depiction of the company’s results and fi nancial 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.
36 1 Introduction to Financial Statements
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 fl ows. In each case provide a brief justifi cation for your choice. Choose only one fi nancial statement in each case.
P1-3A On June 1, 2017, Elite Service Co. was started with an initial investment in the com- pany of $22,100 cash. Here are the assets, liabilities, and common stock of the company at June 30, 2017, and the revenues and expenses for the month of June, its fi rst month of operations:
Cash $ 4,600 Notes payable $12,000 Accounts receivable 4,000 Accounts payable 500 Service revenue 7,500 Supplies expense 1,000 Supplies 2,400 Maintenance and repairs expense 600 Advertising expense 400 Utilities expense 300 Equipment 26,000 Salaries and wages expense 1,400 Common stock 22,100
In June, the company issued no additional stock but paid dividends of $1,400.
Instructions (a) Prepare an income statement and a retained earnings statement for the month of June
and a balance sheet at June 30, 2017. (b) Briefl y discuss whether the company’s fi rst month of operations was a success. (c) Discuss the company’s decision to distribute a dividend.
P1-4A Presented below is selected fi nancial information for Rojo Corporation for December 31, 2017.
Inventory $ 25,000 Cash paid to purchase equipment $ 12,000 Cash paid to suppliers 104,000 Equipment 40,000 Buildings 200,000 Service revenue 100,000 Common stock 50,000 Cash received from customers 132,000 Cash dividends paid 7,000 Cash received from issuing Cash at beginning of period 9,000 common stock 22,000
Instructions (a) Determine which items should be included in a statement of cash fl ows and then pre-
pare the statement for Rojo Corporation. (b) Comment on the adequacy of net cash provided by operating activities to fund the
company’s investing activities and dividend payments.
P1-5A Micado Corporation was formed on January 1, 2017. At December 31, 2017, Miko Liu, the president and sole stockholder, decided to prepare a balance sheet, which appeared as follows.
MICADO CORPORATION Balance Sheet
December 31, 2017
Assets Liabilities and Stockholders’ Equity
Cash $20,000 Accounts payable $30,000 Accounts receivable 50,000 Notes payable 15,000 Inventory 36,000 Boat loan 22,000 Boat 24,000 Stockholders’ equity 63,000
Miko willingly admits that she is not an accountant by training. She is concerned that her balance sheet might not be correct. She has provided you with the following additional information.
1. The boat actually belongs to Miko, not to Micado Corporation. However, because she thinks she might take customers out on the boat occasionally, she decided to list it as an asset of the company. To be consistent, she also listed as a liability of the corpora- tion her personal loan that she took out at the bank to buy the boat.
2. The inventory was originally purchased for $25,000, but due to a surge in demand Miko now thinks she could sell it for $36,000. She thought it would be best to record it at $36,000.
Check fi gures provide a key number to let you know you are on the right track.
(a) Net income $ 3,800 Ret. earnings $ 2,400 Tot. assets $37,000
Determine items included in a statement of cash fl ows, prepare the statement, and comment.
(LO 3), AP
(a) Net increase $31,000
Comment on proper accounting treatment and prepare a corrected balance sheet.
(LO 3), AN
Prepare an income statement, retained earnings statement, and balance sheet; discuss results.
(LO 3), AP
Expand Your Critical Thinking 37
3. Included in the accounts receivable balance is $10,000 that Miko loaned to her brother 5 years ago. Miko included this in the receivables of Micado Corporation so she wouldn’t forget that her brother owes her money.
Instructions (a) Comment on the proper accounting treatment of the three items above. (b) Provide a corrected balance sheet for Micado Corporation. (Hint: To get the balance
sheet to balance, adjust stockholders’ equity.) (b) Tot. assets $85,000
CC1 Natalie Koebel spent much of her childhood learning the art of cookie-making from her grandmother. They spent many happy hours mastering every type of cookie imagin- able and later devised new recipes that were both healthy and delicious. Now at the start of her second year in college, Natalie is investigating possibilities for starting her own business as part of the entrepreneurship program in which she is enrolled. A long-time friend insists that Natalie has to include cookies in her business plan. After a series of brainstorming sessions, Natalie settles on the idea of operating a cookie-making school. She will start on a part-time basis and offer her services in people’s homes. Now that she has started thinking about it, the possibilities seem endless. During the fall, she will con- centrate on holiday cookies. She will offer group sessions (which will probably be more en- tertainment than education) and individual lessons. Natalie also decides to include children in her target market. The fi rst diffi cult decision is coming up with the perfect name for her business. She settles on “Cookie Creations,” and then moves on to more important issues.
Instructions (a) What form of business organization—proprietorship, partnership, or corporation—do
you recommend that Natalie use for her business? Discuss the benefi ts and weak- nesses of each form that Natalie might consider.
(b) Will Natalie need accounting information? If yes, what information will she need and why? How often will she need this information?
(c) Identify specifi c asset, liability, revenue, and expense accounts that Cookie Creations will likely use to record its business transactions.
(d) Should Natalie open a separate bank account for the business? Why or why not? (e) Natalie expects she will have to use her car to drive to people’s homes and to pick up sup-
plies, but she also needs to use her car for personal reasons. She recalls from her fi rst-year accounting course something about keeping business and personal assets separate. She wonders what she should do for accounting purposes. What do you recommend?
CONTINUING PROBLEM Cookie Creations▼
The Cookie Creations problem starts in Chapter 1 and continues in every chapter. You can also fi nd this problem at the book’s companion website.
© leungchopan/ Shutterstock
Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.
PROBLEMS: SET B AND SET C▼
EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.
CT1-1 The fi nancial statements of Apple Inc. for 2014 are presented in Appendix A.
Instructions Refer to Apple’s fi nancial statements and answer the following questions.
(a) What were Apple’s total assets at September 27, 2014? At September 28, 2013? (b) How much cash (and cash equivalents) did Apple have on September 27, 2014? (c) What amount of accounts payable did Apple report on September 27, 2014? On
September 28, 2013? (d) What were Apple’s net sales in 2012? In 2013? In 2014? (e) What is the amount of the change in Apple’s net income from 2013 to 2014?
Financial Reporting
▼
E
38 1 Introduction to Financial Statements
COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation
CT1-2 Columbia Sportswear Company’s fi nancial statements are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.
Instructions (a) Based on the information in these financial statements, determine the following for
each company. (1) Total liabilities at December 31, 2014. (2) Net property, plant, and equipment at December 31, 2014. (3) Net cash provided or (used) in investing activities for 2014. (4) Net income for 2014. (b) What conclusions concerning the two companies can you draw from these data?
COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.
CT1-3 Amazon.com, Inc.’s fi nancial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.
Instructions (a) Based on the information contained in these financial statements, determine the follow-
ing for each company. (1) Total assets at December 31, 2014, for Amazon and for Wal-Mart at January 31,
2015. (2) Receivables (net) at December 31, 2014, for Amazon and for Wal-Mart at January
31, 2015. (3) Net sales (product only) for the year ended in 2014 (2015 for Wal-Mart). (4) Net income for year ended in 2014 (2015 for Wal-Mart). (b) What conclusions concerning these two companies can be drawn from these data?
INTERPRETING FINANCIAL STATEMENTS
CT1-4 Xerox was not having a particularly pleasant year. The company’s stock price had already fallen in the previous year from $60 per share to $30. Just when it seemed things couldn’t get worse, Xerox’s stock fell to $4 per share. The data below were taken from the statement of cash fl ows of Xerox. (All dollars are in millions.)
Cash used in operating activities $ (663) Cash used in investing activities (644) Financing activities Dividends paid $ (587) Net cash received from issuing debt 3,498
Cash provided by fi nancing activities 2,911
Instructions Analyze the information, and then answer the following questions.
(a) If you were a creditor of Xerox, what reaction might you have to the above information? (b) If you were an investor in Xerox, what reaction might you have to the above information? (c) If you were evaluating the company as either a creditor or a stockholder, what other
information would you be interested in seeing? (d) Xerox decided to pay a cash dividend. This dividend was approximately equal to the
amount paid in the previous year. Discuss the issues that were probably considered in making this decision.
REAL-WORLD FOCUS
CT1-5 Purpose: Identify summary information about companies. This information in- cludes basic descriptions of the company’s location, activities, industry, fi nancial health, and fi nancial performance.
Address: http://biz.yahoo.com/i
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Expand Your Critical Thinking 39
Steps 1. Type in a company name, or use the index to find company name. 2. Under Financials, choose Income Statement. Perform instructions (a) and (b) below. 3. Under Company, choose Industry to identify others in this industry. Perform instruc-
tions (c)–(e) below.
Instructions Answer the following questions.
(a) What is the company’s net income? Over what period was this measured? (b) What is the company’s total sales? Over what period was this measured? (c) What is the company’s industry? (d) What are the names of four companies in this industry? (e) Choose one of the competitors. What is this competitor’s name? What is its total sales?
What is its net income?
CT1-6 The June 22, 2011, issue of the Wall Street Journal Online includes an article by Michael Rapoport entitled “Auditors Urged to Tell More.” It provides an interesting discus- sion of the possible expanding role of CPAs.
Instructions Read the article and answer the following questions.
(a) What are some of the ideas that the Public Company Accounting Oversight Board proposed for expanding the role of auditors in “passing judgment on more of what a company does and says?”
(b) How might the financial crisis influence the public’s opinion regarding the need for more information from auditors?
(c) Describe the proposed “Auditor’s Discussion and Analysis.” (d) Discuss whether you think that auditors will view these proposals positively or
negatively.
DECISION-MAKING ACROSS THE ORGANIZATION
CT1-7 Sylvia Ayala recently accepted a job in the production department at Apple. Before she starts work, she decides to review the company’s annual report to better understand its operations. The content and organization of corporate annual reports have become fairly stan- dardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional fi nancial portions of the annual report:
• Financial Highlights • Letter to the Stockholders • Management’s Discussion and Analysis • Financial Statements • Notes to the Financial Statements • Management’s Responsibility for Financial Reporting • Management’s Report on Internal Control over Financial Reporting • Report of Independent Registered Public Accounting Firm • Selected Financial Data
The offi cial SEC fi ling of the annual report is called a Form 10-K, which often omits the public relations pieces found in most standard annual reports. To access Apple’s Form 10-K, including notes to the fi nancial statements, follow these steps:
1. Go to http://investor.apple.com. 2. Select the Financial Information tab. 3. Select the 10-K annual report dated September 2014. 4. The financial portions of the annual report begin on page 21.
Instructions Use Apple’s annual report to answer the following questions.
(a) What CPA firm performed the audit of Apple’s financial statements? (b) What was the amount of Apple’s basic earnings per share in 2014?
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40 1 Introduction to Financial Statements
(c) What are the company’s net sales in foreign countries in 2014? (d) What were net sales in 2012? (e) How many shares of common stock have been authorized? (f) How much cash was spent on capital expenditures in 2014? (g) Over what life does the company depreciate its buildings? (h) What was the value of inventory in 2013?
COMMUNICATION ACTIVITY
CT1-8 Marci Ling is the bookkeeper for Samco Company, Inc. Marci has been trying to get the company’s balance sheet to balance. She fi nally got it to balance, but she still isn’t sure that it is correct.
SAMCO COMPANY, INC. Balance Sheet
For the Month Ended December 31, 2017
Assets Liabilities and Stockholders’ Equity
Equipment $18,000 Common stock $12,000 Cash 9,000 Accounts receivable (6,000) Supplies 1,000 Dividends (2,000) Accounts payable (4,000) Notes payable 10,000
Total assets $24,000 Retained earnings 10,000
Total liabilities and stockholders’ equity $24,000
Instructions Explain to Marci Ling in a memo (a) the purpose of a balance sheet, and (b) why this balance sheet is incorrect and what she should do to correct it.
ETHICS CASE
CT1-9 Rules governing the investment practices of individual certifi ed public accountants prohibit them from investing in the stock of a company that their fi rm audits. The Secu- rities and Exchange Commission (SEC) became concerned that some accountants were violating this rule. In response to an SEC investigation, PricewaterhouseCoopers fi red 10 people and spent $25 million educating employees about the investment rules and install- ing an investment tracking system.
Instructions Answer the following questions.
(a) Why do you think rules exist that restrict auditors from investing in companies that are audited by their firms?
(b) Some accountants argue that they should be allowed to invest in a company’s stock as long as they themselves aren’t involved in working on the company’s audit or consult- ing. What do you think of this idea?
(c) Today, a very high percentage of publicly traded companies are audited by only four very large public accounting firms. These firms also do a high percentage of the con- sulting work that is done for publicly traded companies. How does this fact compli- cate the decision regarding whether CPAs should be allowed to invest in companies audited by their firm?
(d) Suppose you were a CPA and you had invested in IBM when IBM was not one of your firm’s clients. Two years later, after IBM’s stock price had fallen considerably, your firm won the IBM audit contract. You will be involved in working with the IBM audit. You know that your firm’s rules require that you sell your shares immediately. If you do sell immediately, you will sustain a large loss. Do you think this is fair? What would you do?
(e) Why do you think PricewaterhouseCoopers took such extreme steps in response to the SEC investigation?
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Expand Your Critical Thinking 41
ALL ABOUT YOU
CT1-10 Some people are tempted to make their fi nances look worse to get fi nancial aid. Companies sometimes also manage their fi nancial numbers in order to accomplish certain goals. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. In managing earnings, companies’ actions vary from being within the range of ethical activity, to being both unethical and illegal attempts to mislead investors and creditors.
Instructions Provide responses for each of the following questions.
(a) Discuss whether you think each of the following actions (adapted from www.finaid. org/fafsa/maximize.phtml) to increase the chances of receiving financial aid is ethical.
(i) Spend down the student’s assets and income first, before spending parents’ assets and income.
(ii) Accelerate necessary expenses to reduce available cash. For example, if you need a new car, buy it before applying for financial aid.
(iii) State that a truly financially dependent child is independent. (iv) Have a parent take an unpaid leave of absence for long enough to get below the
“threshold” level of income. (b) What are some reasons why a company might want to overstate its earnings? (c) What are some reasons why a company might want to understate its earnings? (d) Under what circumstances might an otherwise ethical person decide to illegally over-
state or understate earnings?
FASB CODIFICATION ACTIVITY
CT1-11 The FASB has developed the Financial Accounting Standards Board Account- ing Standards Codifi cation (or more simply “the Codifi cation”). The FASB’s primary goal in developing the Codifi cation is to provide in one place all the authoritative literature related to a particular topic. To provide easy access to the Codifi cation, the FASB also developed the Financial Accounting Standards Board Codifi cation Research System (CRS). CRS is an online, real-time database that provides easy access to the Codifi cation. The Codifi cation and the related CRS provide a topically organized structure, subdivided into topic, subtopics, sections, and paragraphs, using a numerical index system. You may fi nd this system useful in your present and future studies, and so we have provided an opportunity to use this online system as part of the Expand Your Critical Thinking section.
Instructions Academic access to the FASB Codifi cation is available through university subscriptions, obtained from the American Accounting Association (at http://aaahq.org/FASB/Access. cfm), for an annual fee of $150. This subscription covers an unlimited number of students within a single institution. Once this access has been obtained by your school, you should log in (at http://aaahq.org/ascLogin.cfm) and familiarize yourself with the resources that are accessible at the FASB Codifi cation site.
CONSIDERING PEOPLE, PLANET, AND PROFIT
CT1-12 Although Clif Bar & Company is not a public company, it does share its fi nancial information with its employees as part of its open-book management approach. Further, although it does not publicly share its fi nancial information, it does provide a different form of an annual report to external users. In this report, the company provides informa- tion regarding its sustainability efforts.
Address: www.clifbar.com/article/our-fi ve-aspirations
Instructions Access the article at the site shown above and then answer the following questions.
(a) What are the Five Aspirations? (b) Click on the “All Aspirations Annual Report” link at the bottom of the page. How does
this annual report differ from the annual report discussed in the chapter? Are there any similarities?
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42 1 Introduction to Financial Statements
A Look at IFRS
Most agree that there is a need for one set of international accounting standards. Here is why:
Multinational corporations. Today’s companies view the entire world as their market. For example, Coca-Cola, Intel, and McDonald’s generate more than 50% of their sales outside the United States. Many foreign companies, such as Toyota, Nestlé, and Sony, find their largest market to be the United States.
Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann suggest that we will see even more such business combinations of companies from dif- ferent countries in the future.
Information technology. As communication barriers continue to topple through advances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another.
Financial markets. Financial markets are of international significance today. Whether it is currency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.
KEY POINTS Following are the key similarities and differences between GAAP and IFRS as related to accounting fundamentals.
Similarities • The basic techniques for recording business transactions are the same for U.S. and
international companies. • Both international and U.S. accounting standards emphasize transparency in financial
reporting. Both sets of standards are primarily driven by meeting the needs of investors and creditors.
• The three most common forms of business organizations, proprietorships, partner- ships, and corporations, are also found in countries that use international accounting standards.
Differences • International standards are referred to as International Financial Reporting Standards
(IFRS), developed by the International Accounting Standards Board. Accounting stan- dards in the United States are referred to as generally accepted accounting principles (GAAP) and are developed by the Financial Accounting Standards Board.
• IFRS tends to be simpler in its accounting and disclosure requirements; some people say it is more “principles-based.” GAAP is more detailed; some people say it is more “rules-based.”
• The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation.
LOOKING TO THE FUTURE Both the IASB and the FASB are hard at work developing standards that will lead to the elimination of major differences in the way certain transactions are accounted for and reported.
LEARNING OBJECTIVE 4 Describe the impact of international accounting standards on U.S. fi nancial reporting.▼
A Look at IFRS 43
IFRS Practice IFRS SELF-TEST QUESTIONS 1. Which of the following is not a reason why a single set of high-quality international
accounting standards would be beneficial? (a) Mergers and acquisition activity. (b) Financial markets. (c) Multinational corporations. (d) GAAP is widely considered to be a superior reporting system.
2. The Sarbanes-Oxley Act determines: (a) international tax regulations. (b) internal control standards as enforced by the IASB. (c) internal control standards of U.S. publicly traded companies. (d) U.S. tax regulations.
3. IFRS is considered to be more: (a) principles-based and less rules-based than GAAP. (b) rules-based and less principles-based than GAAP. (c) detailed than GAAP. (d) None of the above.
IFRS EXERCISES IFRS1-1 Who are the two key international players in the development of international accounting standards? Explain their role.
IFRS1-2 What is the benefit of a single set of high-quality accounting standards?
INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS1-3 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.
Instructions Visit Louis Vuitton’s corporate website and answer the following questions from the company’s 2014 annual report.
(a) What accounting firm performed the audit of Louis Vuitton’s financial statements? (b) What is the address of the company’s corporate headquarters? (c) What is the company’s reporting currency?
Answers to IFRS Self-Test Questions 1. d 2. c 3. a
LEARNING OBJECTIVES PRACTICE
CHAPTER OUTLINE
• Current assets • Long-term investments • Property, plant, and equipment • Intangible assets • Current liabilities • Long-term liabilities • Stockholders’ equity
▼1 Identify the sections of a classifi ed balance sheet.
DO IT!
1
1a Assets Section of Classifi ed Balance Sheet
1b Balance Sheet Classifi cations
33
▼Discuss fi nancial reporting concepts.
• The standard-setting environment
• Qualities of useful information • Assumptions in fi nancial
reporting • Principles in fi nancial reporting • Cost constraint
DO IT!
3 Financial Accounting Concepts and Principles
▼2
3
Use ratios to evaluate a company’s profi tability, liquidity, and solvency.
• Ratio analysis • Using the income statement • Using a classifi ed balance
sheet • Using the statement of cash
fl ows
DO IT!
2 Ratio Analysis
If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the shares
are worth? If you manage Columbia Sportswear’s credit department, how should you determine
whether to extend credit to a new customer? If you are a fi nancial executive at Google, how do you
decide whether your company is generating adequate cash to expand operations without borrowing?
Your decision in each of these situations will be infl uenced by a variety of considerations. One of
them should be your careful analysis of a company’s fi nancial statements. The reason: Financial
statements offer relevant and reliable information, which will help you in your decision-making.
In this chapter, we take a closer look at the balance sheet and introduce some useful ways for
evaluating the information provided by the fi nancial statements. We also examine the fi nancial reporting
concepts underlying the fi nancial statements. We begin by introducing the classifi ed balance sheet.
CHAPTER PREVIEW
A Further Look at Financial Statements 2
Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.
Visit for additional tutorials and practice opportunities.
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Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.
Two early pioneers in providing investment information to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare’s As You Like It. The fool in Shakespeare’s play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st-century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders. The Motley Fool’s online bulletin board enables investors to exchange information and insights about companies.
Critics of these bulletin boards contend that they are simply high-tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very
people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.
To show how these bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy Company, the largest seller of electronics equipment in the United States. You scanned the Internet investment bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings:
TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”
broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”
One says sell, and one says buy. Whom should you believe? If you had taken “broachman’s” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 fi ve years later. Best Buy was one of America’s best-performing stocks during that period of time.
Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.
FEATURE STORY
Just Fooling Around?
© mattjeacock/iStockphoto
46 2 A Further Look at Financial Statements
LEARNING OBJECTIVE 1 Identify the sections of a classifi ed balance sheet.▼
In Chapter 1, you learned that a balance sheet presents a snapshot of a com- pany’s fi nancial position at a point in time. It lists individual asset, liability, and stockholders’ equity items. However, to improve users’ understanding of a company’s fi nancial position, companies often use a classifi ed balance sheet instead. A classifi ed balance sheet groups together similar assets and similar liabilities, using a number of standard classifi cations and sections. This is useful because items within a group have similar economic characteristics. A classifi ed balance sheet generally contains the standard classifi cations listed in Illustration 2-1.
These groupings help fi nancial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short- and long-term creditors on the company’s total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2 on the next page. In the sections that follow, we explain each of these groupings.
CURRENT ASSETS
Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2, Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classifi cation as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year. Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one-year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term. Common types of current assets are (1) cash, (2) investments (such as short- term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.
ILLUSTRATION 2-1 Standard balance sheet classifi cations
Assets Liabilities and Stockholders’ Equity
Current assets Current liabilities Long-term investments Long-term liabilities Property, plant, and equipment Stockholders’ equity Intangible assets
Illustration 2-3 presents the current assets of Southwest Airlines Co. in a recent year.
▼ HELPFUL HINT Recall that the accounting equation is Assets = Liabilities + Stockholders’ Equity.
ILLUSTRATION 2-2 Classifi ed balance sheet
Assets
Current assets Cash $ 6,600 Debt investments 2,000 Accounts receivable 7,000 Notes receivable 1,000 Inventory 3,000 Supplies 2,100 Prepaid insurance 400
Total current assets $22,100
Long-term investments Stock investments 5,200 Investment in real estate 2,000 7,200
Property, plant, and equipment Land 10,000 Equipment $24,000 Less: Accumulated depreciation—equipment 5,000 19,000 29,000 Intangible assets Patents 3,100 Total assets $61,400
Liabilities and Stockholders’ Equity
Current liabilities Notes payable $11,000 Accounts payable 2,100 Unearned sales revenue 900 Salaries and wages payable 1,600 Interest payable 450
Total current liabilities $16,050
Long-term liabilities Mortgage payable 10,000 Notes payable 1,300
Total long-term liabilities 11,300
Total liabilities 27,350
Stockholders’ equity Common stock 14,000 Retained earnings 20,050
Total stockholders’ equity 34,050
Total liabilities and stockholders’ equity $61,400
FRANKLIN CORPORATION Balance Sheet
October 31, 2017
ILLUSTRATION 2-3 Current assets section
Current assets Cash and cash equivalents $1,355 Short-term investments 1,797 Accounts receivable 419 Inventories 467 Prepaid expenses and other current assets 418
Total current assets $4,456
SOUTHWEST AIRLINES CO. Balance Sheet (partial)
(in millions)
Real World
47
48 2 A Further Look at Financial Statements
As explained later in the chapter, a company’s current assets are important in assessing its short-term debt-paying ability.
LONG-TERM INVESTMENTS
Long-term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long-term assets such as land or buildings that a company is not currently using in its operating activi- ties, and (3) long-term notes receivable. In Illustration 2-2, Franklin Corporation reported total long-term investments of $7,200 on its balance sheet. Google Inc. reported long-term investments on its balance sheet in a recent year as shown in Illustration 2-4.
ALTERNATIVE TERMINOLOGY Long-term investments are often referred to simply as investments.
PROPERTY, PLANT, AND EQUIPMENT
Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, build- ings, equipment, delivery vehicles, and furniture. In Illustration 2-2, Franklin Corporation reported property, plant, and equipment of $29,000. Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset’s cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life. In Illustration 2-2, Franklin Corporation reported accu- mulated depreciation of $5,000. Illustration 2-5 presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.
ALTERNATIVE TERMINOLOGY Property, plant, and equipment is sometimes called fi xed assets or plant assets.
ILLUSTRATION 2-5 Property, plant, and equipment section
Property, plant, and equipment Machinery, equipment and offi ce furniture $ 322,394 Tooling 230,385 Leasehold improvements 94,763 Building and building improvements 67,707 Land 45,020 Computer equipment and software 42,073 Construction in progress 76,294
878,636 Less: Accumulated depreciation and amortization (140,142)
Total $ 738,494
TESLA MOTORS, INC. Balance Sheet (partial)
(in thousands)
Real World
ILLUSTRATION 2-4 Long-term investments section
Long-term investments Non-marketable equity investments $1,469
GOOGLE INC. Balance Sheet (partial)
(in millions)
Real World
INTANGIBLE ASSETS
Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets. One common intangible
▼ HELPFUL HINT Sometimes intangible assets are reported under a broader heading called “Other assets.”
The Classifi ed Balance Sheet 49
is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specifi ed period of time. In Illustration 2-2, Franklin Corporation reported intangible assets of $3,100. Illustration 2-6 shows the intangible assets of media and theme park giant The Walt Disney Company in a recent year.
ILLUSTRATION 2-6 Intangible assets section
Intangible assets and goodwill Character/franchise intangibles and copyrights $ 5,830 Other amortizable intangible assets 903 Accumulated amortization (1,204)
Net amortizable intangible assets 5,529 FCC licenses 667 Trademarks 1,218 Other indefi nite lived intangible assets 20
7,434 Goodwill 27,881
$35,315
THE WALT DISNEY COMPANY Balance Sheet (partial)
(in millions)
Real World
SOLUTION
1a▼ Assets Section of Classifi ed Balance SheetDO IT! Baxter Hoffman recently received the following information related to Hoffman Corpo- ration’s December 31, 2017, balance sheet.
Prepaid insurance $ 2,300 Inventory $3,400 Cash 800 Accumulated depreciation— Equipment 10,700 equipment 2,700 Accounts receivable 1,100
Prepare the assets section of Hoffman Corporation’s classifi ed balance sheet.
Assets
Current assets Cash $ 800 Accounts receivable 1,100 Inventory 3,400 Prepaid insurance 2,300
Total current assets $ 7,600 Property, plant, and equipment Equipment 10,700 Less: Accumulated depreciation—equipment 2,700 8,000
Total assets $15,600
HOFFMAN CORPORATION Balance Sheet (partial)
December 31, 2017
Action Plan ✔ Present current assets
fi rst. Current assets are cash and other resources that the company expects to convert to cash or use up within one year.
✔ Present current assets in the order in which the company expects to convert them into cash.
✔ Subtract accumulated depreciation—equipment from equipment to deter- mine net equipment.
Related exercise material: BE2-2, DO IT! 2-1a, E2-3, and E2-4.
50 2 A Further Look at Financial Statements
CURRENT LIABILITIES
In the liabilities and stockholders’ equity section of the balance sheet, the fi rst grouping is current liabilities. Current liabilities are obligations that the com- pany is to pay within the next year or operating cycle, whichever is longer. Com- mon examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable. Also included as current liabilities are current maturities of long-term obligations—payments to be made within the next year on long-term obligations. In Illustration 2-2, Franklin Corporation reported fi ve different types of current liabilities, for a total of $16,050. Illustration 2-7 shows the current liabilities section adapted from the balance sheet of Google Inc. in a recent year.
ILLUSTRATION 2-7 Current liabilities section
Current liabilities Accounts payable $ 2,012 Short-term debt 2,549 Accrued compensation and benefi ts 2,239 Accrued expenses and other current liabilities 7,297 Income taxes payable, net 240
Total current liabilities $14,337
GOOGLE INC. Balance Sheet (partial)
(in millions)
Real World
ILLUSTRATION 2-8 Long-term liabilities section
Long-term liabilities Bonds payable $1,106 Notes payable 51 Deferred income taxes and other 1,544
Total long-term liabilities $2,701
NIKE, INC. Balance Sheet (partial)
(in millions)
Real World
LONG-TERM LIABILITIES
Long-term liabilities (long-term debt) are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. Many companies report long-term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the fi nancial statements. Others list the various types of long-term liabilities. In Illus- tration 2-2, Franklin Corporation reported long-term liabilities of $11,300. Illustration 2-8 shows the long-term liabilities that Nike, Inc. reported in its balance sheet in a recent year.
STOCKHOLDERS’ EQUITY
Stockholders’ equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business. These two parts, combined, make up stockholders’ equity on the balance sheet. In Illustration 2-2, Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.
ALTERNATIVE TERMINOLOGY Common stock is sometimes called capital stock.
Analyzing the Financial Statements 51
1b▼ Balance Sheet Classifi cationsDO IT! The following fi nancial statement items were taken from the fi nancial statements of Callahan Corp.
Salaries and wages payable Equipment Service revenue Accumulated depreciation— Interest payable equipment Goodwill Depreciation expense Debt investments (short-term) Retained earnings Mortgage payable (due in 3 years) Unearned service revenue Investment in real estate
Match each of the items to its proper balance sheet classifi cation, shown below. If the item would not appear on a balance sheet, use “NA.”
Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Stockholders’ equity (SE) Intangible assets (IA)
SOLUTION CL Salaries and wages payable LTI Investment in real estate NA Service revenue PPE Equipment CL Interest payable PPE Accumulated depreciation— IA Goodwill equipment CA Debt investments (short-term) NA Depreciation expense LTL Mortgage payable SE Retained earnings (due in 3 years) CL Unearned service revenue
Action Plan ✔ Analyze whether each
fi nancial statement item is an asset, liability, or stockholders’ equity item.
✔ Determine if asset and liability items are current or long-term.
Related exercise material: BE2-1, DO IT! 2-1b, E2-1, E2-2, E2-3, E2-5, and E2-6.
LEARNING OBJECTIVE 2 Use ratios to evaluate a company’s profi tability, liquidity, and solvency.▼
In Chapter 1, we introduced the four fi nancial statements. We discussed how these statements provide information about a company’s performance and fi nan- cial position. In this chapter, we extend this discussion by showing you specifi c tools that you can use to analyze fi nancial statements in order to make a more meaningful evaluation of a company.
RATIO ANALYSIS
Ratio analysis expresses the relationship among selected items of fi nancial state- ment data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary fi nancial statements, we classify ratios as shown in Illustration 2-9 (page 52). A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:
1. Intracompany comparisons covering two years for the same company.
2. Industry-average comparisons based on average ratios for particular industries.
3. Intercompany comparisons based on comparisons with a competitor in the same industry.
52 2 A Further Look at Financial Statements
Next, we use some ratios and comparisons to analyze the fi nancial statements of Best Buy.
USING THE INCOME STATEMENT
Best Buy generates profi ts for its stockholders by selling electronics. The income statement reveals how successful the company is at generating a profi t from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2-10 shows a simplifi ed income statement for Best Buy.
ILLUSTRATION 2-9 Financial ratio classifi cations
Liquidity Ratios
Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash
Profitability Ratios
Measure the income or operating success of a company for a given period of time
Solvency Ratios
Measure the ability of the company to survive over a long period of time
Founded in 1892
TRUE GRIT Co.
Net income– =
Revenues Expenses
ILLUSTRATION 2-10 Best Buy’s income statement
2014 2013 Revenues Net sales and other revenue $42,410 $39,827
Expenses Cost of goods sold 32,720 30,528 Selling, general, and administrative expenses and other 8,760 9,471 Income tax expense 398 269
Total expenses 41,878 40,268
Net income/(loss) $ 532 $ (441)
BEST BUY CO., INC. Income Statements
For the 12 Months Ended February 1, 2014, and 11 Months Ended February 2, 2013 (in millions)
Real World
From this income statement, we can see that Best Buy’s sales and net income increased during the period. Net income increased from a $441 million loss to a positive $532 million. One extremely unusual aspect of Best Buy’s income state- ment is that the 2013 comparative column only covers 11 months. This occurred because Best Buy changed its year-end from “the Saturday nearest the end of February to the Saturday nearest the end of January.” Such a change is very uncommon and complicates efforts to compare performance across years. A much smaller competitor of Best Buy is hhgregg. hhgregg operates 228 stores in 20 states and is headquartered in Indianapolis, Indiana. It reported net income of $228,000 for the year ended March 31, 2014.
Analyzing the Financial Statements 53
To evaluate the profi tability of Best Buy, we will use ratio analysis. Profi tability ratios, such as earnings per share, measure the operating success of a company for a given period of time.
Earnings per Share Earnings per share (EPS) measures the net income earned on each share of common stock. Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stating net income earned as a per share amount provides a useful perspective for deter- mining the investment return. Advanced accounting courses present more refi ned techniques for calculating earnings per share. For now, a basic approach for calculating earnings per share is to divide earnings available to common stockholders by weighted-average common shares outstanding during the year. What is “earnings available to common stockholders”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income − Preferred dividends). By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder— that is, on a per share basis. It is very important to note that comparisons of earn- ings per share across companies are not meaningful because of the wide varia- tions in the numbers of shares of outstanding stock among companies. Illustration 2-11 shows the earnings per share calculation for Best Buy in 2014 and 2013, based on the information presented below. Recall that Best Buy’s 2013 income is based on 11 months of results. Further, to simplify our calcula- tions, we assumed that any change in the number of shares for Best Buy occurred in the middle of the year.
(in millions) 2014 2013
Net income (loss) $532 $(441) Preferred dividends –0– –0– Shares outstanding at beginning of year 338 341 Shares outstanding at end of year 347 338
USING A CLASSIFIED BALANCE SHEET
You can learn a lot about a company’s fi nancial health by also evaluating the relationship between its various assets and liabilities. Illustration 2-12 (page 54) provides a simplifi ed balance sheet for Best Buy.
Liquidity Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Hewlett-Packard interested in selling computers to Best Buy on credit. You would be concerned about Best Buy’s liquidity—its abil- ity to pay obligations expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities.
DECISION TOOLS
Earnings per share helps users compare a company’s performance with that of previous years.
Earnings per = Net Income – Preferred Dividends Share Weighted-Average Common Shares Outstanding
Earnings per share $532 – $0 = $1.55 –$441 – $0 = –$1.30 (347 + 338)/2 (338 + 341)/2
($ and shares in millions) 2014 2013
ILLUSTRATION 2-11 Best Buy’s earnings per share
54 2 A Further Look at Financial Statements
WORKING CAPITAL One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities:
ILLUSTRATION 2-12 Best Buy’s balance sheet
Assets February 1, 2014 February 2, 2013
Current assets Cash and cash equivalents $ 2,678 $ 1,826 Short-term investments 223 0 Receivables 1,308 2,704 Merchandise inventories 5,376 6,571 Other current assets 900 946
Total current assets 10,485 12,047
Property and equipment 7,575 8,375 Less: Accumulated depreciation 4,977 5,105
Net property and equipment 2,598 3,270
Other assets 930 1,470
Total assets $14,013 $16,787
Liabilities and Stockholders’ Equity
Current liabilities Accounts payable $ 5,122 $ 6,951 Accrued liabilities 873 1,188 Accrued income taxes 147 129 Accrued compensation payable 444 520 Other current liabilities 850 2,022
Total current liabilities 7,436 10,810
Long-term liabilities Long-term debt 976 1,109 Other long-term liabilities 1,612 1,153
Total long-term liabilities 2,588 2,262
Total liabilities 10,024 13,072
Stockholders’ equity Common stock 335 88 Retained earnings and other 3,654 3,627
Total stockholders’ equity 3,989 3,715
Total liabilities and stockholders’ equity $14,013 $16,787
BEST BUY CO., INC. Balance Sheets
(in millions)
Real World
When current assets exceed current liabilities, working capital is positive. When this occurs, there is a greater likelihood that the company will pay its liabilities. When working capital is negative, a company might not be able to pay short-term creditors, and the company might ultimately be forced into bankruptcy. Best Buy had working capital in 2014 of $3,049 million ($10,485 million − $7,436 million).
CURRENT RATIO Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio, computed as current assets divided by current liabilities. The current ratio is a more dependable indicator of liquidity than work- ing capital. Two companies with the same amount of working capital may
ILLUSTRATION 2-13 Working capital Working Capital = Current Assets − Current Liabilities
DECISION TOOLS The current ratio helps users determine if a company can meet its near-term obligations.
Analyzing the Financial Statements 55
have signifi cantly different current ratios. Illustration 2-14 shows the 2014 and 2013 current ratios for Best Buy and for hhgregg, along with the 2014 industry average.
ETHICS NOTE A company that has more current assets than current liabilities can increase the ratio of current assets to current liabilities by using cash to pay off some current liabilities. This gives the appearance of being more liquid. Do you think this move is ethical?
▼
What does the ratio actually mean? Best Buy’s 2014 current ratio of 1.41:1 means that for every dollar of current liabilities, Best Buy has $1.41 of current assets. Best Buy’s current ratio increased in 2014. When compared to the indus- try average of .88:1, Best Buy’s liquidity seems strong. It is lower than hhgregg’s but not signifi cantly so. One potential weakness of the current ratio is that it does not take into account the composition of the current assets. For example, a satisfactory cur- rent ratio does not disclose whether a portion of the current assets is tied up in slow-moving inventory. The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inven- tory. For example, suppose a company’s cash balance declined while its mer- chandise inventory increased substantially. If inventory increased because the company is having diffi culty selling its products, then the current ratio might not fully refl ect the reduction in the company’s liquidity.
Can a Company Be Too Liquid?
There actually is a point where a company can be too liquid—that is, it can have too much working capi- tal. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money.
By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative
excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a “ deterioration in the management of operations.” Given that managers throughout a company are interested in improving profi tability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.
Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).
What can various company managers do to ensure that working capital is managed effi ciently to maximize net income? (Go to WileyPLUS for this answer and additional questions.)
ACCOUNTING ACROSS THE ORGANIZATION REL Consultancy Group
Jorge Salcedo/iStockphoto
Solvency Now suppose that instead of being a short-term creditor, you are interested in either buying Best Buy’s stock or extending the company a long-term loan. Long- term creditors and stockholders are interested in a company’s solvency—its abil- ity to pay interest as it comes due and to repay the balance of a debt due at its
Current Ratio = Current Assets Current Liabilities
Best Buy Industry ($ in millions) hhgregg Average
$10,485 = 1.41:1 1.11:1 1.68:1 .88:1 $7,436
2014 2013 2014 2014
ILLUSTRATION 2-14 Current ratio
56 2 A Further Look at Financial Statements
maturity. Solvency ratios measure the ability of the company to survive over a long period of time.
DEBT TO ASSETS RATIO The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long-term) by total assets. It measures the percentage of total fi nancing provided by creditors rather than stockholders. Debt fi nancing is more risky than equity fi nancing because debt must be repaid at specifi c points in time, whether the company is performing well or not. Thus, the higher the percentage of debt fi nancing, the riskier the company. The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. Illus- tration 2-15 shows the debt to assets ratios for Best Buy and hhgregg, along with the industry average.
▼ HELPFUL HINT Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the lower is a company’s solvency.
The 2014 ratio of 72% means that every dollar of assets was fi nanced by 72 cents of debt. Best Buy’s ratio is less than the industry average of 88% and is signifi cantly higher than hhgregg’s ratio of 51%. The higher the ratio, the more reliant the company is on debt fi nancing. This means that Best Buy has a lower equity “buffer” available to creditors if the company becomes insolvent when compared to hhgregg. Thus, from the creditors’ point of view, a high ratio of debt to assets is undesirable. Best Buy’s solvency appears lower than hhgregg’s and higher than the average company in the industry. The adequacy of this ratio is often judged in light of the company’s earn-
ings. Generally, companies with relatively stable earnings, such as pub- lic utilities, can support higher debt to assets ratios than can cyclical companies with widely fl uctuating earnings, such as many high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.
When Debt Is Good
Debt fi nancing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:
Debt to Assets Ratio
Google 23% Nike 41% Microsoft 48% ExxonMobil 48% General Motors 74%
Discuss the difference in the debt to assets ratio of Microsoft and General Motors. (Go to WileyPLUS for this answer and additional questions.)
© David Crockett/iStockphoto
INVESTOR INSIGHT
ILLUSTRATION 2-15 Debt to assets ratio
Best Buy Industry ($ in millions) hhgregg Average
$10,024 = 72% 78% 51% 88% $14,013
2014 2013 2014 2014
Debt to Assets Ratio = Total Liabilities Total Assets
DECISION TOOLS The debt to assets ratio helps users determine if a company can meet its long-term obligations.
Analyzing the Financial Statements 57
USING THE STATEMENT OF CASH FLOWS
In the statement of cash fl ows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A measurement to provide additional insight regarding a company’s cash- generating ability is free cash fl ow. Free cash fl ow describes the net cash provided by operat- ing activities after adjusting for capital expenditures and dividends paid. Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 net cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash fl ow was $80,000 ($100,000 − $15,000 − $5,000). The company could use this $80,000 to purchase new assets to expand the business, pay off debts, or increase its dividend distribu- tion. In practice, analysts often calculate free cash fl ow with the for- mula shown in Illustration 2-16. (Alternative defi nitions also exist.)
DECISION TOOLS
Free cash fl ow helps users determine the amount of cash a company generated to expand operations, pay off debts, or increase dividends.
ILLUSTRATION 2-16 Free cash fl ow
We can calculate Best Buy’s 2014 free cash fl ow as shown in Illustration 2-17 (dollars in millions).
ILLUSTRATION 2-17 Best Buy’s free cash fl owNet cash provided by operating activities $1,094
Less: Expenditures on property, plant, and equipment 547 Dividends paid 233
Free cash fl ow $ 314
Best Buy generated free cash fl ow of $314 million, which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of addi- tional dividends. Long-term creditors consider a high free cash fl ow amount an indication of solvency. hhgregg’s free cash fl ow for 2014 is $60 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash fl ow to be much lower.
2▼ Ratio AnalysisDO IT! The following information is available for Ozone Inc.
2017 2016
Current assets $ 88,000 $ 60,800 Total assets 400,000 341,000 Current liabilities 40,000 38,000 Total liabilities 120,000 150,000 Net income 100,000 50,000 Net cash provided by operating activities 110,000 70,000 Preferred dividends 10,000 10,000 Common dividends 5,000 2,500 Expenditures on property, plant, and equipment 45,000 20,000
Shares outstanding at beginning of year 60,000 40,000 Shares outstanding at end of year 120,000 60,000
Free Cash = Net Cash Provided − Capital − Cash Flow by Operating Activities Expenditures Dividends
58 2 A Further Look at Financial Statements
(a) Compute earnings per share for 2017 and 2016 for Ozone, and comment on the change. Ozone’s primary competitor, Frost Corporation, had earnings per share of $2 in 2017. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.
(c) Compute free cash fl ow for each year, and comment on the changes.
Action Plan ✔ Use the formula for
earnings per share (EPS): (Net income − Preferred dividends) ÷ Weighted- average common shares outstanding.
✔ Use the formula for the current ratio: Current assets ÷ Current liabilities.
✔ Use the formula for the debt to assets ratio: Total liabilities ÷ Total assets.
✔ Use the formula for free cash fl ow: Net cash provided by operating activities − Capital expenditures − Cash dividends.
SOLUTION (a) Earnings per share
Ozone’s profi tability, as measured by the amount of income available to each share of common stock, increased by 25% [($1.00 − $0.80) ÷ $0.80] during 2017. Earnings per share should not be compared across companies because the number of shares issued by companies varies widely. Thus, we cannot conclude that Frost Corporation is more profi table than Ozone based on its higher EPS.
(b)
Current ratio
Debt to assets ratio
The company’s liquidity, as measured by the current ratio, improved from 1.60:1 to 2.20:1. Its solvency also improved, as measured by the debt to assets ratio, which de- clined from 44% to 30%.
(c) Free cash fl ow
2017: $110,000 − $45,000 − ($10,000 + $5,000) = $50,000 2016: $70,000 − $20,000 − ($10,000 + $2,500) = $37,500
The amount of cash generated by the company above its needs for dividends and capi- tal expenditures increased from $37,500 to $50,000.
2017
($100,000 − $10,000) = $1.00
(120,000 + 60,000)/2
2016
($50,000 − $10,000) = $0.80
(60,000 + 40,000)/2
2017
$88,000 = 2.20:1 $40,000
2016
$60,800 = 1.60:1 $38,000
$120,000 = 30% $400,000
$150,000 = 44% $341,000
Related exercise material: BE2-3, BE2-4, BE2-5, DO IT! 2-2, E2-7, E2-9, E2-10, and E2-11.
You have now learned about the four fi nancial statements and some basic ways to interpret those statements. In this last section, we will discuss concepts that underlie these fi nancial statements. It would be unwise to make business deci- sions based on fi nancial statements without understanding the implications of these concepts.
THE STANDARD-SETTING ENVIRONMENT
How does Best Buy decide on the type of fi nancial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard- setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.
Discuss fi nancial reporting concepts. LEARNING OBJECTIVE 3▼
Financial Reporting Concepts 59
The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. fi nancial markets and accounting standard- setting bodies. The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently evaluating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the fi nan- cial reporting environment was that, as a result of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the performance of auditing fi rms. If the United States adopts IFRS for its accounting standards, it will also have to coordinate its auditing regulations with those of other countries.
INTERNATIONAL NOTE Over 115 countries use interna- tional standards (called IFRS). For example, all companies in the European Union follow IFRS. In this textbook, we highlight any signifi cant differences using International Notes like this one, as well as a more in-depth discussion in the A Look at IFRS section at the end of each chapter.
The Korean Discount
If you think that account- ing standards don’t matter, consider recent events in South Korea. For many years, inter- national investors com- plained that the fi nancial reports of South Korean companies were in-
adequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of compa- rable companies in different countries. This difference in share price was often referred to as the “Korean discount.”
In response, Korean regulators decided that companies would have to comply with international accounting stan- dards. This change was motivated by a desire to “make the country’s businesses more transparent” in order to build in- vestor confi dence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international stan- dards or to create standards that are based on the interna- tional standards.
Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).
What is meant by the phrase “make the country’s businesses more transparent”? Why would increasing transparency spur economic growth? (Go to WileyPLUS for this answer and additional questions.)
INTERNATIONAL INSIGHT
SeongJoon Cho/Bloomberg/Getty Images, Inc.
QUALITIES OF USEFUL INFORMATION
Recently, the FASB and IASB completed the fi rst phase of a joint project in which they developed a conceptual framework to serve as the basis for future account- ing standards. The framework begins by stating that the primary objective of fi nancial reporting is to provide fi nancial information that is useful to inves- tors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-18 (page 60).
Enhancing Qualities In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include com- parability, verifi ability, timeliness, and understandability. In accounting,
60 2 A Further Look at Financial Statements
comparability results when different companies use the same accounting prin- ciples. Another type of comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifi able if independent observers, using the same methods, obtain similar results. As noted in Chapter 1, certifi ed public accountants (CPAs) perform audits of fi nancial statements to verify their accuracy. For accounting information to have relevance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to infl uence decisions. The SEC requires that large public companies provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.
ILLUSTRATION 2-18 Fundamental qualities of useful information
Faithful Representation Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error.
Relevance Accounting information has relevance if it would make a difference in a business decision. Information is considered relevant if it provides information that has predictive value, that is, helps provide accurate expecta- tions about the future, and has confi rmatory value, that is, confi rms or corrects prior expectations. Materiality is a company-specifi c aspect of relevance. An item is material when its size makes it likely to infl uence the decision of an investor or creditor.BIG SHOT
Tell me what I need
to know.
What Do These Companies Have in Common?
Another issue related to comparability is the ac- counting time period. An accounting period that is one-year long is called a fi scal year. But a fi scal year need not match the calendar year. For example, a company could end its fi scal year on April 30 rather than on December 31.
Why do companies choose the particular year-ends that they do? For example, why doesn’t every company use
December 31 as its accounting year-end? Many companies choose to end their accounting year when inventory or opera- tions are at a low point. This is advantageous because com- piling accounting information requires much time and effort by managers, so they would rather do it when they aren’t as busy operating the business. Also, inventory is easier and less costly to count when its volume is low. Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; The Walt Disney Company, September 30; and Dunkin’ Donuts, Inc., October 31. In the notes to its fi nancial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of January.
What problems might Best Buy’s year-end create for analysts? (Go to WileyPLUS for this answer and additional questions.)
ACCOUNTING ACROSS THE ORGANIZATION
© Skip O’Donnell/iStockphoto
ASSUMPTIONS IN FINANCIAL REPORTING
To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-19. These include assumptions about the monetary unit, economic entity, periodicity, and going concern.
Financial Reporting Concepts 61
PRINCIPLES IN FINANCIAL REPORTING
Measurement Principles GAAP generally uses one of two measurement principles, the historical cost prin- ciple or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.
HISTORICAL COST PRINCIPLE The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.
FAIR VALUE PRINCIPLE The fair value principle indicates that assets and liabili- ties should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for cer- tain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, the FASB uses two qualities that make accounting information useful for decision-making— relevance and faithful representation. In determining which measurement principle to use, the FASB weighs the factual nature of cost fi gures versus the relevance of fair value. In general, the FASB indicates that most assets must fol- low the historical cost principle because market values may not be represen- tationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.
ILLUSTRATION 2-19 Key assumptions in fi nancial reporting
Monetary Unit Assumption The monetary unit assumption requires that only those things that can be expressed in money are included in the accounting records. This means that certain important information needed by investors, creditors, and managers, such as customer satisfaction, is not reported in the fi nancial statements. This assumption relies on the monetary unit remaining relatively stable in value.
Accounting Records
– Salaries paid
$ $ $ $ $
Measure of employee satisfaction
Total number of employees
Salaries paid
Percent of international employees
$
Economic Entity Assumption The economic entity assumption states that every economic entity can be separately identifi ed and accounted for. In order to assess a company’s performance and fi nancial position accurately, it is important to not blur company trans- actions with personal transactions (especially those of its managers) or transactions of other companies.
Periodicity Assumption Notice that the income statement, retained earnings statement, and state- ment of cash fl ows all cover periods of one year, and the balance sheet is prepared at the end of each year. The periodicity assumption states that the life of a business can be divided into artifi cial time periods and that useful reports covering those periods can be prepared for the business.
Going Concern Assumption The going concern assumption states that the business will remain in operation for the foreseeable future. Of course, many businesses do fail, but in general it is reasonable to assume that the business will continue operating.
Ford
Chrysler
GM
Ford
Chrysler
GM
Start of business
End of business
2013
2015 2017 2019 2021
2023
J F
QTR 1
QTR 2
QTR 3
QTR 4
M A M J J A S O N D
Now Future
ETHICS NOTE The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees’ fi nancial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.
▼
62 2 A Further Look at Financial Statements
Full Disclosure Principle The full disclosure principle requires that companies disclose all circum- stances and events that would make a difference to fi nancial statement users. If an important item cannot reasonably be reported directly in one of the four types of fi nancial statements, then it should be discussed in notes that accompany the statements.
COST CONSTRAINT
Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to pro- vide the information against the benefi t that fi nancial statement users will gain from having the information available.
Cost
Benefits
SOLUTION 1. Comparability 7. Historical cost principle
2. Going concern assumption 8. Consistency
3. Materiality 9. Economic entity assumption
4. Full disclosure principle 10. Faithful representation
5. Periodicity assumption 11. Monetary unit assumption
6. Relevance
3▼ Financial Accounting Concepts and PrinciplesDO IT! The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption Faithful representation Going concern assumption Comparability Historical cost principle Consistency Full disclosure principle Monetary unit assumption Materiality Economic entity assumption
Match each item above with a description below.
1. ________ Ability to easily evaluate one company’s results relative to another’s.
2. ________ Belief that a company will continue to operate for the foreseeable future.
3. ________ The judgment concerning whether an item is large enough to matter to decision-makers.
4. ________ The reporting of all information that would make a difference to fi nancial statement users.
5. ________ The practice of preparing fi nancial statements at regular intervals.
6. ________ The quality of information that indicates the information makes a differ- ence in a decision.
7. ________ A belief that items should be reported on the balance sheet at the price that was paid to acquire the item.
8. ________ A company’s use of the same accounting principles and methods from year to year.
9. ________ Tracing accounting events to particular companies.
10. ________ The desire to minimize errors and bias in fi nancial statements.
11. ________ Reporting only those things that can be measured in dollars.
Action Plan ✔ Understand the need for
conceptual guidelines in accounting.
✔ List the characteristics of useful fi nancial information.
✔ Review the assumptions, principles, and constraint that comprise the guidelines in accounting.
Related exercise material: BE2-8, BE2-9, BE2-10, DO IT! 2-3, E2-12, and E2-13.
Using Decision Tools 63
In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high-end features. Tweeter fi led for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.
September 30 (amounts in millions) 2006 2005 Current assets $146.4 $158.2 Total assets 258.6 284.0 Current liabilities 107.1 119.0 Total liabilities 190.4 201.1 Total common stockholders’ equity 68.2 82.9 Net income (loss) (16.5) (74.4) Net cash provided (used) by operating activities 15.6 (26.7) Capital expenditures (net) 17.4 22.2 Dividends paid 0 0 Weighted-average shares of common stock (millions) 25.2 24.6
INSTRUCTIONS
Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter’s fi nancial troubles.
1. Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquidity position. 2. Calculate the debt to assets ratio and free cash fl ow for Tweeter for 2006 and 2005 and discuss its solvency. 3. Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in profi tability. 4. Best Buy’s accounting year-end was February 28, 2006; Tweeter’s was September 30, 2006. How does this difference
affect your ability to compare their profi tability?
SOLUTION 1. Current ratio: 2006: $146.4 ÷ $107.1 = 1.37:1 2005: $158.2 ÷ $119.0 = 1.33:1 Tweeter’s liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered
inadequate. In 2006, Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger com- panies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter’s size would normally want a higher ratio.
2. Debt to assets ratio: 2006: $190.4 ÷ $258.6 = 73.6% 2005: $201.1 ÷ $284.0 = 70.8% Tweeter’s solvency, as measured by its debt to assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that
every dollar of assets was fi nanced by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter’s ability to meet its debt payments was questionable.
Free cash fl ow: 2006: $15.6 − $17.4 − $0 = −$1.8 million 2005: −$26.7 − $22.2 − $0 = −$48.9 million Tweeter’s free cash fl ow was negative in both years. The company did not generate enough net cash provided by
operating activities even to cover its capital expenditures, and it was not paying a dividend. While this is not unusual for new companies in their early years, it is also not sustainable for very long. Part of the reason that its debt to assets ratio, discussed above, was so high was that it had to borrow money to make up for its defi cient free cash fl ow.
3. Loss per share: 2006: −$16.5 ÷ 25.2 = −$0.65 per share 2005: −$74.4 ÷ 24.6 = −$3.02 per share Tweeter’s loss per share declined substantially. However, this was little consolation for its shareholders, who experienced
losses in previous years as well. The company’s lack of profi tability, combined with its poor liquidity and solvency, in- creased the likelihood that it would eventually fi le for bankruptcy.
4. Tweeter’s income statement covers 7 months not covered by Best Buy’s. Suppose that the economy changed dramatically during this 7-month period, either improving or declining. This change in the economy would be refl ected in Tweeter’s income statement but would not be refl ected in Best Buy’s income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.
USING DECISION TOOLS—TWEETER HOME ENTERTAINMENT
64 2 A Further Look at Financial Statements
LEARNING OBJECTIVES REVIEW
REVIEW AND PRACTICE
1 Identify the sections of a classifi ed balance sheet. In a classifi ed balance sheet, companies classify assets as current assets; long-term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long-term. A stockholders’ equity section shows common stock and retained earnings.
2 Use ratios to evaluate a company’s profi tability, liquidity, and solvency. Ratio analysis expresses the relationship among selected items of fi nancial statement data. Profi tability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time. Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obli- gations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the abil- ity of a company to survive over a long period. Free cash fl ow indicates a company’s ability to generate net cash pro- vided by operating activities that is suffi cient to pay debts, acquire assets, and distribute dividends.
3 Discuss fi nancial reporting concepts. Generally accepted accounting principles are a set of rules and practices recog- nized as a general guide for fi nancial reporting purposes. The basic objective of fi nancial reporting is to provide information that is useful for decision-making.
To be judged useful, information should have the pri- mary characteristics of relevance and faithful representa- tion. In addition, useful information is com parable, con- sistent, verifi able, timely, and understandable. The monetary unit assumption requires that com- panies include in the accounting records only transac- tion data that can be expressed in terms of money. The economic entity assumption states that economic events can be identifi ed with a particular unit of account- ability. The periodicity assumption states that the eco- nomic life of a business can be divided into artifi cial time periods and that meaningful accounting reports can be prepared for each period. The going concern assump- tion states that the company will continue in operation long enough to carry out its existing objectives and commitments. The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose circumstances and events that matter to fi nancial statement users. The cost constraint weighs the cost that companies incur to provide a type of information against its benefi t to fi nancial statement users.
▼
Classifi ed balance sheet A balance sheet that groups together similar assets and similar liabilities, using a number of standard classifi cations and sections. (p. 46).
Comparability Ability to compare the accounting infor- mation of different companies because they use the same accounting principles. (p. 60).
GLOSSARY REVIEW▼
DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
How does the company’s earnings performance compare with that of previous years?
Net income available to common stockholders and weighted-average common shares outstanding
Can the company meet its near-term obligations?
Current assets and current liabilities
Higher ratio suggests favorable liquidity.
Can the company meet its long-term obligations?
Total liabilities and total assets
Lower value suggests favorable solvency.
How much cash did the company generate to expand operations, pay off debts, or distribute dividends?
Net cash provided by operating activities, cash spent on fi xed assets, and cash dividends
Signifi cant free cash fl ow indicates greater potential to fi nance new investments and pay additional dividends.
A higher measure suggests improved performance, although the number is subject to manipulation. Values should not be com- pared across companies.
Net income − Preferred dividends Weighted-average common shares
outstanding
Earnings per =share
Current ratio
= Current assets
Current liabilities
Debt to assets ratio
= Total liabilities Total assets
Free cash = fl ow
Net cash provided by operating activities
Capital expen- ditures
Cash dividends
− −
Glossary Review 65
Consistency Use of the same accounting principles and methods from year to year within a company. (p. 60).
Cost constraint Constraint that weighs the cost that com- panies will incur to provide the information against the benefi t that fi nancial statement users will gain from having the information available. (p. 62).
Current assets Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer. (p. 46).
Current liabilities Obligations that a company expects to pay within the next year or operating cycle, whichever is longer. (p. 50).
Current ratio A measure of liquidity computed as current assets divided by current liabilities. (p. 54).
Debt to assets ratio A measure of solvency calculated as total liabilities divided by total assets. It measures the percentage of total fi nancing provided by creditors. (p. 56).
Earnings per share (EPS) A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the weighted-average number of common shares outstand- ing during the year. (p. 53).
Economic entity assumption An assumption that every economic entity can be separately identifi ed and accounted for. (p. 61).
Fair value principle Assets and liabilities should be re- ported at fair value (the price received to sell an asset or settle a liability). (p. 61).
Faithful representation Information that is complete, neutral, and free from error. (p. 60).
Financial Accounting Standards Board (FASB) The pri- mary accounting standard-setting body in the United States. (p. 59).
Free cash fl ow Net cash provided by operating activities after adjusting for capital expenditures and cash divi- dends paid. (p. 57).
Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to fi nancial statement users. (p. 62).
Generally accepted accounting principles (GAAP) A set of accounting standards that have substantial authorita- tive support and which guide accounting professionals. (p. 58).
Going concern assumption The assumption that the company will continue in operation for the foreseeable future. (p. 61).
Historical cost principle An accounting principle that states that companies should record assets at their cost. (p. 61).
Intangible assets Assets that do not have physical sub- stance. (p. 48).
International Accounting Standards Board (IASB) An accounting standard-setting body that issues standards adopted by many countries outside of the United States. (p. 59).
International Financial Reporting Standards (IFRS) Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States. (p. 59).
Liquidity The ability of a company to pay obligations that are expected to become due within the next year or operating cycle. (p. 53).
Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. (p. 54).
Long-term investments Generally, (1) investments in stocks and bonds of other corporations that companies hold for more than one year; (2) long-term assets, such as land and buildings, not currently being used in the company’s operations; and (3) long-term notes receiv- able. (p. 48).
Long-term liabilities (long-term debt) Obligations that a company expects to pay after one year. (p. 50).
Materiality Whether an item is large enough to likely in- fl uence the decision of an investor or creditor. (p. 60).
Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records. (p. 61).
Operating cycle The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash. (p. 46).
Periodicity assumption An assumption that the life of a business can be divided into artifi cial time periods and that useful reports covering those periods can be pre- pared for the business. (p. 61).
Profi tability ratios Measures of the operating success of a company for a given period of time. (p. 53).
Property, plant, and equipment Assets with relatively long useful lives that are currently used in operating the business. (p. 48).
Public Company Accounting Oversight Board (PCAOB) The group charged with determining auditing standards and reviewing the performance of auditing fi rms. (p. 59).
Ratio An expression of the mathematical relationship be- tween one quantity and another. (p. 51).
Ratio analysis A technique that expresses the relationship among selected items of fi nancial statement data. (p. 51).
Relevance The quality of information that indicates the information makes a difference in a decision. (p. 60).
Securities and Exchange Commission (SEC) The agency of the U.S. government that oversees U.S. fi nancial mar- kets and accounting standard-setting bodies. (p. 59).
Solvency The ability of a company to pay interest as it comes due and to repay the balance of debt due at its maturity. (p. 55).
Solvency ratios Measures of the ability of the company to survive over a long period of time. (p. 56).
Timely Information that is available to decision-makers before it loses its capacity to infl uence decisions. (p. 60).
Understandability Information presented in a clear and concise fashion so that users can interpret it and com- prehend its meaning. (p. 60).
Verifi able The quality of information that occurs when in- dependent observers, using the same methods, obtain similar results. (p. 60).
Working capital The difference between the amounts of current assets and current liabilities. (p. 54).
66 2 A Further Look at Financial Statements
1. In a classifi ed balance sheet, assets are usually classi- fi ed as: (a) current assets; long-term assets; property, plant,
and equipment; and intangible assets. (b) current assets; long-term investments; property,
plant, and equipment; and common stock. (c) current assets; long-term investments; tangible
assets; and intangible assets. (d) current assets; long-term investments; property,
plant, and equipment; and intangible assets. 2. Current assets are listed:
(a) by order of expected conversion to cash. (b) by importance. (c) by longevity. (d) alphabetically.
3. The correct order of presentation in a classifi ed bal- ance sheet for the following current assets is: (a) accounts receivable, cash, prepaid insurance,
inventory. (b) cash, inventory, accounts receivable, prepaid
insurance. (c) cash, accounts receivable, inventory, prepaid
insurance. (d) inventory, cash, accounts receivable, prepaid
insurance. 4. A company has purchased a tract of land. It expects to
build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. The land should be reported as: (a) property, plant, and equipment. (b) land expense. (c) a long-term investment. (d) an intangible asset.
5. The balance in retained earnings is not affected by: (a) net income. (b) net loss. (c) issuance of common stock. (d) dividends.
6. Which is an indicator of profi tability? (a) Current ratio. (b) Earnings per share. (c) Debt to assets ratio. (d) Free cash fl ow.
7. For 2017, Spanos Corporation reported net income $26,000, net sales $400,000, and weighted- average shares outstanding 4,000. There were pre- ferred dividends of $2,000. What was the 2017 earn- ings per share? (a) $6.00. (c) $99.50. (b) $6.50. (d) $100.00.
8. Which of these measures is an evaluation of a company’s ability to pay current liabilities? (a) Earnings per share. (b) Current ratio.
(LO 1)
(LO 1)
(LO 1)
(LO 1)
(LO 1)
(LO 2)
(LO 2)
(LO 2)
(c) Both (a) and (b). (d) None of the above.
9. The following ratios are available for Reilly Inc. and O’Hare Inc.
Current Debt to Earnings Ratio Assets Ratio per Share
Reilly Inc. 2:1 75% $3.50 O’Hare Inc. 1.5:1 40% $2.75
Compared to O’Hare Inc., Reilly Inc. has: (a) higher liquidity, higher solvency, and higher
profi tability. (b) lower liquidity, higher solvency, and higher
profi tability. (c) higher liquidity, lower solvency, and higher
profi tability. (d) higher liquidity and lower solvency, but profi tability
cannot be compared based on information provided.
10. Companies can use free cash fl ow to: (a) pay additional dividends. (b) acquire more property, plant, and equipment. (c) pay off debts. (d) All of the above.
11. Generally accepted accounting principles are: (a) a set of standards and rules that are recognized
as a general guide for fi nancial reporting. (b) usually established by the Internal Revenue
Service. (c) the guidelines used to resolve ethical dilemmas. (d) fundamental truths that can be derived from the
laws of nature. 12. What organization issues U.S. accounting standards?
(a) Financial Accounting Standards Board. (b) International Accounting Standards Committee. (c) International Auditing Standards Committee. (d) None of the above.
13. What is the primary criterion by which accounting information can be judged? (a) Consistency. (b) Predictive value. (c) Usefulness for decision-making. (d) Comparability.
14. Neutrality is an ingredient of:
Faithful Representation Relevance (a) Yes Yes (b) No No (c) Yes No (d) No Yes
15. The characteristic of information that evaluates whether it is large enough to impact a decision. (a) Comparability. (c) Cost. (b) Materiality. (d) Consistency.
(LO 2)
(LO 2)
(LO 3)
(LO 3)
(LO 3)
(LO 3)
(LO 3)
PRACTICE MULTIPLE-CHOICE QUESTIONS▼
SOLUTIONS 1. (d) Assets are classifi ed as current assets; long-term investments; property, plant and equipment; and intangible
assets. The other choices are incorrect because (a) long-term assets includes long-term investments; property, plant, and equipment; and intangible assets; (b) common stock refers to the equity of the fi rm and is not an asset; and
Practice Exercises 67
1. Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fi ne food products—for the year ended April 30, 2017.
Prepaid insurance $ 168,182 Buildings $4,344,269 Land 56,007 Cash 617,687 Goodwill 4,411,521 Accounts receivable 1,161,481 Trademarks 723,243 Accumulated depreciation— Inventory 1,378,216 buildings 2,295,563
PRACTICE EXERCISES▼
Prepare assets section of a classifi ed balance sheet.
(LO 1)
(c) while tangible assets describes property, plant, and equipment, it is better to use the more common terminol- ogy of property, plant, and equipment.
2. (a) Current assets should be listed by order of expected conversion to cash (liquidity), not (b) by importance, (c) by longevity, or (d) alphabetically.
3. (c) The correct order of presentation for current assets is cash, accounts receivable, inventory, and then prepaid insurance. The other choices are therefore incorrect.
4. (c) Land or buildings that are currently not used in operations are considered to be long-term investments. The other choices are incorrect because (a) this classifi cation is for property, plant, and equipment used in operations; (b) land is never expensed; and (d) intangible assets have no physical existence and are used in the production of income.
5. (c) Issuance of common stock has no impact on retained earnings. The other choices are incorrect because (a) net income increases retained earnings, (b) net loss decreases retained earnings, and (d) dividends decrease retained earnings.
6. (b) Earnings per share is a measure of profi tability. The other choices are incorrect because (a) the current ratio is a measure of liquidity, (c) the debt to assets ratio is a measure of solvency, and (d) free cash fl ow is a measure of solvency.
7. (a) Earnings per share = Net income ($26,000) less Preferred dividends ($2,000) divided by Weighted-average shares outstanding (4,000) = $6.00/share, not (b) $6.50, (c) $99.50, or (d) $100.00.
8. (b) The current ratio measures liquidity. Higher current ratios indicate higher liquidity. The other choices are incorrect because (a) earnings per share is a measure of a fi rm’s profi tability, not its ability to pay its current liabili- ties; (c) one of these answers is incorrect; and (d) there is a correct answer.
9. (d) Reilly Inc. has higher liquidity as it has a higher current ratio, and lower solvency due to its higher debt to as- sets ratio. However, profi tability cannot be compared across companies using earnings per share because of the wide variations in the number of shares of common stock of different companies. The other choices are therefore incorrect.
10. (d) Free cash fl ow can be used to pay dividends; acquire more property, plant, and equipment; and pay off debts. Although choices (a), (b), and (c) are correct, choice (d) is the better answer.
11. (a) All U.S. companies get guidance from a set of rules and practices that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard-setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards. The other choices are incorrect because GAAP is (b) not established by the Internal Revenue Service, (c) not intended to provide guidance in re- solving ethical dilemmas, or (d) created by people and can evolve over time, unlike laws of nature, such as those in physics and chemistry.
12. (a) The Financial Accounting Standards Board (FASB) is the organization that issues U.S. accounting standards, not the (b) International Accounting Standards Committee or (c) International Auditing Standards Committee. Choice (d) is wrong as there is a correct answer.
13. (c) Usefulness for decision-making is the primary criterion by which accounting information can be judged. The other choices are incorrect because (a) consistency, (b) predictive value, and (d) comparability all help to make accounting information more useful but are not the primary criterion by which accounting information is judged.
14. (c) Neutrality is an ingredient of faithful representation but not relevance. The other choices are therefore incorrect.
15. (b) Materiality evaluates whether information is large enough to impact a decision, not (a) comparability, (c) cost, or (d) consistency.
68 2 A Further Look at Financial Statements
SOLUTION
1.
Assets
Current assets Cash $ 617,687 Accounts receivable 1,161,481 Inventory 1,378,216 Prepaid insurance 168,182
Total current assets $ 3,325,566
Property, plant, and equipment Land 56,007 Buildings $4,344,269 Less: Accumulated depr.—buildings 2,295,563 2,048,706 2,104,713
Intangible assets Goodwill 4,411,521 Trademarks 723,243 5,134,764
Total assets $10,565,043
H. J. HEINZ COMPANY Partial Balance Sheet
April 30, 2017 (in thousands)
INSTRUCTIONS
Prepare the assets section of a classifi ed balance sheet, listing the items in proper sequence and including a statement heading.
2. Suppose the following data were taken from the 2017 and 2016 fi nancial statements of American Eagle Outfi tters. (All dollars are in thousands.)
2017 2016
Current assets $1,020,834 $1,189,108 Total assets 1,867,680 1,979,558 Current liabilities 376,178 464,618 Total liabilities 527,216 562,246 Net income 400,019 387,359 Net cash provided by operating activities 464,270 749,268 Capital expenditures 250,407 225,939 Dividends paid on common stock 80,796 61,521 Weighted-average shares outstanding 216,119 222,662
INSTRUCTIONS
Perform each of the following.
(a) Calculate the current ratio for each year.
(b) Calculate earnings per share for each year.
(c) Calculate the debt to assets ratio for each year.
(d) Calculate the free cash fl ow for each year.
(e) Discuss American Eagle’s solvency in 2017 versus 2016.
Compute and interpret various ratios.
(LO 2)
SOLUTION
2. 2017 2016
(a) Current ratio $1,020,834 $376,178
= 2.71:1 $1,189,108 $464,618
= 2.56:1
Practice Problem 69
2017 2016
(b) Earning per share $400,019 216,119
= $1.85 $387,359 222,662
= $1.74
(c) Debt to assets ratio $527,216
$1,867,680 = 28.2% $562,246
$1,979,558 = 28.4%
(d) Free cash fl ow $464,270 − $250,407 − $749,268 − $225,939 − $80,796 = $133,067 $61,521 = $461,808
(e) Using the debt to assets ratio and free cash fl ow as measures of solvency produces negative results for American Eagle Outfi tters. Its debt to assets ratio decreased slightly from 28.4% for 2016 to 28.2% for 2017, indicating a very small increase in solvency for 2017. Its free cash fl ow decreased by 71%, indicating a signifi cant decline in solvency.
Listed here are items taken from the income statement and balance sheet of Bargain Elec- tronics, Inc. for the year ended December 31, 2017. Certain items have been combined for simplifi cation. (Amounts are given in thousands.)
Notes payable (due in 3 years) $ 50.5 Cash 141.1 Salaries and wages expense 2,933.6 Common stock 454.9 Accounts payable 922.2 Accounts receivable 723.3 Equipment, net 921.0 Cost of goods sold 9,501.4 Income taxes payable 7.2 Interest expense 1.5 Mortgage payable 451.5 Retained earnings 1,336.3 Inventory 1,636.5 Sales revenue 12,456.9 Debt investments (short-term) 382.6 Income tax expense 30.5 Goodwill 202.7 Notes payable (due in 6 months) 784.6
INSTRUCTIONS
Prepare an income statement and a classifi ed balance sheet using the items listed. Do not use any item more than once.
Prepare fi nancial statements.
(LO 1)
PRACTICE PROBLEM▼
Revenues Sales revenue $12,456.9 Expenses Cost of goods sold $9,501.4 Salaries and wages expense 2,933.6 Interest expense 1.5 Income tax expense 30.5
Total expenses 12,467.0
Net loss $ (10.1)
BARGAIN ELECTRONICS, INC. Income Statement
For the Year Ended December 31, 2017 (in thousands)
SOLUTION
70 2 A Further Look at Financial Statements
Assets
Current assets Cash $ 141.1 Debt investments 382.6 Accounts receivable 723.3 Inventory 1,636.5
Total current assets $2,883.5 Equipment, net 921.0 Goodwill 202.7
Total assets $4,007.2
Liabilities and Stockholders’ Equity
Current liabilities Notes payable $ 784.6 Accounts payable 922.2 Income taxes payable 7.2
Total current liabilities $1,714.0
Long-term liabilities Mortgage payable 451.5 Notes payable 50.5 502.0
Total liabilities 2,216.0
Stockholders’ equity Common stock 454.9 Retained earnings 1,336.3
Total stockholders’ equity 1,791.2
Total liabilities and stockholders’ equity $4,007.2
BARGAIN ELECTRONICS, INC. Balance Sheet
December 31, 2017 (in thousands)
1. What is meant by the term operating cycle?
2. Define current assets. What basis is used for or- dering individual items within the current assets section?
3. Distinguish between long-term investments and prop- erty, plant, and equipment.
4. How do current liabilities differ from long-term liabilities?
5. Identify the two parts of stockholders’ equity in a cor- poration and indicate the purpose of each.
6. (a) Geena Lowe believes that the analysis of financial state-
ments is directed at two characteristics of a company: liquidity and profitability. Is Geena correct? Explain.
(b) Are short-term creditors, long-term creditors, and stockholders primarily interested in the same characteristics of a company? Explain.
7. Name ratios useful in assessing (a) liquidity, (b) solvency, and (c) profitability.
8. Tom Dawes, the founder of Footwear Inc., needs to raise $500,000 to expand his company’s
Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.
QUESTIONS▼
Brief Exercises 71
operations. He has been told that raising the money through debt will increase the riskiness of his company much more than issuing stock. He doesn’t understand why this is true. Explain it to him.
9. What do these classes of ratios measure? (a) Liquidity ratios. (b) Profi tability ratios. (c) Solvency ratios.
10. Holding all other factors constant, indi- cate whether each of the following signals generally good or bad news about a company. (a) Increase in earnings per share. (b) Increase in the current ratio. (c) Increase in the debt to assets ratio. (d) Decrease in free cash fl ow.
11. Which ratio or ratios from this chapter do you think should be of greatest interest to: (a) a pension fund considering investing in a corpora-
tion’s 20-year bonds? (b) a bank contemplating a short-term loan? (c) an investor in common stock?
12. (a) What are generally accepted accounting principles (GAAP)?
(b) What body provides authoritative support for GAAP?
13. (a) What is the primary objective of financial reporting?
(b) Identify the characteristics of useful accounting in- formation.
14. Merle Hawkins, the president of Pathway Company, is pleased. Pathway substantially increased its net in- come in 2017 while keeping its unit inventory relatively the same. Jon Dietz, chief accountant, cautions Merle, however. Dietz says that since Pathway changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether Path- way is better off. Is Dietz correct? Why or why not?
15. What is the distinction between comparability and consistency?
16. Describe the constraint inherent in the presentation of accounting information.
17. Your roommate believes that accounting standards are uniform throughout the world. Is your roommate correct? Explain.
18. Wanda Roberts is president of Best Texts. She has no accounting background. Wanda cannot understand why fair value is not used as the basis for all account- ing measurement and reporting. Discuss.
19. What is the economic entity assumption? Give an example of its violation.
20. What was Apple’s largest current asset, largest current liability, and largest item under “Assets” at September 27, 2014?
BE2-1 The following are the major balance sheet classifi cations:
Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Common stock (CS) Intangible assets (IA) Retained earnings (RE)
Match each of the following accounts to its proper balance sheet classifi cation.
_____ Accounts payable _____ Income taxes payable _____ Accounts receivable _____ Investment in long-term bonds _____ Accumulated depreciation _____ Land _____ Buildings _____ Inventory _____ Cash _____ Patent _____ Goodwill _____ Supplies
BE2-2 A list of fi nancial statement items for Chin Company includes the following: ac- counts receivable $14,000, prepaid insurance $2,600, cash $10,400, supplies $3,800, and debt investments (short-term) $8,200. Prepare the current assets section of the balance sheet listing the items in the proper sequence.
BE2-3 The following information (in millions of dollars) is available for Limited Brands for a recent year: sales revenue $9,043, net income $220, preferred dividend $0, and weighted- average shares outstanding 333 million. Compute the earnings per share for Limited Brands.
BE2-4 These selected condensed data are taken from a recent balance sheet of Bob Evans Farms (in millions of dollars).
Cash $ 29.3 Accounts receivable 20.5 Inventory 28.7 Other current assets 24.0
Total current assets $102.5 Total current liabilities $201.2
Compute working capital and the current ratio.
Classify accounts on balance sheet.
(LO 1), K
Prepare the current assets section of a balance sheet.
(LO 1), AP
Compute earnings per share.
(LO 2), AP
Calculate liquidity ratios.
(LO 2), AP
BRIEF EXERCISES▼
72 2 A Further Look at Financial Statements
BE2-5 Ross Music Inc. reported the following selected information at March 31.
2017
Total current assets $262,787 Total assets 439,832 Total current liabilities 293,625 Total liabilities 376,002 Net cash provided by operating activities 62,300
Calculate (a) the current ratio, (b) the debt to assets ratio, and (c) free cash fl ow for March 31, 2017. The company paid dividends of $12,000 and spent $24,787 on capital expendi- tures.
BE2-6 Indicate whether each statement is true or false. (a) GAAP is a set of rules and practices established by accounting standard-setting bodies
to serve as a general guide for fi nancial reporting purposes. (b) Substantial authoritative support for GAAP usually comes from two standards-setting
bodies: the FASB and the IRS.
BE2-7 The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.
Calculate liquidity and solvency ratios.
(LO 2), AP
Recognize generally accepted accounting principles.
(LO 3), K
Identify characteristics of useful information.
(LO 3), K
BE2-8 Given the characteristics of useful accounting information, complete each of the following statements. (a) For information to be _____, it should have predictive and confi rmatory value. (b) _____ means that information accurately depicts what really happened. (c) _____ means using the same accounting principles and methods from year to year
within a company.
BE2-9 Here are some qualitative characteristics of useful accounting information: 1. Predictive value 3. Verifiable 2. Neutral 4. Timely
Match each qualitative characteristic to one of the following statements. ______ (a) Accounting information should help provide accurate expectations about
future events. ______ (b) Accounting information cannot be selected, prepared, or presented to favor
one set of interested users over another. ______ (c) The quality of information that occurs when independent observers, using the
same methods, obtain similar results. ______ (d) Accounting information must be available to decision-makers before it loses its
capacity to infl uence their decisions.
Identify characteristics of useful information.
(LO 3), K
Identify characteristics of useful information.
(LO 3), K
Fundamental Qualities
Relevance
(a)
(b)
(c)
Faithful Representation
(d)
Neutral
(e)
Enhancing Qualities
(f)
(g)
(h)
Understandability
Usefulness
DO IT! Exercises 73
BE2-10 The full disclosure principle dictates that: (a) fi nancial statements should disclose all assets at their cost. (b) fi nancial statements should disclose only those events that can be measured in
dollars. (c) fi nancial statements should disclose all events and circumstances that would matter
to users of fi nancial statements. (d) fi nancial statements should not be relied on unless an auditor has expressed an un-
qualifi ed opinion on them.
Defi ne full disclosure principle.
(LO 3), K
Mylar Corporation has collected the following information related to its December 31, 2017, balance sheet.
Accounts receivable $22,000 Equipment $180,000 Accumulated depreciation—equipment 50,000 Inventory 58,000 Cash 13,000 Supplies 7,000
Prepare the assets section of Mylar Corporation’s balance sheet.
The following fi nancial statement items were taken from the fi nancial state- ments of Gomez Corp.
____ Trademarks ____ Inventory ____ Notes payable (current) ____ Accumulated depreciation ____ Interest revenue ____ Land ____ Income taxes payable ____ Common stock ____ Debt investments (long-term) ____ Advertising expense ____ Unearned sales revenue ____ Mortgage payable (due in 3 years)
Match each of the fi nancial statement items to its proper balance sheet classifi cation. (See E2-1, on page 74, for a list of the balance sheet classifi cations.) If the item would not appear on a balance sheet, use “NA.”
The following information is available for Nguoi Corporation.
2017 2016
Current assets $ 54,000 $ 36,000 Total assets 240,000 205,000 Current liabilities 22,000 30,000 Total liabilities 72,000 100,000 Net income 80,000 40,000 Net cash provided by operating activities 90,000 56,000 Preferred dividends 6,000 6,000 Common dividends 3,000 1,500 Expenditures on property, plant, and equipment 27,000 12,000
Shares outstanding at beginning of year 40,000 30,000 Shares outstanding at end of year 75,000 40,000
(a) Compute earnings per share for 2017 and 2016 for Nguoi, and comment on the change. Nguoi’s primary competitor, Matisse Corporation, had earnings per share of $1 per share in 2017. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.
(c) Compute free cash fl ow for each year, and comment on the changes.
The following characteristics, assumptions, principles, and constraint guide the FASB when it creates accounting standards.
Relevance Periodicity assumption Faithful representation Going concern assumption Comparability Historical cost principle Consistency Full disclosure principle Monetary unit assumption Materiality Economic entity assumption Cost constraint
DO IT! 2-1a Prepare assets section of balance sheet.
(LO 1), AP
DO IT! 2-1b Classify fi nancial statement items by balance sheet classifi cation.
(LO 1), AP
DO IT! 2-2 Compute ratios and analyze.
(LO 2), AP
DO IT! 2-3 Identify fi nancial accounting concepts and principles.
(LO 3), K
EXERCISES▼DO IT!
74 2 A Further Look at Financial Statements
Match each item above with a description below.
1. __________ Items not easily quantifi ed in dollar terms are not reported in the fi nancial statements.
2. __________ Accounting information must be complete, neutral, and free from error. 3. __________ Personal transactions are not mixed with the company’s transactions. 4. __________ The cost to provide information should be weighed against the benefi t
that users will gain from having the information available. 5. __________ A company’s use of the same accounting principles from year to year. 6. __________ Assets are recorded and reported at original purchase price. 7. __________ Accounting information should help users predict future events, and
should confi rm or correct prior expectations. 8. __________ The life of a business can be divided into artifi cial segments of time. 9. __________ The reporting of all information that would make a difference to fi nancial
statement users. 10. __________ The judgment concerning whether an item’s size makes it likely to infl u-
ence a decision-maker. 11. __________ Assumes a business will remain in operation for the foreseeable future. 12. __________ Different companies use the same accounting principles.
E2-1 The following are the major balance sheet classifi cations.
Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Stockholders’ equity (SE) Intangible assets (IA)
Instructions Classify each of the following financial statement items taken from Ming Corporation’s balance sheet.
____ Accounts payable ____ Income taxes payable ____ Accounts receivable ____ Inventory ____ Accumulated depreciation— ____ Stock investments (to be sold in 7 months) equipment ____ Land (in use) ____ Buildings ____ Mortgage payable ____ Cash ____ Supplies ____ Interest payable ____ Equipment ____ Goodwill ____ Prepaid rent
E2-2 The major balance sheet classifications are listed in E2-1.
Instructions Classify each of the following financial statement items based upon the major balance sheet classifications listed in E2-1.
____ Prepaid advertising ____ Patents ____ Equipment ____ Bonds payable ____ Trademarks ____ Common stock ____ Salaries and wages payable ____ Accumulated depreciation— ____ Income taxes payable equipment ____ Retained earnings ____ Unearned sales revenue ____ Accounts receivable ____ Inventory ____ Land (held for future use)
E2-3 Suppose the following items were taken from the December 31, 2017, assets section of the Boeing Company balance sheet. (All dollars are in millions.)
Inventory $16,933 Patents $12,528 Notes receivable—due after Buildings 21,579 December 31, 2018 5,466 Cash 9,215 Notes receivable—due before Accounts receivable 5,785 December 31, 2018 368 Debt investments (short-term) 2,008 Accumulated depreciation—buildings 12,795
Classify accounts on balance sheet.
(LO 1), AP
Classify fi nancial statement items by balance sheet classifi cation.
(LO 1), AP
Classify items as current or noncurrent, and prepare assets section of balance sheet.
(LO 1), AP
EXERCISES▼
Exercises 75
Instructions Prepare the assets section of a classified balance sheet, listing the current assets in order of their liquidity.
E2-4 Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fine food products—for the year ended April 30, 2017.
Prepaid insurance $ 125,765 Buildings $4,033,369 Land 76,193 Cash 373,145 Goodwill 3,982,954 Accounts receivable 1,171,797 Trademarks 757,907 Accumulated depreciation— Inventory 1,237,613 buildings 2,131,260
Instructions Prepare the assets section of a classified balance sheet, listing the items in proper sequence and including a statement heading.
E2-5 These items are taken from the fi nancial statements of Longhorn Co. at December 31, 2017.
Buildings $105,800 Accounts receivable 12,600 Prepaid insurance 3,200 Cash 11,840 Equipment 82,400 Land 61,200 Insurance expense 780 Depreciation expense 5,300 Interest expense 2,600 Common stock 60,000 Retained earnings (January 1, 2017) 40,000 Accumulated depreciation—buildings 45,600 Accounts payable 9,500 Notes payable 93,600 Accumulated depreciation—equipment 18,720 Interest payable 3,600 Service revenue 14,700
Instructions Prepare a classified balance sheet. Assume that $13,600 of the note payable will be paid in 2018.
E2-6 Suppose the following items were taken from the 2017 financial statements of Texas Instruments, Inc. (All dollars are in millions.)
Common stock $2,826 Accumulated depreciation— Prepaid rent 164 equipment $3,547 Equipment 6,705 Accounts payable 1,459 Stock investments (long-term) 637 Patents 2,210 Debt investments (short-term) 1,743 Notes payable (long-term) 810 Income taxes payable 128 Retained earnings 6,896 Cash 1,182 Accounts receivable 1,823 Inventory 1,202
Instructions Prepare a classified balance sheet in good form as of December 31, 2017.
E2-7 Suppose the following information is available for Callaway Golf Company for the years 2017 and 2016. (Dollars are in thousands, except share information.)
2017 2016
Net sales $1,117,204 $1,124,591 Net income (loss) 66,176 54,587 Total assets 855,338 838,078
Prepare a classifi ed balance sheet.
(LO 1), AP
Prepare a classifi ed balance sheet.
(LO 1), AP
Compute and interpret profi tability ratio.
(LO 2), AP
Prepare assets section of a classifi ed balance sheet.
(LO 1), AP
76 2 A Further Look at Financial Statements
Share information 2017 2016
Shares outstanding at year-end 64,507,000 66,282,000 Preferred dividends –0– –0–
There were 73,139,000 shares outstanding at the end of 2015.
Instructions (a) What was the company’s earnings per share for each year? (b) Based on your fi ndings above, how did the company’s profi tability change from 2016
to 2017? (c) Suppose the company had paid dividends on preferred stock and on common stock
during the year. How would this affect your calculation in part (a)?
E2-8 These fi nancial statement items are for Fairview Corporation at year-end, July 31, 2017.
Salaries and wages payable $ 2,080 Salaries and wages expense 57,500 Supplies expense 15,600 Equipment 18,500 Accounts payable 4,100 Service revenue 66,100 Rent revenue 8,500 Notes payable (due in 2020) 1,800 Common stock 16,000 Cash 29,200 Accounts receivable 9,780 Accumulated depreciation—equipment 6,000 Dividends 4,000 Depreciation expense 4,000 Retained earnings (beginning of the year) 34,000
Instructions (a) Prepare an income statement and a retained earnings statement for the year. Fairview
Corporation did not issue any new stock during the year. (b) Prepare a classifi ed balance sheet at July 31. (c) Compute the current ratio and debt to assets ratio. (d) Suppose that you are the president of Lunar Equipment. Your sales manager has ap-
proached you with a proposal to sell $20,000 of equipment to Fairview. He would like to provide a loan to Fairview in the form of a 10%, 5-year note payable. Evaluate how this loan would change Fairview’s current ratio and debt to assets ratio, and discuss whether you would make the sale.
E2-9 Nordstrom, Inc. operates department stores in numerous states. Selected fi nancial statement data (in millions of dollars) for a recent year follow.
End of Year Beginning of Year
Cash and cash equivalents $ 72 $ 358 Receivables (net) 1,942 1,788 Merchandise inventory 900 956 Other current assets 303 259
Total current assets $3,217 $3,361
Total current liabilities $1,601 $1,635
Instructions (a) Compute working capital and the current ratio at the beginning of the year and at the
end of the year. (b) Did Nordstrom’s liquidity improve or worsen during the year? (c) Using the data in the chapter, compare Nordstrom’s liquidity with Best Buy’s (see
page 55).
E2-10 The chief fi nancial offi cer (CFO) of Myeneke Corporation requested that the ac- counting department prepare a preliminary balance sheet on December 30, 2017, so that the CFO could get an idea of how the company stood. He knows that certain debt agreements
Compute liquidity measures and discuss fi ndings.
(LO 2), AP
Compute liquidity ratios and compare results.
(LO 2), AP
Prepare fi nancial statements.
(LO 1, 2), AP
Exercises 77
with its creditors require the company to maintain a current ratio of at least 2:1. The pre- liminary balance sheet is as follows.
MYENEKE CORP. Balance Sheet
December 30, 2017
Current assets Current liabilities Cash $25,000 Accounts payable $ 20,000 Accounts receivable 30,000 Salaries and wages payable 10,000 $ 30,000
Prepaid insurance 5,000 $ 60,000 Long-term liabilities Equipment (net) 200,000 Notes payable 80,000
Total assets $260,000 Total liabilities 110,000 Stockholders’ equity Common stock 100,000 Retained earnings 50,000 150,000
Total liabilities and stockholders’ equity $260,000
Instructions (a) Calculate the current ratio and working capital based on the preliminary balance sheet. (b) Based on the results in (a), the CFO requested that $20,000 of cash be used to pay off
the balance of the Accounts Payable account on December 31, 2017. Calculate the new current ratio and working capital after the company takes these actions.
(c) Discuss the pros and cons of the current ratio and working capital as measures of liquidity.
(d) Was it unethical for the CFO to take these steps?
E2-11 Suppose the following data were taken from the 2017 and 2016 fi nancial statements of American Eagle Outfi tters. (All numbers, including share data, are in thousands.)
2017 2016
Current assets $ 925,359 $1,020,834 Total assets 1,963,676 1,867,680 Current liabilities 401,763 376,178 Total liabilities 554,645 527,216 Net income 179,061 400,019 Net cash provided by operating activities 302,193 464,270 Capital expenditures 265,335 250,407 Dividends paid on common stock 82,394 80,796
Weighted-average shares outstanding 205,169 216,119
Instructions Perform each of the following. (a) Calculate the current ratio for each year. (b) Calculate earnings per share for each year. (c) Calculate the debt to assets ratio for each year. (d) Calculate the free cash fl ow for each year. (e) Discuss American Eagle’s solvency in 2017 versus 2016. (f) Discuss American Eagle’s ability to fi nance its investment activities with net cash pro-
vided by operating activities, and how any defi ciency would be met.
E2-12 Presented below are the assumptions and principles discussed in this chapter. 1. Full disclosure principle 4. Periodicity assumption 2. Going concern assumption 5. Historical cost principle 3. Monetary unit assumption 6. Economic entity assumption
Instructions Identify by number the accounting assumption or principle that is described below. Do not use a number more than once. ______ (a) Is the rationale for why plant assets are not reported at liquidation value.
(Note: Do not use the historical cost principle.)
Identify accounting assumptions and principles.
(LO 3), K
Compute and interpret solvency ratios.
(LO 2), AP
78 2 A Further Look at Financial Statements
______ (b) Indicates that personal and business recordkeeping should be separately maintained.
______ (c) Assumes that the dollar is the “measuring stick” used to report on fi nancial performance.
______ (d) Separates fi nancial information into time periods for reporting purposes. ______ (e) Measurement basis used when a reliable estimate of fair value is not available. ______ (f) Dictates that companies should disclose all circumstances and events that
make a difference to fi nancial statement users.
E2-13 Lopez Co. had three major business transactions during 2017. (a) Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000. (b) The president of Lopez Co., Victor Lopez, purchased a truck for personal use and
charged it to his expense account. (c) Lopez Co. wanted to make its 2017 income look better, so it added 2 more weeks to its
income statement reporting period (a 54-week year). Previous years were 52 weeks.
Instructions In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.
Identify the assumption or principle that has been violated.
(LO 3), C
Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.
EXERCISES: SET B AND CHALLENGE EXERCISES
▼
P2-1A Suppose the following items are taken from the 2017 balance sheet of Yahoo! Inc. (All dollars are in millions.)
Goodwill $3,927 Common stock 6,283 Equipment 1,737 Accounts payable 152 Patents 234 Stock investments (long-term) 3,247 Accounts receivable 1,061 Prepaid rent 233 Debt investments (short-term) 1,160 Retained earnings 6,108 Cash 2,292 Notes payable (long-term) 734 Unearned sales revenue 413 Accumulated depreciation—equipment 201
Instructions Prepare a classifi ed balance sheet for Yahoo! Inc. as of December 31, 2017.
P2-2A These items are taken from the fi nancial statements of Martin Corporation for 2017.
Retained earnings (beginning of year) $31,000 Utilities expense 2,000 Equipment 66,000 Accounts payable 18,300 Cash 10,100 Salaries and wages payable 3,000 Common stock 12,000 Dividends 12,000
Prepare a classifi ed balance sheet.
(LO 1), AP
Tot. current assets $4,746 Tot. assets $13,690
Prepare fi nancial statements.
(LO 1), AP
PROBLEMS: SET A▼
Problems: Set A 79
Service revenue 68,000 Prepaid insurance 3,500 Maintenance and repairs expense 1,800 Depreciation expense 3,600 Accounts receivable 11,700 Insurance expense 2,200 Salaries and wages expense 37,000 Accumulated depreciation—equipment 17,600
Instructions Prepare an income statement, a retained earnings statement, and a classifi ed balance sheet as of December 31, 2017.
P2-3A You are provided with the following information for Lazuris Enterprises, effective as of its April 30, 2017, year-end.
Accounts payable $ 834 Accounts receivable 810 Accumulated depreciation—equipment 670 Cash 1,270 Common stock 900 Cost of goods sold 1,060 Depreciation expense 335 Dividends 325 Equipment 2,420 Income tax expense 165 Income taxes payable 135 Insurance expense 210 Interest expense 400 Inventory 967 Land 3,100 Mortgage payable 3,500 Notes payable 61 Prepaid insurance 60 Retained earnings (beginning) 1,600 Salaries and wages expense 700 Salaries and wages payable 222 Sales revenue 5,100 Stock investments (short-term) 1,200
Instructions (a) Prepare an income statement and a retained earnings statement for Lazuris Enter-
prises for the year ended April 30, 2017. (b) Prepare a classifi ed balance sheet for Lazuris Enterprises as of April 30, 2017.
P2-4A Comparative fi nancial statement data for Loeb Corporation and Bowsh Corpora- tion, two competitors, appear below. All balance sheet data are as of December 31, 2017.
Loeb Corporation Bowsh Corporation
2017 2017
Net sales $1,800,000 $620,000 Cost of goods sold 1,175,000 340,000 Operating expenses 283,000 98,000 Interest expense 9,000 3,800 Income tax expense 85,000 36,000 Current assets 407,200 190,336 Plant assets (net) 532,000 139,728 Current liabilities 66,325 33,716 Long-term liabilities 108,500 40,684 Net cash provided by operating activities 138,000 36,000 Capital expenditures 90,000 20,000 Dividends paid on common stock 36,000 15,000
Weighted-average number of shares outstanding 80,000 50,000
Net income $21,400 Tot. assets $73,700
Prepare fi nancial statements.
(LO 1), AP
(a) Net income $2,230 (b) Tot. current assets $4,307 Tot. assets $9,157
Compute ratios; comment on relative profi tability, liquidity, and solvency.
(LO 2), AN
80 2 A Further Look at Financial Statements
Additional information: The net cash provided by operating activities for 2017 was $190,800. The cash used for capital expenditures was $92,000. The cash used for dividends was $31,000. The weighted-average number of shares outstanding during the year was 50,000.
Instructions (a) Compute the following values and ratios for 2017. (We provide the results from 2016
for comparative purposes.) (i) Working capital. (2016: $160,500) (ii) Current ratio. (2016: 1.65:1) (iii) Free cash fl ow. (2016: $48,700) (iv) Debt to assets ratio. (2016: 31%) (v) Earnings per share. (2016: $3.15) (b) Using your calculations from part (a), discuss changes from 2016 in liquidity, solvency,
and profi tability.
Instructions (a) Comment on the relative profi tability of the companies by computing the net income
and earnings per share for each company for 2017. (b) Comment on the relative liquidity of the companies by computing working capital and
the current ratio for each company for 2017. (c) Comment on the relative solvency of the companies by computing the debt to assets
ratio and the free cash fl ow for each company for 2017.
P2-5A The following are fi nancial statements of Ohara Company.
OHARA COMPANY Income Statement
For the Year Ended December 31, 2017
Net sales $2,218,500 Cost of goods sold 1,012,400 Selling and administrative expenses 906,000 Interest expense 78,000 Income tax expense 69,000
Net income $ 153,100
OHARA COMPANY Balance Sheet
December 31, 2017
Assets
Current assets Cash $ 60,100 Debt investments 84,000 Accounts receivable (net) 169,800 Inventory 145,000
Total current assets 458,900
Plant assets (net) 575,300
Total assets $1,034,200
Liabilities and Stockholders’ Equity
Current liabilities Accounts payable $ 160,000 Income taxes payable 35,500
Total current liabilities 195,500
Bonds payable 200,000
Total liabilities 395,500
Stockholders’ equity Common stock 350,000 Retained earnings 288,700
Total stockholders’ equity 638,700
Total liabilities and stockholders’ equity $1,034,200
Compute and interpret liquidity, solvency, and profi tability ratios.
(LO 2), AP
Problems: Set A 81
Additional information:
Net cash provided by operating activities $82,000 $56,000 Cash used for capital expenditures $45,000 $38,000 Dividends paid $20,000 $15,000 Weighted-average number of shares outstanding 33,000 30,000
Instructions Compute these values and ratios for 2016 and 2017.
(a) Earnings per share. (b) Working capital. (c) Current ratio. (d) Debt to assets ratio. (e) Free cash fl ow. (f) Based on the ratios calculated, discuss briefl y the improvement or lack thereof
in fi nancial position and operating results from 2016 to 2017 of Danke Corporation.
P2-7A Selected fi nancial data of two competitors, Target and Wal-Mart, are presented here. (All dollars are in millions.) Suppose the data were taken from the 2017 fi nancial statements of each company.
Compute ratios and compare liquidity, solvency, and profi tability for two companies.
(LO 2), AP
P2-6A Condensed balance sheet and income statement data for Danke Corporation are presented as follows.
Target Wal-Mart (1/31/17) (1/31/17)
Income Statement Data for Year
Net sales $64,948 $401,244 Cost of goods sold 44,157 306,158 Selling and administrative expenses 16,389 76,651 Interest expense 894 2,103 Other income 28 4,213 Income taxes 1,322 7,145
Net income $ 2,214 $ 13,400
DANKE CORPORATION Balance Sheets December 31
2017 2016 Assets
Cash $ 28,000 $ 20,000 Receivables (net) 70,000 62,000 Other current assets 90,000 73,000 Long-term investments 62,000 60,000 Property, plant, and equipment (net) 510,000 470,000
Total assets $760,000 $685,000
Liabilities and Stockholders’ Equity
Current liabilities $ 75,000 $ 70,000 Long-term liabilities 80,000 90,000 Common stock 330,000 300,000 Retained earnings 275,000 225,000
Total liabilities and stockholders’ equity $760,000 $685,000
DANKE CORPORATION Income Statements
For the Years Ended December 31
2017 2016
Sales revenue $750,000 $680,000 Cost of goods sold 440,000 400,000 Operating expenses (including income taxes) 240,000 220,000
Net income $ 70,000 $ 60,000
Compute and interpret liquidity, solvency, and profi tability ratios.
(LO 2), AP
82 2 A Further Look at Financial Statements
Target Wal-Mart
Balance Sheet Data (End of Year)
Current assets $17,488 $ 48,949 Noncurrent assets 26,618 114,480
Total assets $44,106 $163,429
Current liabilities $10,512 $ 55,390 Long-term liabilities 19,882 42,754 Total stockholders’ equity 13,712 65,285
Total liabilities and stockholders’ equity $44,106 $163,429
Net cash provided by operating activities $4,430 $23,147 Cash paid for capital expenditures $3,547 $11,499 Dividends declared and paid on common stock $465 $3,746
Weighted-average shares outstanding (millions) 774 3,951
Instructions For each company, compute these values and ratios.
(a) Working capital. (b) Current ratio. (c) Debt to assets ratio. (d) Free cash fl ow. (e) Earnings per share. (f) Compare the liquidity and solvency of the two companies.
P2-8A A friend of yours, Saira Ortiz, recently completed an undergraduate degree in sci- ence and has just started working with a biotechnology company. Saira tells you that the owners of the business are trying to secure new sources of fi nancing which are needed in order for the company to proceed with development of a new healthcare product. Saira said that her boss told her that the company must put together a report to present to potential investors. Saira thought that the company should include in this package the detailed scientifi c fi ndings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scientifi c fi ndings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting prin- ciples. Why do we need to look at some accounting rules? What they need to realize is that we have scientifi c results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven’t made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”
Instructions (a) What is accounting information? Explain to Saira what is meant by generally accepted
accounting principles. (b) Comment on how Saira’s suggestions for what should be reported to prospective inves-
tors conforms to the qualitative characteristics of accounting information. Do you think that the things that Saira wants to include in the information for investors will conform to fi nancial reporting guidelines?
Comment on the objectives and qualitative characteristics of fi nancial reporting.
(LO 3), E
Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.
PROBLEMS: SET B AND SET C▼
Expand Your Critical Thinking 83
(Note: This is a continuation of the Cookie Creations problem from Chapter 1.)
CC2 After investigating the different forms of business organization, Natalie Koebel decides to operate her business as a corporation, Cookie Creations Inc. She then begins the process of getting her business running.
Go to the book’s companion website, www.wiley.com/college/kimmel, to see the com- pletion of this problem.
CONTINUING PROBLEM Cookie Creations▼
EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.
CT2-1 The fi nancial statements of Apple Inc. are presented in Appendix A at the end of this textbook.
Instructions Answer the following questions using the fi nancial statements and the notes to the fi nancial statements.
(a) What were Apple’s total current assets at September 27, 2014, and September 28, 2013?
(b) Are the assets included in current assets listed in the proper order? Explain. (c) How are Apple’s assets classified? (d) What were Apple’s current liabilities at September 27, 2014, and September 28, 2013?
COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation
CT2-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C. Assume Columbia’s weighted-average number of shares outstanding was 227,514,000, and VF’s was 56,997,000.
Instructions (a) For each company, calculate the following values for 2014. (1) Working capital. (3) Debt to assets ratio. (2) Current ratio. (4) Free cash flow. (Hint: When calculating free cash flow, do not consider business acquisitions to be
part of capital expenditures.) (b) Based on your findings above, discuss the relative liquidity and solvency of the two
companies.
COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.
CT2-3 Amazon.com, Inc.’s fi nancial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.
Instructions (a) For each company, calculate the following values for 2014. (1) Working capital. (3) Debt to assets ratio. (2) Current ratio. (4) Free cash flow. (b) Based on your findings above, discuss the relative liquidity and solvency of the two
companies.
INTERPRETING FINANCIAL STATEMENTS
CT2-4 Suppose the following information was reported by Gap, Inc.
Financial Reporting
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84 2 A Further Look at Financial Statements
2017 2016 2015 2014 2013
Total assets (millions) $7,065 $7,985 $7,564 $7,838 $8,544 Working capital $1,831 $2,533 $1,847 $1,653 $2,757 Current ratio 1.87:1 2.19:1 1.86:1 1.68:1 2.21:1 Debt to assets ratio .42:1 .39:1 .42:1 .45:1 .39:1 Earnings per share $1.89 $1.59 $1.35 $1.05 $0.94
(a) Determine the overall percentage decrease in Gap’s total assets from 2013 to 2017. What was the average decrease per year?
(b) Comment on the change in Gap’s liquidity. Does working capital or the current ratio appear to provide a better indication of Gap’s liquidity? What might explain the change in Gap’s liquidity during this period?
(c) Comment on the change in Gap’s solvency during this period. (d) Comment on the change in Gap’s profi tability during this period. How might this
affect your prediction about Gap’s future profi tability?
REAL-WORLD FOCUS
CT2-5 Purpose: Identify summary liquidity, solvency, and profi tability information about companies, and compare this information across companies in the same industry.
Address: http://biz.yahoo.com/i
Steps 1. Type in a company name, or use the index to find a company name. Choose Profile.
Choose Key Statistics. Perform instruction (a) below. 2. Go back to Profile. Click on the company’s particular industry behind the heading
“Industry.” Perform instructions (b), (c), and (d).
Instructions Answer the following questions.
(a) What is the company’s name? What was the company’s current ratio and debt to equity ratio (a variation of the debt to assets ratio)?
(b) What is the company’s industry? (c) What is the name of a competitor? What is the competitor’s current ratio and its debt
to equity ratio? (d) Based on these measures, which company is more liquid? Which company is more
solvent?
CT2-6 The Feature Story described the dramatic effect that investment bulletin boards are having on the investment world. This exercise will allow you to evaluate a bulletin board discussing a company of your choice.
Address: http://biz.yahoo.com/i
Steps 1. Type in a company name, or use the index to find a company name. 2. Choose Msgs or Message Board. (for messages). 3. Read the 10 most recent messages.
Instructions Answer the following questions.
(a) State the nature of each of these messages (e.g., offering advice, criticizing company, predicting future results, ridiculing other people who have posted messages).
(b) For those messages that expressed an opinion about the company, was evidence pro- vided to support the opinion?
(c) What effect do you think it would have on bulletin board discussions if the partici- pants provided their actual names? Do you think this would be a good policy?
CT2-7 The July 6, 2011, edition of the Wall Street Journal Online includes an article by Michael Rapoport entitled “U.S. Firms Clash Over Accounting Rules.” The article discusses why some U.S. companies favored adoption of International Financial Reporting Stan- dards (IFRS) while other companies opposed it.
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Expand Your Critical Thinking 85
Instructions Read the article and answer the following questions.
(a) The articles says that the switch to IFRS tends to be favored by “larger companies, big accounting firms, and rule makers.” What reasons are given for favoring the switch?
(b) What two reasons are given by many smaller companies that oppose the switch? (c) What criticism of IFRS is raised with regard to regulated companies? (d) Explain what is meant by “condorsement.”
DECISION-MAKING ACROSS THE ORGANIZATION
CT2-8 As a fi nancial analyst in the planning department for Erin Industries, Inc., you must develop ratios from the comparative fi nancial statements. This information is to be used to convince creditors that, despite a slight decline in sales, Erin Industries, Inc. is liquid, solvent, and profi table, and that it deserves their continued support. Lenders are particularly concerned about the company’s ability to continue as a going concern. Here are the data requested and the computations developed from the fi nancial statements:
2017 2016
Current ratio 3.1 2.1 Working capital Up 22% Down 7% Free cash flow Up 25% Up 18% Debt to assets ratio 0.60 0.70 Net income Up 32% Down 8% Earnings per share $2.40 $1.15
Instructions Erin Industries, Inc. asks you to prepare brief comments stating how each of these items supports the argument that its fi nancial health is improving. The company wishes to use these comments to support presentation of data to its creditors. With the class divided into groups, prepare the comments as requested, giving the implications and the limitations of each item regarding Erin’s fi nancial well-being.
COMMUNICATION ACTIVITY
CT2-9 B. P. Palmer is the chief executive offi cer of Future Products. Palmer is an expert engineer but a novice in accounting.
Instructions Write a letter to B. P. Palmer that explains (a) the three main types of ratios; (b) examples of each, how they are calculated, and what they measure; and (c) the bases for comparison in analyzing Future Products’ fi nancial statements.
ETHICS CASE
CT2-10 At one time, Boeing closed a giant deal to acquire another manufacturer, McDonnell Douglas. Boeing paid for the acquisition by issuing shares of its own stock to the stockhold- ers of McDonnell Douglas. In order for the deal not to be revoked, the value of Boeing’s stock could not decline below a certain level for a number of months after the deal. During the fi rst half of the year, Boeing suffered signifi cant cost overruns because of ineffi ciencies in its production methods. Had these problems been disclosed in the quar- terly fi nancial statements during the fi rst and second quarters of the year, the company’s stock most likely would have plummeted, and the deal would have been revoked. Com- pany managers spent considerable time debating when the bad news should be disclosed. One public relations manager suggested that the company’s problems be revealed on the date of either Princess Diana’s or Mother Teresa’s funeral, in the hope that it would be lost among those big stories that day. Instead, the company waited until October 22 of that year to announce a $2.6 billion write-off due to cost overruns. Within one week, the com- pany’s stock price had fallen 20%, but by this time the McDonnell Douglas deal could not be reversed.
Financial Analysis
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86 2 A Further Look at Financial Statements
Instructions Answer the following questions.
(a) Who are the stakeholders in this situation? (b) What are the ethical issues? (c) What assumptions or principles of accounting are relevant to this case? (d) Do you think it is ethical to try to “time” the release of a story so as to diminish its
effect? (e) What would you have done if you were the chief executive officer of Boeing? (f) Boeing’s top management maintains that it did not have an obligation to reveal its
problems during the first half of the year. What implications does this have for inves- tors and analysts who follow Boeing’s stock?
ALL ABOUT YOU
CT2-11 Every company needs to plan in order to move forward. Its top management must consider where it wants the company to be in three to fi ve years. Like a company, you need to think about where you want to be three to fi ve years from now, and you need to start taking steps now in order to get there.
Instructions Provide responses to each of the following items.
(a) Where would you like to be working in three to five years? Describe your plan for getting there by identifying between five and 10 specific steps that you need to take in order to get there.
(b) In order to get the job you want, you will need a résumé. Your résumé is the equivalent of a company’s annual report. It needs to provide relevant and reliable information about your past accomplishments so that employers can decide whether to “invest” in you. Do a search on the Internet to find a good résumé format. What are the basic elements of a résumé?
(c) A company’s annual report provides information about a company’s accomplish- ments. In order for investors to use the annual report, the information must be reliable; that is, users must have faith that the information is accurate and believ- able. How can you provide assurance that the information on your résumé is reliable?
(d) Prepare a résumé assuming that you have accomplished the five to 10 specific steps you identified in part (a). Also, provide evidence that would give assurance that the information is reliable.
FASB CODIFICATION ACTIVITY
CT2-12 If your school has a subscription to the FASB Codifi cation, go to http://aaahq. org/ascLogin.cfm to log in and prepare responses to the following.
Instructions (a) Access the glossary (“Master Glossary”) at the FASB Codification website to answer
the following. (1) What is the definition of current assets? (2) What is the definition of current liabilities? (b) A company wants to offset its accounts payable against its cash account and show a
cash amount net of accounts payable on its balance sheet. Identify the criteria (found in the FASB Codification) under which a company has the right of set off. Does the company have the right to offset accounts payable against the cash account?
CONSIDERING PEOPLE, PLANET, AND PROFIT
CT2-13 Auditors provide a type of certifi cation of corporate fi nancial statements. Certi- fi cation is used in many other aspects of business as well. For example, it plays a critical role in the sustainability movement. The February 7, 2012, issue of the New York Times contained an article by S. Amanda Caudill entitled “Better Lives in Better Coffee,” which discusses the role of certifi cation in the coffee business.
Address: http://scientistatwork.blogs.nytimes.com/2012/02/07/better-lives-in-better- coffee/
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A Look at IFRS 87
Instructions Read the article and answer the following questions.
(a) The article mentions three different certification types that coffee growers can obtain from three different certification bodies. Using financial reporting as an example, what potential problems might the existence of multiple certification types present to coffee purchasers?
(b) According to the author, which certification is most common among coffee growers? What are the possible reasons for this?
(c) What social and environmental benefits are coffee certifications trying to achieve? Are there also potential financial benefits to the parties involved?
The classified balance sheet, although generally required internationally, contains certain variations in format when reporting under IFRS.
KEY POINTS Following are the key similarities and differences between GAAP and IFRS related to the financial statements.
Similarities • IFRS generally requires a classified statement of financial position similar to the classi-
fied balance sheet under GAAP. • IFRS follows the same guidelines as this textbook for distinguishing between current
and noncurrent assets and liabilities.
Differences • IFRS recommends but does not require the use of the title “statement of financial pos-
ition” rather than balance sheet. • The format of statement of financial position information is often presented differently
under IFRS. Although no specific format is required, many companies that follow IFRS present statement of financial position information in this order: ♦ Non-current assets ♦ Current assets ♦ Equity ♦ Non-current liabilities ♦ Current liabilities
• Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.
• IFRS has many differences in terminology from what are shown in your textbook. For example, in the sample statement of financial position illustrated on the next page, notice in the investment category that stock is called shares.
LEARNING OBJECTIVE 4 Compare the classifi ed balance sheet format under GAAP and IFRS.▼
A Look at IFRS
88 2 A Further Look at Financial Statements
Assets Intangible assets Patents $ 3,100 Property, plant, and equipment Land $10,000 Equipment $24,000 Less: Accumulated depreciation 5,000 19,000 29,000 Long-term investments Share investments 5,200 Investment in real estate 2,000 7,200 Current assets Prepaid insurance 400 Supplies 2,100 Inventory 3,000 Notes receivable 1,000 Accounts receivable 7,000 Debt investments 2,000 Cash 6,600 22,100 Total assets $61,400
Equity and Liabilities Equity Share capital $20,050 Retained earnings 14,000 Non-current liabilities Mortgage payable $10,000 Notes payable 1,300 11,300 Current liabilities Notes payable 11,000 Accounts payable 2,100 Salaries and wages payable 1,600 Unearned service revenue 900 Interest payable 450 16,050 Total equity and liabilities $61,400
FRANKLIN CORPORATION Statement of Financial Position
October 31, 2017
• Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment, and in some cases intangible assets.
LOOKING TO THE FUTURE The IASB and the FASB are working on a project to converge their standards related to finan- cial statement presentation. A key feature of the proposed framework is that each of the statements will be organized in the same format, to separate an entity’s financing activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the income statement and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://www.fasb.org/project/-financial_statement_presentation.shtml.
IFRS Practice IFRS SELF-TEST QUESTIONS 1. A company has purchased a tract of land and expects to build a production plant on
the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as: (a) land expense. (b) property, plant, and equipment.
A Look at IFRS 89
(c) an intangible asset. (d) a long-term investment.
2. Current assets under IFRS are listed generally: (a) by importance. (b) in the reverse order of their expected conversion to cash. (c) by longevity. (d) alphabetically.
3. Companies that use IFRS: (a) may report all their assets on the statement of financial position at fair value. (b) may offset assets against liabilities and show net assets and net liabilities on their
statements of financial position, rather than the underlying detailed line items. (c) may report non-current assets before current assets on the statement of financial
position. (d) do not have any guidelines as to what should be reported on the statement of
financial position. 4. Companies that follow IFRS to prepare a statement of financial position generally use
the following order of classification: (a) current assets, current liabilities, non-current assets, non-current liabilities, equity. (b) non-current assets, non-current liabilities, current assets, current liabilities, equity. (c) non-current assets, current assets, equity, non-current liabilities, current liabilities. (d) equity, non-current assets, current assets, non-current liabilities, current liabilities.
IFRS EXERCISES IFRS2-1 In what ways does the format of a statement of financial of position under IFRS often differ from a balance sheet presented under GAAP?
IFRS2-2 What term is commonly used under IFRS in reference to the balance sheet?
IFRS2-3 The statement of financial position for Sundell Company includes the following accounts (in British pounds): Accounts Receivable £12,500, Prepaid Insurance £3,600, Cash £15,400, Supplies £5,200, and Debt Investments (short-term) £6,700. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence.
IFRS2-4 The following information is available for Lessila Bowling Alley at December 31, 2017.
Buildings $128,800 Share Capital $100,000 Accounts Receivable 14,520 Retained Earnings (beginning) 15,000 Prepaid Insurance 4,680 Accumulated Depreciation—Buildings 42,600 Cash 18,040 Accounts Payable 12,300 Equipment 62,400 Notes Payable 97,780 Land 64,000 Accumulated Depreciation—Equipment 18,720 Insurance Expense 780 Interest Payable 2,600 Depreciation Expense 7,360 Bowling Revenues 14,180 Interest Expense 2,600
Prepare a classified statement of financial position. Assume that $13,900 of the notes payable will be paid in 2018.
INTERNATIONAL COMPARATIVE ANALYSIS PROBLEM: Apple vs. Louis Vuitton IFRS2-5 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.
Instructions Identify five differences in the format of the statement of financial position used by Louis Vuitton compared to a company, such as Apple, that follows GAAP. (Apple’s financial statements are available in Appendix A.)
Answers to IFRS Self-Test Questions 1. d 2. b 3. c 4. c
As indicated in the Feature Story, a reliable information system is a necessity for any company. The
purpose of this chapter is to explain and illustrate the features of an accounting information system.
CHAPTER PREVIEW
The Accounting Information System 3
LEARNING OBJECTIVES PRACTICE
CHAPTER OUTLINE
• Accounting transactions • Analyzing transactions • Summary of transactions
▼1 Analyze the effect of business transactions on the basic accounting equation.
DO IT!
1 Transaction Analysis
▼3 Indicate how a journal is used in the recording process.
• The recording process • The journal
DO IT!
3 Journal Entries
▼4 Explain how a ledger and posting help in the recording process.
• The ledger • Chart of accounts • Posting • The recording process
illustrated • Summary illustration
DO IT!
4 Posting
▼5 Prepare a trial balance. • Limitations of a trial balance DO IT!
5 Trial Balance
▼2 Explain how accounts, debits, and credits are used to record business transactions.
• Debits and credits • Debit and credit procedures • Stockholders’ equity
relationships • Summary of debit/credit rules
DO IT!
2 Debits and Credits for Balance Sheet Accounts
Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.
Visit for additional tutorials and practice opportunities.
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How organized are you fi nancially? Take a short quiz. Answer yes or no to each question:
• Does your wallet contain so many cash machine receipts that you’ve been declared a walking fi re hazard?
• Do you wait until your debit card is denied before checking the status of your funds?
• Was Aaron Rodgers (the quarterback for the Green Bay Packers) playing high school football the last time you verifi ed the accuracy of your bank account?
If you think it is hard to keep track of the many transactions that make up your life, imagine how diffi cult it is for a big corporation to do so. Not only that, but now consider how important it is for a big company to have good accounting records, especially if it has control of your life savings. MF Global Holdings Ltd was such a company. As a large investment broker, it held billions of dollars of investments for clients. If you had your life savings invested at MF Global, you might be slightly displeased if you heard this from one of its representatives: “You know, I kind of remember an account for someone with a name like yours—now what did we do with that?”
Unfortunately, that is almost exactly what happened to MF Global’s clients shortly before it fi led for bankruptcy. During the days immediately following
the bankruptcy fi ling, regulators and auditors struggled to piece things together. In the words of one regulator, “Their books are a disaster . . . we’re trying to fi gure out what numbers are real numbers.” One company that considered buying an interest in MF Global walked away from the deal
because it “couldn’t get a sense of what was on the balance sheet.” That company said the information that should have been instantly available instead took days to produce.
It now appears that MF Global did not properly segregate customer accounts from company accounts. And, because of its sloppy recordkeeping, customers were not protected when the company had fi nancial troubles. Total customer losses were approximately $1 billion. As you can see, accounting matters!
Source: S. Patterson and A. Lucchetti, “Inside the Hunt for MF Global Cash,” Wall Street Journal Online (November 11, 2011).
FEATURE STORY
Accidents Happen
© Nick Laham/Getty Images, Inc.
92 3 The Accounting Information System
LEARNING OBJECTIVE 1 Analyze the effect of business transactions on the basic accounting equation.▼
The system of collecting and processing transaction data and communicating fi nancial information to decision-makers is known as the accounting infor- mation system. Factors that shape an accounting information system include the nature of the company’s business, the types of transactions, the size of the company, the volume of data, and the information demands of management and others. Most businesses use computerized accounting systems—sometimes referred to as electronic data processing (EDP) systems. These systems handle all the steps involved in the recording process, from initial data entry to preparation of the fi nancial statements. In order to remain competitive, companies continu- ally improve their accounting systems to provide accurate and timely data for decision-making. For example, in a recent annual report, Tootsie Roll stated, “We also invested in additional processing and data storage hardware during the year. We view information technology as a key strategic tool, and are committed to deploying leading edge technology in this area.” In addition, many companies have upgraded their accounting information systems in response to the require- ments of Sarbanes-Oxley. Accounting information systems rely on a process referred to as the accounting cycle. As you can see from the graphic above, the accounting cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance. We explain each of the steps in this chapter as well as in Chapter 4. In this chapter, in order to emphasize the underlying concepts and principles, we focus on a manual accounting system. The accounting concepts and prin- ciples do not change whether a system is computerized or manual.
ACCOUNTING TRANSACTIONS
To use an accounting information system, you need to know which economic events to recognize (record). Not all events are recorded and reported in the fi nancial statements. For example, suppose General Motors hired a new employee and purchased a new computer. Are these events entered in its accounting records? The fi rst event would not be recorded, but the second event would. We call economic events that require recording in the fi nancial statements accounting transactions. An accounting transaction occurs when assets, liabilities, or stockholders’ equity items change as a result of some economic event. The purchase of a com- puter by General Motors, the payment of rent by Microsoft, and the sale of a multi-day guided trip by Sierra Corporation are examples of events that change a company’s assets, liabilities, or stockholders’ equity. Illustration 3-1 summarizes the decision process companies use to decide whether or not to record economic events.
The accounting cycle graphic above illustrates the steps companies follow each period to record transactions and eventually prepare fi nancial statements.
JOURNALIZE POST TRIAL
BALANCE
ADJUSTING ENTRIES
ADJUSTED TRIAL
BALANCE
FINANCIAL STATEMENTS
CLOSING ENTRIES
POST-CLOSING TRIAL BALANCE
JJJOJJ Analyze business
transactions
Using the Accounting Equation to Analyze Transactions 93
ANALYZING TRANSACTIONS
In Chapter 1, you learned the basic accounting equation:
TRAV EL
RENTRENT
CHIP CITY
DELL
YesNoYes
Events
Criterion
Record/ Don’t Record
Pay rentDiscuss guided trip options with potential customer
Purchase computer
Is the financial position (assets, liabilities, or stockholders’ equity) of the company changed?
ILLUSTRATION 3-1 Transaction identifi cation process
Assets = Liabilities + Stockholders’ Equity
In this chapter, you will learn how to analyze transactions in terms of their effect on assets, liabilities, and stockholders’ equity. Transaction analysis is the process of identifying the specifi c effects of economic events on the accounting equation.
The accounting equation must always balance. Each transaction has a dual (double-sided) effect on the equation. For example, if an individual asset is increased, there must be a corresponding:
• Decrease in another asset, or
• Increase in a specifi c liability, or
• Increase in stockholders’ equity.
Two or more items could be affected when an asset is increased. For exam- ple, if a company purchases a computer for $10,000 by paying $6,000 in cash and signing a note for $4,000, one asset (equipment) increases $10,000, another asset (cash) decreases $6,000, and a liability (notes payable) increases $4,000. The result is that the accounting equation remains in balance—assets increased by a net $4,000 and liabilities increased by $4,000, as shown below.
DECISION TOOLS
The accounting equation is used to determine if an accounting transac- tion has occurred.
Assets = Liabilities + Stockholders’ Equity +$10,000 +$4,000 − 6,000 $ 4,000 = $4,000
Chapter 1 presented the fi nancial statements for Sierra Corporation for its fi rst month. You should review those fi nancial statements (on page 16) at this time. To illustrate how economic events affect the accounting equation, we will examine events affecting Sierra during its fi rst month.
94 3 The Accounting Information System
In order to analyze the transactions for Sierra, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transac- tions on stockholders’ equity. Recall from the balance sheets in Chapters 1 and 2 that stockholders’ equity is comprised of two parts: common stock and retained earnings. Common stock is affected when the company issues new shares of stock in exchange for cash. Retained earnings is affected when the company recognizes revenue, incurs expenses, or pays dividends. Illustration 3-2 shows the expanded equation.
ILLUSTRATION 3-2 Expanded accounting equation
Assets Liabilities Stockholders’ Equity5 1
Retained EarningsCommon Stock 1
Expenses DividendsRevenues 2 2
If you are tempted to skip ahead after you’ve read a few of the following transaction analyses, don’t do it. Each has something unique to teach, some- thing you’ll need later. (We assure you that we’ve kept them to the minimum needed!)
EVENT (1). INVESTMENT OF CASH BY STOCKHOLDERS. On October 1, cash of $10,000 is invested in the business by investors in exchange for $10,000 of com- mon stock. This event is an accounting transaction that results in an increase in both assets and stockholders’ equity.
The equation is in balance after the issuance of common stock. Keeping track of the source of each change in stockholders’ equity is essential for later account- ing activities. In particular, items recorded in the revenue and expense columns are used for the calculation of net income.
EVENT (2). NOTE ISSUED IN EXCHANGE FOR CASH. On October 1, Sierra borrowed $5,000 from Castle Bank by signing a 3-month, 12%, $5,000 note payable. This transaction results in an equal increase in assets and liabilities. The specifi c effect of this transaction and the cumulative effect of the fi rst two transactions are as follows.
Basic Analysis
The asset Cash is increased $10,000; stockholders’ equity (specifically Common Stock) is increased $10,000.
Equation Analysis
Assets = Liabilities + Stockholders’ Equity Common Cash = Stock
(1) +$10,000 +$10,000 Issued stock
Using the Accounting Equation to Analyze Transactions 95
Total assets are now $15,000, and liabilities plus stockholders’ equity also total $15,000.
EVENT (3). PURCHASE OF EQUIPMENT FOR CASH. On October 2, Sierra purchased equipment by paying $5,000 cash to Superior Equipment Sales Co. This transac- tion results in an equal increase and decrease in Sierra’s assets.
The total assets are now $15,000, and liabilities plus stockholders’ equity also total $15,000.
EVENT (4). RECEIPT OF CASH IN ADVANCE FROM CUSTOMER. On October 2, Sierra received a $1,200 cash advance from R. Knox, a client. Sierra received cash (an asset) for guide services for multi-day trips that it expects to complete in the future. Although Sierra received cash, it does not record revenue until it has performed the work. In some industries, such as the magazine and airline industries, customers are expected to prepay. These companies have a liability to the customer until they deliver the magazines or provide the fl ight. When the company eventually provides the product or service, it records the revenue. Since Sierra received cash prior to performance of the service, Sierra has a liability for the work due.
Basic Analysis
Equation Analysis
The asset Cash is increased $5,000; the liability Notes Payable is increased $5,000.
� � � � � � � � � � � � � � � � � � � � �
Assets = Liabilities + Stockholders’ Equity Notes Common Cash = Payable + Stock
$10,000 $10,000 (2) +5,000 +$5,000 $15,000 = $5,000 + $10,000
$15,000
Basic Analysis The asset Equipment is increased $5,000; the asset Cash is decreased $5,000.
Equation Analysis
Assets = Liabilities + Stockholders’ Equity Notes Common Cash + Equipment = Payable + Stock
$15,000 $5,000 $10,000 (3) −5,000 +$5,000 $10,000 + $5,000 = $5,000 + $10,000
$15,000 $15,000
Basic Analysis
The asset Cash is increased $1,200; the liability Unearned Service Revenue is increased $1,200 because the service has not been performed yet. That is, when an advance payment is received, unearned revenue (a liability) should be recorded in order to recognize the obligation that exists.
Equation Analysis
Assets = Liabilities + Stockholders’ Equity Equip- Notes Unearned Service Common Cash + ment = Payable + Revenue + Stock $10,000 $5,000 $5,000 $10,000 (4) +1,200 +$1,200 $11,200 + $5,000 = $5,000 + $1,200 + $10,000
$16,200 $16,200
96 3 The Accounting Information System
EVENT (5). SERVICES PERFORMED FOR CASH. On October 3, Sierra received $10,000 in cash (an asset) from Copa Company for guide services performed for a cor- porate event. Guide service is the principal revenue-producing activity of Sierra. Revenue increases stockholders’ equity. This transaction, then, increases both assets and stockholders’ equity.
Often companies perform services “on account.” That is, they perform services for which they are paid at a later date. Revenue, however, is recorded when services are performed. Therefore, revenues would increase when services are performed, even though cash has not been received. Instead of receiving cash, the company receives a different type of asset, an account receivable. Accounts receivable represent the right to receive payment at a later date. Suppose that Sierra had performed these services on account rather than for cash. This event would be reported using the accounting equation as:
Assets = Liabilities + Stockholders’ Equity Accounts Receivable = Revenues +$10,000 +$10,000 Service Revenue
Assets = Liabilities + Stockholders’ Equity Accounts Cash Receivable
+$10,000 −$10,000
Later, when Sierra collects the $10,000 from the customer, Accounts Receivable decreases by $10,000, and Cash increases by $10,000.
Note that in this case, revenues are not affected by the collection of cash. Instead Sierra records an exchange of one asset (Accounts Receivable) for a different asset (Cash).
EVENT (6). PAYMENT OF RENT. On October 3, Sierra paid its offi ce rent for the month of October in cash, $900. This rent payment is a transaction that results in a decrease in an asset, cash. Rent is a cost incurred by Sierra in its effort to generate revenues. It is treated as an expense because it pertains only to the current month. Expenses decrease stockholders’ equity. Sierra records the rent payment by decreasing cash and increasing expenses to maintain the balance of the accounting equation.
Basic Analysis The asset Cash is increased $10,000; the revenue Service Revenue is increased $10,000.
Assets = Liabilities + Stockholders’ Equity Equip- Notes Unearned Common Retained Earnings Cash + ment = Pay. + Serv. Rev. + Stock + Rev. – Exp. – Div.
$11,200 $5,000 $5,000 $1,200 $10,000 (5) +10,000 +$10,000
$21,200 + $5,000 = $5,000 + $1,200 + $10,000 + $10,000
$26,200 $26,200
Service Revenue
Equation Analysis
Using the Accounting Equation to Analyze Transactions 97
EVENT (7). PURCHASE OF INSURANCE POLICY FOR CASH. On October 4, Sierra paid $600 for a one-year insurance policy that will expire next year on September 30. Payments of expenses that will benefi t more than one accounting period are iden- tifi ed as assets called prepaid expenses or prepayments.
The balance in total assets did not change; one asset account decreased by the same amount that another increased.
EVENT (8). PURCHASE OF SUPPLIES ON ACCOUNT. On October 5, Sierra purchased an estimated three months of supplies on account from Aero Supply for $2,500. In this case, “on account” means that the company receives goods or services that it will pay for at a later date. This transaction increases both an asset (supplies) and a liability (accounts payable).
Basic Analysis
The expense account Rent Expense is increased $900 because the payment pertains only to the current month; the asset Cash is decreased $900.
Assets = Liabilities + Stockholders’ Equity
Equip- Notes Unearned Common Retained Earnings Cash + ment = Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.
$21,200 $5,000 $5,000 $1,200 $10,000 $10,000 (6) −900 −$900
$20,300 + $5,000 = $5,000 + $1,200 + $10,000 + $10,000 − $900
$25,300 $25,300
Rent Expense
Equation Analysis
Basic Analysis The asset Cash is decreased $600; the asset Prepaid Insurance is increased $600.
Equation Analysis
Assets = Liabilities + Stockholders’ Equity
Prepaid Equip- Notes Unearned Common Retained Earnings Cash + Insurance + ment = Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.
$20,300 $5,000 $5,000 $1,200 $10,000 $10,000 $900 (7) −600 +$600
$19,700 + $600 + $5,000 = $5,000 + $1,200 + $10,000 + $10,000 − $900
$25,300 $25,300
Basic Analysis The asset Supplies is increased $2,500; the liability Accounts Payable is increased $2,500.
Assets = Liabilities + Stockholders’ Equity
Prepd. Equip- Notes Accounts Unearned Common Retained Earnings Cash + Supplies + Insur. + ment = Pay. + Payable + Serv. Rev. + Stock + Rev. − Exp. − Div.
$19,700 $600 $5,000 $5,000 $1,200 $10,000 $10,000 $900 (8) +$2,500 +$2,500
$19,700 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $900
$27,800 $27,800
Equation Analysis
98 3 The Accounting Information System
EVENT (9). HIRING OF NEW EMPLOYEES. On October 9, Sierra hired four new employees to begin work on October 15. Each employee will receive a weekly salary of $500 for a fi ve-day work week, payable every two weeks. Employees will receive their fi rst paychecks on October 26. On the date Sierra hires the employees, there is no effect on the accounting equation because the assets, liabilities, and stockholders’ equity of the company have not changed.
Basic Analysis
An accounting transaction has not occurred. There is only an agreement that the employees will begin work on October 15. (See Event (11) for the first payment.)
EVENT (10). PAYMENT OF DIVIDEND. On October 20, Sierra paid a $500 cash dividend. Dividends are a reduction of stockholders’ equity but not an expense. Dividends are not included in the calculation of net income. Instead, a dividend is a distribution of the company’s assets to its stockholders.
Basic Analysis The Dividends account is increased $500; the asset Cash is decreased $500.
Equation Analysis
Assets = Liabilities + Stockholders’ Equity
Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings Cash + plies + Insur. + ment = Pay. + Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.
$19,700 $2,500 $600 $5,000 $5,000 $2,500 $1,200 $10,000 $10,000 $900 (10) −500 − $500
$19,200 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $900 − $500
$27,300 $27,300
EVENT (11). PAYMENT OF CASH FOR EMPLOYEE SALARIES. Employees have worked two weeks, earning $4,000 in salaries, which were paid on October 26. Salaries and Wages Expense is an expense that reduces stockholders’ equity. In this transaction, both assets and stockholders’ equity are reduced.
Basic Analysis
The asset Cash is decreased $4,000; the expense account Salaries and Wages Expense is increased $4,000.
Equation Analysis
Assets = Liabilities + Stockholders’ Equity
Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings
Cash + plies + Insur. + ment = Pay. + Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.
$19,200 $2,500 $600 $5,000 $5,000 $2,500 $1,200 $10,000 $10,000 $ 900 $500
(11) −4,000 − 4,000 Sal./Wages
$15,200 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $4,900 − $500 Expense
$23,300 $23,300
Using the Accounting Equation to Analyze Transactions 99
SUMMARY OF TRANSACTIONS
Illustration 3-3 summarizes the transactions of Sierra Corporation to show their cumulative effect on the basic accounting equation. It includes the transaction number in the fi rst column on the left. The right-most column shows the specifi c effect of any transaction that affects stockholders’ equity. Remember that Event (9) did not result in a transaction, so no entry is included for that event. The illus- tration demonstrates three important points:
1. Each transaction is analyzed in terms of its effect on assets, liabilities, and stockholders’ equity.
2. The two sides of the equation must always be equal.
3. The cause of each change in stockholders’ equity must be indicated.
© Enviromatic/iStockphoto
INVESTOR INSIGHT
Why Accuracy Matters
While most companies record trans- actions very carefully, the reality is that mistakes still happen. For example, bank regulators fi ned Bank One Corporation (now JPMorgan Chase) $1.8 million because they felt that the unreliability of the bank’s accounting system caused it to violate regulatory requirements.
Also, in recent years Fannie Mae, the government- chartered mortgage association, announced a series of large accounting errors. These announcements caused alarm among investors, regulators, and politicians because they feared that the errors might suggest larger, undetected problems. This was important because the home-mortgage
market depends on Fannie Mae to buy hundreds of billions of dollars of mortgages each year from banks, thus enabling the banks to issue new mortgages. Finally, before a major overhaul of its accounting system, the fi nancial records of Waste Management Company were in such disarray that of the company’s 57,000 employees, 10,000 were receiving pay slips that were in error. The Sarbanes-Oxley Act was created to minimize the occurrence of errors like these by increasing every employee’s responsibility for accurate fi nancial reporting.
In order for these companies to prepare and issue fi nancial statements, their accounting equations (debits and credits) must have been in balance at year-end. How could these errors or misstatements have occurred? (Go to WileyPLUS for this answer and additional questions.)
Assets = Liabilities + Stockholders’ Equity
Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings
Cash + plies + Insur. + ment = Pay. + Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.
(1) +$10,000 = +$10,000 Issued stock (2) +5,000 +$5,000 (3) −5,000 +$5,000 (4) +1,200 +$1,200 (5) +10,000 +$10,000 Service Revenue (6) −900 −$ 900 Rent Expense (7) −600 +$600 (8) +$2,500 + $2,500 (10) −500 −$500 Dividends (11) −4,000 −4,000 Sal./Wages Expense $15,200 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $4,900 − $500
$23,300 $23,300
ILLUSTRATION 3-3 Summary of transactions
100 3 The Accounting Information System
SOLUTION 1. The company issued shares of stock to stockholders for $25,000 cash.
2. The company purchased $7,000 of equipment on account.
3. The company received $8,000 of cash in exchange for services performed.
4. The company paid $850 for this month’s rent.
1▼ Transaction AnalysisDO IT! A tabular analysis of the transactions made by Roberta Mendez & Co., a certifi ed public accounting fi rm, for the month of August is shown below. Each increase and decrease in stockholders’ equity is explained.
Assets = Liabilities + Stockholders’ Equity Accounts Common Retained Earnings Cash + Equipment = Payable + Stock + Revenue − Expenses
1. +$25,000 +$25,000 Issued stock 2. +$7,000 = +$7,000 3. +8,000 +$8,000 Service Revenue 4. −850 −$850 Rent Expense $32,150 + $7,000 = $7,000 + $25,000 + $8,000 − $850
$39,150 $39,150
Describe each transaction that occurred for the month.Action Plan ✔ Analyze the tabular
analysis to determine the nature and effect of each transaction.
✔ Keep the accounting equation in balance.
✔ Remember that a change in an asset will require a change in another asset, a liability, or in stockholders’ equity. Related exercise material: BE3-1, BE3-2, BE3-3, DO IT! 3-1, E3-1, E3-2, E3-3, and E3-4.
LEARNING OBJECTIVE 2 Explain how accounts, debits, and credits are used to record business transactions.▼
Rather than using a tabular summary like the one in Illustration 3-3 for Sierra Corporation, an accounting information system uses accounts. An account is an individual accounting record of increases and decreases in a specifi c asset, liability, stockholders’ equity, revenue, or expense item. For example, Sierra Cor- poration has separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries and Wages Expense, and so on. (Note that whenever we are referring to a specifi c account, we capitalize the name.) In its simplest form, an account consists of three parts: (1) the title of the account, (2) a left or debit side, and (3) a right or credit side. Because the align- ment of these parts of an account resembles the letter T, it is referred to as a T-account. The basic form of an account is shown in Illustration 3-4.
Title of Account
Left or debit side Right or credit side
ILLUSTRATION 3-4 Basic form of account
Accounts, Debits, and Credits 101
We use this form of account often throughout this textbook to explain basic accounting relationships.
DEBITS AND CREDITS
The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease, as is commonly thought. We use the terms debit and credit repeatedly in the recording process to describe where entries are made in accounts. For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account. When comparing the totals of the two sides, an account shows a debit bal- ance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits. Note the position of the debit side and credit side in Illustration 3-4. The procedure of recording debits and credits in an account is shown in Illustra- tion 3-5 for the transactions affecting the Cash account of Sierra Corporation. The data are taken from the Cash column of the tabular summary in Illustration 3-3.
$10,000 5,000
–5,000 1,200
10,000 –900 –600 –500
–4,000
5,000 900 600 500
4,000
10,000 5,000 1,200
10,000
(Debits)
(Debit) Balance
(Credits) Cash Cash
$15,200
15,200
Account FormTabular Summary ILLUSTRATION 3-5 Tabular summary and account form for Sierra Corporation’s Cash account
Every positive item in the tabular summary represents a receipt of cash; every negative amount represents a payment of cash. Notice that in the account form, we record the increases in cash as debits and the decreases in cash as credits. For example, the $10,000 receipt of cash (in blue) is debited to Cash, and the −$5,000 payment of cash (in red) is credited to Cash. Having increases on one side and decreases on the other reduces recording errors and helps in determining the totals of each side of the account as well as the account balance. The balance is determined by netting the two sides (subtracting one amount from the other). The account balance, a debit of $15,200, indicates that Sierra had $15,200 more increases than decreases in cash. That is, since it started with a balance of zero, it has $15,200 in its Cash account.
DEBIT AND CREDIT PROCEDURES
Each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits. The equality of debits and credits provides the basis for the double-entry accounting system. Under the double-entry system, the two-sided effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. The double-entry system also helps to ensure the accuracy of the recorded amounts and helps to detect errors such as those at MF Global as discussed in the Feature Story. If every transaction is recorded with equal debits
INTERNATIONAL NOTE Rules for accounting for specifi c events sometimes differ across countries. For example, European companies rely less on historical cost and more on fair value than U.S. companies. Despite the differences, the double-entry accounting system is the basis of accounting systems worldwide.
102 3 The Accounting Information System
and credits, then the sum of all the debits to the accounts must equal the sum of all the credits. The double-entry system for determining the equality of the accounting equation is much more effi cient than the plus/minus procedure used earlier.
Dr./Cr. Procedures for Assets and Liabilities In Illustration 3-5 for Sierra Corporation, increases in Cash—an asset—are entered on the left side, and decreases in Cash are entered on the right side. We know that both sides of the basic equation (Assets = Liabilities + Stockholders’ Equity) must be equal. It therefore follows that increases and decreases in liabili- ties have to be recorded opposite from increases and decreases in assets. Thus, increases in liabilities are entered on the right or credit side, and decreases in liabilities are entered on the left or debit side. The effects that debits and credits have on assets and liabilities are summarized in Illustration 3-6.
Debits Credits
Increase assets Decrease assets Decrease liabilities Increase liabilities
ILLUSTRATION 3-6 Debit and credit effects–assets and liabilities
Asset accounts normally show debit balances. That is, debits to a specifi c asset account should exceed credits to that account. Likewise, liability accounts normally show credit balances. That is, credits to a liability account should exceed debits to that account. The normal balances may be diagrammed as in Illustration 3-7.
Debit for increase
Assets Credit for decrease
Normal balance Normal balance
Debit for decrease
Liabilities Credit for increase Normal balance Normal balance
ILLUSTRATION 3-7 Normal balances–assets and liabilities
Knowing which is the normal balance in an account may help when you are trying to identify errors. For example, a credit balance in an asset account, such as Land, or a debit balance in a liability account, such as Salaries and Wages Pay- able, usually indicates errors in recording. Occasionally, however, an abnormal balance may be correct. The Cash account, for example, will have a credit balance when a company has overdrawn its bank balance by spending more than it has in its account. In automated accounting systems, the computer is programmed to fl ag violations of the normal balance and to print out error or exception reports. In manual systems, careful visual inspection of the accounts is required to detect normal balance problems.
Dr./Cr. Procedures for Stockholders’ Equity In Chapter 1, we indicated that stockholders’ equity is comprised of two parts: common stock and retained earnings. In the transaction events earlier in this chapter, you saw that revenues, expenses, and the payment of dividends affect retained earnings. Therefore, the subdivisions of stockholders’ equity are com- mon stock, retained earnings, dividends, revenues, and expenses.
COMMON STOCK Common stock is issued to investors in exchange for the stock- holders’ investment. The Common Stock account is increased by credits and
▼ HELPFUL HINT The normal balance is the side where increases in the account are recorded.
Accounts, Debits, and Credits 103
decreased by debits. For example, when cash is invested in the business, Cash is debited and Common Stock is credited. The effects of debits and credits on the Common Stock account are shown in Illustration 3-8.
Debits Credits
Decrease Common Stock Increase Common Stock
ILLUSTRATION 3-8 Debit and credit effects– common stock
Debits Credits
Decrease Retained Earnings Increase Retained Earnings
ILLUSTRATION 3-10 Debit and credit effects– retained earnings
The normal balance in the Common Stock account may be diagrammed as in Illustration 3-9.
Debit for decrease
Common Stock Credit for increase Normal balance Normal balance
ILLUSTRATION 3-9 Normal balance–common stock
RETAINED EARNINGS Retained earnings is net income that is retained in the busi- ness. It represents the portion of stockholders’ equity that has been accumulated through the profi table operation of the company. Retained Earnings is increased by credits (for example, by net income) and decreased by debits (for example, by a net loss), as shown in Illustration 3-10.
The normal balance for the Retained Earnings account may be diagrammed as in Illustration 3-11.
Debit for decrease
Retained Earnings Credit for increase Normal balance Normal balance
ILLUSTRATION 3-11 Normal balance–retained earnings
DIVIDENDS A dividend is a distribution by a corporation to its stockholders. The most common form of distribution is a cash dividend. Dividends result in a reduc- tion of the stockholders’ claims on retained earnings. Because dividends reduce stockholders’ equity, increases in the Dividends account are recorded with debits. As shown in Illustration 3-12, the Dividends account normally has a debit balance.
Debit for increase
Dividends Credit for decrease
Normal balance Normal balance
ILLUSTRATION 3-12 Normal balance–dividends
104 3 The Accounting Information System
REVENUES AND EXPENSES When a company recognizes revenues, stockholders’ equity is increased. Revenue accounts are increased by credits and decreased by debits. Expenses decrease stockholders’ equity. Thus, expense accounts are increased by debits and decreased by credits. The effects of debits and credits on revenues and expenses are shown in Illustration 3-13.
Debits Credits
Decrease revenue Increase revenue Increase expenses Decrease expenses
ILLUSTRATION 3-13 Debit and credit effects– revenues and expenses
Credits to revenue accounts should exceed debits; debits to expense accounts should exceed credits. Thus, revenue accounts normally show credit balances, and expense accounts normally show debit balances. The normal balances may be diagrammed as in Illustration 3-14.
Debit for increase
Expenses Credit for decrease
Debit for decrease
Revenues Credit for increase Normal balance Normal balance
Normal balance Normal balance
ILLUSTRATION 3-14 Normal balances–revenues and expenses
© Jonathan Daniel/Getty Images, Inc.
INVESTOR INSIGHT Chicago Cubs
Keeping Score
The Chicago Cubs baseball team has these major revenue and expense accounts: Revenues Expenses Admissions (ticket sales) Players’ salaries Concessions Administrative salaries Television and radio Travel Advertising Ballpark maintenance
Do you think that the Chicago Bears football team would be likely to have the same major revenue and expense accounts as the Cubs? (Go to WileyPLUS for this answer and additional questions.)
STOCKHOLDERS’ EQUITY RELATIONSHIPS
Companies report the subdivisions of stockholders’ equity in various places in the fi nancial statements:
• Common stock and retained earnings: in the stockholders’ equity section of the balance sheet.
• Dividends: on the retained earnings statement.
• Revenues and expenses: on the income statement.
Dividends, revenues, and expenses are eventually transferred to retained earn- ings at the end of the period. As a result, a change in any one of these three items affects stockholders’ equity. Illustration 3-15 shows the relationships of the accounts affecting stockholders’ equity.
Accounts, Debits, and Credits 105
SUMMARY OF DEBIT/CREDIT RULES
Illustration 3-16 summarizes the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the funda- mentals of the double-entry system. No matter what the transaction, total debits must equal total credits in order to keep the accounting equation in balance.
Income Statement
Revenues
Less: Expenses Net income or net loss
Retained Earnings Statement
Beginning retained earnings
Add: Net income
Less: Dividends Ending retained earnings
Balance Sheet
Assets
Liabilities
Stockholders’ equity Common stock Retained earnings
Investments by stockholders
Net income retained in the business
ILLUSTRATION 3-15 Stockholders’ equity relationships
Assets Stockholders’ Equity+Basic Equation
Expanded Basic Equation
Debit / Credit Rules
Liabilities=
= + + –
Dr. +
Assets
Cr. –
Dr. –
Liabilities
Cr. +
Dr. –
Retained Earnings
Cr. +
–
Dr. +
Dividends
Cr. –
Dr. –
Revenues
Cr. +
Dr. +
Expenses
Cr. –
+
Dr. –
Common Stock
Cr. +
ILLUSTRATION 3-16 Summary of debit/credit rules
2▼ Debits and Credits for Balance Sheet AccountsDO IT! Kate Browne, president of Hair It Is Inc., has just rented space in a shopping mall for the purpose of opening and operating a beauty salon. Long before opening day and before purchasing equipment, hiring assistants, and remodeling the space, Kate was strongly advised to set up a double-entry set of accounting records in which to record all of her business transactions. Identify the balance sheet accounts that Hair It Is Inc. will likely need to record the transactions necessary to establish and open for business. Also, indicate whether the normal balance of each account is a debit or a credit.
Action Plan ✔ First identify asset
accounts for each different type of asset invested in the business.
✔ Then identify liability accounts for debts incurred by the business.
106 3 The Accounting Information System
SOLUTION Hair It Is Inc. would likely need the following accounts in which to record the transactions necessary to establish and ready the beauty salon for opening day: Cash (debit balance); Equipment (debit balance); Supplies (debit balance); Accounts Payable (credit balance); Notes Payable (credit balance), if the business borrows money; and Common Stock (credit balance).
Related exercise material: BE3-4, BE3-5, DO IT! 3-2, E3-6, E3-7, and E3-8.
Action Plan (cont.) ✔ Hair It Is Inc. needs only
one stockholders’ equity account, Common Stock, when it begins the business. The other stockholders’ equity account, Retained Earnings, will be needed after the business is operating.
THE RECORDING PROCESS
Although it is possible to enter transaction information directly into the accounts, few businesses do so. Practically every business uses these basic steps in the recording process (an integral part of the accounting cycle):
1. Analyze each transaction in terms of its effect on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger.
The actual sequence of events begins with the transaction. Evidence of the transaction comes in the form of a source document, such as a sales slip, a check, a bill, or a cash register document. This evidence is analyzed to determine the effect of the transaction on specifi c accounts. The transaction is then entered in the journal. Finally, the journal entry is transferred to the designated accounts in the ledger. The sequence of events in the recording process is shown in Illustration 3-17.
ANALYZE POST TRIAL
BALANCE
ADJUSTING ENTRIES
ADJUSTED TRIAL
BALANCE
FINANCIAL STATEMENTS
CLOSING ENTRIES
POST-CLOSING TRIAL BALANCE
Journalize the transactions
Indicate how a journal is used in the recording process. LEARNING OBJECTIVE 3▼
THE JOURNAL
Transactions are initially recorded in chronological order in a journal before they are transferred to the accounts. For each transaction, the journal shows the debit and credit effects on specifi c accounts. (In a computerized system, journals are kept as fi les, and accounts are recorded in computer databases.)
ILLUSTRATION 3-17 The recording process
Superior Equipment Sales
9/26/20XX
Bill to: Sierra Corporation
Description Purchase of Equipment for $5,000
INVOICE
Date Account Titles and Explanation Debit Credit
20XX Oct. 2 Equipment Cash (Purchased Equ
GENERAL JOURNAL
2. Enter transaction
3. Transfer from journal to ledger
1. Analyze transaction
Cash Equipment
Oct. 1 10,000 Oct. 2 5,000 Oct 2. 5,000 2 5,000 Bal. 5,000
GENERAL LEDGER
Using a Journal 107
Companies may use various kinds of journals, but every company has at least the most basic form of journal, a general journal. The journal makes three signifi cant contributions to the recording process:
1. It discloses in one place the complete effect of a transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be readily compared.
Entering transaction data in the journal is known as journalizing. To illus- trate the technique of journalizing, let’s look at the fi rst three transactions of Sierra Corporation in equation form.
On October 1, Sierra issued common stock in exchange for $10,000 cash:
Assets = Liabilities + Stockholders’ Equity Common Cash = Stock
+$10,000 +$10,000 Issued stock
Assets = Liabilities + Stockholders’ Equity Notes Cash = Payable
+$5,000 +$5,000
On October 1, Sierra borrowed $5,000 by signing a note:
On October 2, Sierra purchased equipment for $5,000:
Assets = Liabilities + Stockholders’ Equity Cash Equipment
−$5,000 +$5,000
Sierra makes separate journal entries for each transaction. A complete entry consists of (1) the date of the transaction, (2) the accounts and amounts to be debited and credited, and (3) a brief explanation of the transaction. These trans- actions are journalized in Illustration 3-18.
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit
2017
Oct. 1 Cash 10,000 Common Stock 10,000 (Issued stock for cash)
1 Cash 5,000 Notes Payable 5,000
(Issued 3-month, 12% note payable for cash)
2 Equipment 5,000 Cash 5,000
(Purchased equipment for cash)
ILLUSTRATION 3-18 Recording transactions in journal form
ETHICS NOTE Business documents provide evidence that transactions actually occurred. International Outsourcing Services, LLC was accused of submitting fraudulent documents (store coupons) to companies such as Kraft Foods and PepsiCo for reimbursement of as much as $250 million. Use of proper business documents reduces the likelihood of fraudulent activity.
▼
108 3 The Accounting Information System
Note the following features of the journal entries.
1. The date of the transaction is entered in the Date column.
2. The account to be debited is entered fi rst at the left. The account to be credited is then entered on the next line, indented under the line above. The indentation differentiates debits from credits and decreases the possibility of switching the debit and credit amounts.
3. The amounts for the debits are recorded in the Debit (left) column, and the amounts for the credits are recorded in the Credit (right) column.
4. A brief explanation of the transaction is given.
It is important to use correct and specifi c account titles in journalizing. Erroneous account titles lead to incorrect fi nancial statements. Some fl exibility exists initially in selecting account titles. The main criterion is that each title must appropriately describe the content of the account. For example, a company could use any of these account titles for recording the cost of delivery trucks: Equipment, Delivery Equipment, Delivery Trucks, or Trucks. Once the company chooses the specifi c title to use, however, it should record under that account title all subsequent transactions involving the account.
3▼ Journal EntriesDO IT! The following events occurred during the fi rst month of business of Hair It Is Inc., Kate Browne’s beauty salon:
1. Issued common stock to shareholders in exchange for $20,000 cash.
2. Purchased $4,800 of equipment on account (to be paid in 30 days).
3. Interviewed three people for the position of stylist.
Prepare the entries to record the transactions.
ACCOUNTING ACROSS THE ORGANIZATION Microsoft
© fl yfl oor/iStockphoto
Boosting Profi ts
Microsoft originally designed the Xbox 360 to have 256 megabytes of memory. But the design department said that amount of memory wouldn’t support the best special effects. The purchasing department said that adding more memory would cost $30— which was 10% of the estimated selling price of $300. The marketing department, how- ever, “determined that adding the memory would let Microsoft reduce marketing costs and attract more game developers, boost- ing royalty revenue. It would also extend the life of the console, generating more sales.”
As a result of these changes, Xbox en- joyed great success. But, it does have com- petitors. Its newest video game console, Xbox One, is now in a battle with Sony’s
Playstation4 for market share. How to compete? First, Micro- soft bundled the critically acclaimed Titanfall with its Xbox One. By including the game most Xbox One buyers were going to purchase anyway, Microsoft was making its console more attractive. In addition, retailers are also discounting the Xbox, which should get the momentum going for increased sales. What Microsoft is doing is making sure that Xbox One is the center of the home entertainment system in the long run.
Sources: Robert A. Guth, “New Xbox Aim for Microsoft: Profi t- ability,” Wall Street Journal (May 24, 2005), p. C1; and David Thier, “Will Microsoft Give the Xbox One a $50 Price Cut? www.Forbes. com (March 26, 2014).
In what ways is this Microsoft division using accounting to assist in its effort to become more profi table? (Go to WileyPLUS for this answer and additional questions.)
The Ledger and Posting 109
SOLUTION The three activities are recorded as follows.
1. Cash 20,000 Common Stock 20,000 (Issued stock for cash)
2. Equipment 4,800 Accounts Payable 4,800 (Purchased equipment on account)
3. No entry because no transaction occurred.
Action Plan ✔ Make sure to provide a
complete and accurate representation of the transactions’ effects on the assets, liabilities, and stockholders’ equity of the business.
Related exercise material: BE3-6, BE3-9, DO IT! 3-3, E3-7, E3-9, E3-10, E3-11, and E3-12.
LEARNING OBJECTIVE 4 Explain how a ledger and posting help in the recording process.▼
THE LEDGER
The entire group of accounts maintained by a company is referred to collectively as the ledger. The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances. Companies may use various kinds of ledgers, but every company has a general ledger. A general ledger contains all the asset, liability, stockholders’ equity, rev- enue, and expense accounts, as shown in Illustration 3-19. Whenever we use the term ledger in this textbook without additional specifi cation, it will mean the general ledger.
ANALYZE JOURNALIZE TRIAL
BALANCE
ADJUSTING ENTRIES
ADJUSTED TRIAL
BALANCE
FINANCIAL STATEMENTS
CLOSING ENTRIES
POST-CLOSING TRIAL BALANCE
E BBA
Post to ledger accounts
Equipment Land
Supplies
Cash
Interest Payable Salaries and Wages
Payable Accounts Payable
Notes Payable
Salaries and Wages Expense
Service Revenue Dividends
Retained Earnings
Common Stock
Asset Accounts
Liability Accounts
Stockholders’ Equity Accounts
ILLUSTRATION 3-19 The general ledger
CHART OF ACCOUNTS
The number and type of accounts used differ for each company, depending on the size, complexity, and type of business. For example, the number of accounts depends on the amount of detail desired by management. The management of one company may want one single account for all types of utility expense. Another may keep separate expense accounts for each type of utility expenditure,
110 3 The Accounting Information System
such as gas, electricity, and water. A small corporation like Sierra Corpora- tion will not have many accounts compared with a corporate giant like Ford Motor Company. Sierra may be able to manage and report its activities in 20 to 30 accounts, whereas Ford requires thousands of accounts to keep track of its worldwide activities. Most companies list the accounts in a chart of accounts. They may create new accounts as needed during the life of the business. Illustration 3-20 shows the chart of accounts for Sierra in the order that they are typically listed (assets, liabilities, stockholders’ equity, revenues, and expenses). Accounts shown in red are used in this chapter; accounts shown in black are explained in later chapters.ILLUSTRATION 3-20
Chart of accounts for Sierra Corporation
SIERRA CORPORATION Chart of Accounts
Stockholders’ Assets Liabilities Equity Revenues Expenses
Cash Notes Payable Common Stock Service Revenue Salaries and Wages Accounts Receivable Accounts Payable Retained Earnings Expense Supplies Interest Payable Dividends Supplies Expense Prepaid Insurance Unearned Income Summary Rent Expense Equipment Service Revenue Insurance Expense Accumulated Depreciation— Salaries and Wages Interest Expense Equipment Payable Depreciation Expense
POSTING
The procedure of transferring journal entry amounts to ledger accounts is called posting. This phase of the recording process accumulates the effects of jour- nalized transactions in the individual accounts. Posting involves these steps:
1. In the ledger, enter in the appropriate columns of the debited account(s) the date and debit amount shown in the journal.
2. In the ledger, enter in the appropriate columns of the credited account(s) the date and credit amount shown in the journal.
A Convenient Overstatement
Sometimes a company’s invest- ment securities suffer a perma- nent decline in value below their original cost. When this occurs, the company is supposed to reduce the recorded value of the securi- ties on its balance sheet (“write them down” in common fi nancial lingo) and record a loss. It appears, however, that during the fi nancial crisis of 2008, employees at some
fi nancial institutions chose to look the other way as the value of their investments skidded. A number of Wall Street traders that worked for the investment bank Credit Suisse Group were charged with
intentionally overstating the value of securities that had suf- fered declines of approximately $2.85 billion. One reason that they may have been reluctant to record the losses is out of fear that the company’s shareholders and clients would panic if they saw the magnitude of the losses. However, personal self-interest might have been equally to blame—the bonuses of the traders were tied to the value of the investment securities.
Source: S. Pulliam, J. Eaglesham, and M. Siconolfi , “U.S. Plans Changes on Bond Fraud,” Wall Street Journal Online (February 1, 2012).
What incentives might employees have had to overstate the value of these investment securities on the company’s fi nancial statements? (Go to WileyPLUS for this answer and additional questions.)
ETHICS INSIGHT Credit Suisse Group
© Nuno Silva/iStockphoto
The Ledger and Posting 111
THE RECORDING PROCESS ILLUSTRATED
Illustrations 3-21 through 3-31 on the following pages show the basic steps in the recording process using the October transactions of Sierra Corporation. Sierra’s accounting period is a month. A basic analysis and a debit–credit analysis pre- cede the journalizing and posting of each transaction. Study these transaction analyses carefully. The purpose of transaction analysis is fi rst to identify the type of account involved and then to determine whether a debit or a credit to the account is required. You should always perform this type of analysis before preparing a journal entry. Doing so will help you understand the journal entries discussed in this chapter as well as more complex journal entries to be described in later chapters.
Debit–Credit Analysis
Debits increase assets: debit Cash $10,000. Credits increase stockholders’ equity: credit Common Stock $10,000.
Journal Entry
Posting Oct. 1 10,000
Cash Common Stock
Oct. 1 Cash Common Stock (Issued stock for cash)
10,000 10,000
On October 1, stockholders invest $10,000 cash in an outdoor guide service company to be known as Sierra Corporation.
Basic Analysis
Equation Analysis
The asset Cash is increased $10,000; stockholders’ equity (specifically Common Stock) is increased $10,000.
Assets
Cash
+$10,000(1)
=
=
+Liabilities Stockholders’ Equity Common
Stock
+$10,000 Issued stock
Event 1
Oct. 1 10,000
ILLUSTRATION 3-21 Investment of cash by stockholders
Cash Flows +10,000
Cash fl ow analyses show the impact of each transaction on cash.
112 3 The Accounting Information System
Equation Analysis
On October 1, Sierra borrows cash of $5,000 by signing a 3-month, 12%, $5,000 note payable.
Basic Analysis
The asset Cash is increased $5,000; the liability Notes Payable is increased $5,000.
Debit–Credit Analysis
Debits increase assets: debit Cash $5,000. Credits increase liabilities: credit Notes Payable $5,000.
Journal Entry
Cash
Oct. 1 5,000
Notes Payable Posting
Oct. 1 Cash Notes Payable (Issued 3-month, 12% note payable for cash)
5,000 5,000
Oct. 1 10,000 1 5,000
Assets
Cash
+$5,000(2)
=
=
+Liabilities Stockholders’ Equity Notes Payable
+$5,000
Event 2
ILLUSTRATION 3-22 Issue of note payable
Cash Flows +5,000
Equation Analysis
On October 2, Sierra used $5,000 cash to purchase equipment.
Basic Analysis
Debit–Credit Analysis
Debits increase assets: debit Equipment $5,000. Credits decrease assets: credit Cash $5,000.
The asset Equipment is increased $5,000; the asset Cash is decreased $5,000.
Journal Entry
Posting Cash Equipment
Oct. 2 Equipment Cash (Purchased equipment for cash)
5,000 5,000
Oct. 1 10,000 1 5,000
Oct. 2 5,000
+$5,000
Assets
Cash +
–$5,000(3)
= +Liabilities Stockholders’
Equity
Equipment
Oct. 2 5,000
Event 3
ILLUSTRATION 3-23 Purchase of equipment
Cash Flows −5,000
The Ledger and Posting 113
Equation Analysis
On October 2, Sierra received a $1,200 cash advance from R. Knox, a client, for guide services for multi-day trips that are expected to be completed in the future.
Basic Analysis
The asset Cash is increased $1,200; the liability Unearned Service Revenue is increased $1,200 because the service has not been performed yet. That is, when an advance payment is received, unearned revenue (a liability) should be recorded in order to recognize the obligation that exists.
Debit–Credit Analysis
Debits increase assets: debit Cash $1,200. Credits increase liabilities: credit Unearned Service Revenue $1,200.
Journal Entry
Posting Oct. 1 10,000 1 5,000 2 1,200
Cash Oct. 2 1,200Oct. 2 5,000
Unearned Service Revenue
Oct. 2 Cash Unearned Service Revenue (Received advance from R. Knox for future services)
1,200 1,200
Assets
Cash
+$1,200(4)
=
=
+Liabilities Stockholders’ Equity Unearned Serv. Rev.
+$1,200
Event 4 ILLUSTRATION 3-24 Receipt of cash in advance from customer
Equation Analysis
On October 3, Sierra received $10,000 in cash from Copa Company for guide services performed in October.
Basic Analysis
The asset Cash is increased $10,000; the revenue Service Revenue is increased $10,000.
Debit–Credit Analysis
Debits increase assets: debit Cash $10,000. Credits increase revenues: credit Service Revenue $10,000.
Journal Entry
Posting Oct. 3 10,000
Service RevenueCash
Oct. 2 5,000
Oct. 3 Cash Service Revenue (Received cash for services performed)
10,000 10,000
Assets
Cash
+$10,000(5)
=
=
+Liabilities Stockholders’ Equity
Revenues
+$10,000 Service Revenue
Event 5
Oct. 1 10,000 1 5,000 2 1,200 3 10,000
ILLUSTRATION 3-25 Services performed for cash
Cash Flows +1,200
Cash Flows +10,000
▼ HELPFUL HINT Many liabilities have the word “payable” in their title. But, note that Unearned Service Revenue is considered a liability even though the word payable is not used.
114 3 The Accounting Information System
Equation Analysis
Debit–Credit Analysis
Debits increase expenses: debit Rent Expense $900. Credits decrease assets: credit Cash $900.
On October 3, Sierra paid office rent for October in cash, $900.
Basic Analysis
The expense account Rent Expense is increased $900 because the payment pertains only to the current month; the asset Cash is decreased $900.
Journal Entry
Posting
Rent Expense
Oct. 3 Rent Expense Cash (Paid cash for October office rent)
900 900
Oct. 3 900Oct. 1 10,000 1 5,000 2 1,200 3 10,000
Cash
Oct. 2 5,000 3 900
Assets
Cash
–$900(6)
=
=
+Liabilities Stockholders’ Equity
Expenses
–$900 Rent Expense
Event 6 ILLUSTRATION 3-26 Payment of rent with cash
Equation Analysis
Posting Oct. 1 10,000 1 5,000 2 1,200 3 10,000
Cash
Oct. 2 5,000 3 900 4 600
Debit–Credit Analysis
Debits increase assets: debit Prepaid Insurance $600. Credits decrease assets: credit Cash $600.
On October 4, Sierra paid $600 for a 1-year insurance policy that will expire next year on September 30.
Basic Analysis
The asset Cash is decreased $600. Payments of expenses that will benefit more than one accounting period are identified as prepaid expenses or prepayments. When a payment is made, an asset account is debited in order to show the service or benefit that will be received in the future. Therefore, the asset Prepaid Insurance is increased $600.
Journal Entry
Oct. 4 600
Prepaid Insurance
Oct. 4 Prepaid Insurance Cash (Paid 1-year policy; effective date October 1)
600 600
+$600
Assets
Cash +
–$600(7)
= +Liabilities Stockholders’
Equity Prepaid
Insurance
Event 7 ILLUSTRATION 3-27 Purchase of insurance policy with cash
Cash Flows −900
Cash Flows −600
The Ledger and Posting 115
Equation Analysis
Debit–Credit Analysis
Debits increase assets: debit Supplies $2,500. Credits increase liabilities: credit Accounts Payable $2,500.
On October 5, Sierra purchased an estimated 3 months of supplies on account from Aero Supply for $2,500.
Basic Analysis
The asset Supplies is increased $2,500; the liability Accounts Payable is increased $2,500.
Journal Entry
Posting Oct. 5 2,500
Supplies
Oct. 5 2,500
Accounts Payable
Oct. 5 Supplies Accounts Payable (Purchased supplies on account from Aero Supply)
2,500 2,500
Assets
Supplies
+$2,500(8)
=
=
+Liabilities Stockholders’ Equity Accounts Payable
+$2,500
Event 8
ILLUSTRATION 3-28 Purchase of supplies on account
Cash Flows no eff ect
On October 9, Sierra hired four employees to begin work on October 15. Each employee will receive a weekly salary of $500 for a 5-day work week, payable every 2 weeks—first payment made on October 26.
Basic Analysis
An accounting transaction has not occurred. There is only an agreement that the employees will begin work on October 15. Thus, a debit–credit analysis is not needed because there is no accounting entry. (See transaction of October 26 (Event II) for first payment.)
Event 9
ILLUSTRATION 3-29 Hiring of new employees
116 3 The Accounting Information System
Equation Analysis
Posting Oct. 1 10,000
1 5,000 2 1,200 3 10,000
Cash
Oct. 2 5,000 3 900 4 600
20 500
Oct. 20 500
Dividends
Debit–Credit Analysis
Debits increase dividends: debit Dividends $500. Credits decrease assets: credit Cash $500.
On October 20, Sierra paid a $500 cash dividend to stockholders.
Basic Analysis
The Dividends account is increased $500; the asset Cash is decreased $500.
Journal Entry
Oct. 20 Dividends Cash (Declared and paid a cash dividend)
500 500
Assets
Cash
–$500(10)
=
=
+Liabilities Stockholders’ Equity
Dividends
–$500
Event 10 ILLUSTRATION 3-30 Payment of dividend
Equation Analysis
Debit–Credit Analysis
Debits increase expenses: debit Salaries and Wages Expense $4,000. Credits decrease assets: credit Cash $4,000.
On October 26, Sierra paid employee salaries of $4,000 in cash. (See October 9 event.)
Basic Analysis
The expense account Salaries and Wages Expense is increased $4,000; the asset Cash is decreased $4,000.
Journal Entry
Posting
Oct. 26 Salaries and Wages Expense Cash (Paid salaries to date)
4,000 4,000
Cash
Oct. 26 4,000
Salaries and Wages Expense
Oct. 1 10,000 1 5,000 2 1,200 3 10,000
Oct. 2 5,000 3 900 4 600
20 500 26 4,000
Assets
Cash
–$4,000(11)
= =
+Liabilities Stockholders’ Equity
Expenses
–$4,000 Salaries and Wages Expense
Event 11 ILLUSTRATION 3-31 Payment of cash for employee salaries
Cash Flows −500
Cash Flows −4,000
The Ledger and Posting 117
SUMMARY ILLUSTRATION OF JOURNALIZING AND POSTING
The journal for Sierra Corporation for the month of October is summarized in Illustration 3-32. The ledger is shown in Illustration 3-33 (on page 118) with all balances highlighted in red.
ILLUSTRATION 3-32 General journal for Sierra Corporation
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit
2017
Oct. 1 Cash 10,000 Common Stock 10,000 (Issued stock for cash)
1 Cash 5,000 Notes Payable 5,000 (Issued 3-month, 12% note payable for cash)
2 Equipment 5,000 Cash 5,000 (Purchased equipment for cash)
2 Cash 1,200 Unearned Service Revenue 1,200 (Received advance from R. Knox for future service)
3 Cash 10,000 Service Revenue 10,000 (Received cash for services performed)
3 Rent Expense 900 Cash 900 (Paid cash for October offi ce rent)
4 Prepaid Insurance 600 Cash 600 (Paid 1-year policy; effective date October 1)
5 Supplies 2,500 Accounts Payable 2,500 (Purchased supplies on account from Aero Supply)
20 Dividends 500 Cash 500 (Declared and paid a cash dividend)
26 Salaries and Wages Expense 4,000 Cash 4,000 (Paid salaries to date)
118 3 The Accounting Information System
SOLUTION
4▼ PostingDO IT! Selected transactions from the journal of Faital Inc. during its fi rst month of operations are presented below. Post these transactions to T-accounts.
Action Plan ✔ Journalize transactions
to keep track of fi nan- cial activities (receipts, payments, receivables, payables, etc.).
✔ To make entries useful, classify and summarize them by posting the entries to specifi c ledger accounts.
Related exercise material: BE3-10, DO IT! 3-4, and E3-14.
Date Account Titles Debit Credit
July 1 Cash 30,000 Common Stock 30,000
9 Accounts Receivable 6,000 Service Revenue 6,000
24 Cash 4,000 Accounts Receivable 4,000
Cash
July 1 30,000 24 4,000
Common Stock
July 1 30,000
Accounts Receivable
July 9 6,000 July 24 4,000
Service Revenue
July 9 6,000
ILLUSTRATION 3-33 General ledger for Sierra Corporation
Supplies
Oct. 5 2,500
Bal. 2,500
Prepaid Insurance
Oct. 4 600
Bal. 600
Equipment
Oct. 2 5,000
Bal. 5,000
Notes Payable
Oct. 1 5,000
Bal. 5,000
Accounts Payable
Oct. 5 2,500
Bal. 2,500
Common Stock
Oct. 1 10,000
Bal. 10,000
Dividends
Oct. 20 500
Bal. 500
Service Revenue
Oct. 3 10,000
Bal. 10,000
Salaries and Wages Expense
Oct. 26 4,000
Bal. 4,000
Rent Expense
Oct. 3 900
Bal. 900
GENERAL LEDGER
Cash
Oct. 1 10,000 Oct. 2 5,000 1 5,000 3 900 2 1,200 4 600 3 10,000 20 500 26 4,000
Bal. 15,200
Unearned Service Revenue
Oct. 2 1,200
Bal. 1,200
The Trial Balance 119
A trial balance lists accounts and their balances at a given time. A company usually prepares a trial balance at the end of an accounting period. The accounts are listed in the order in which they appear in the ledger. Debit balances are listed in the left column and credit balances in the right column. The totals of the two columns must be equal.
The trial balance proves the mathematical equality of debits and cred- its after posting. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance may also uncover errors in journalizing and posting. For example, a trial balance may well have detected the error at MF Global discussed in the Feature Story. In addition, a trial balance is useful in the preparation of fi nancial statements. These are the procedures for preparing a trial balance:
1. List the account titles and their balances.
2. Total the debit column and total the credit column.
3. Verify the equality of the two columns.
Illustration 3-34 presents the trial balance prepared from the ledger of Sierra Corporation. Note that the total debits, $28,700, equal the total credits, $28,700.
LEARNING OBJECTIVE 5▼ Prepare a trial balance.
DECISION TOOLS
A trial balance proves that debits equal credits.
Debit Credit
Cash $ 15,200 Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries and Wages Expense 4,000 Rent Expense 900
$28,700 $28,700
SIERRA CORPORATION Trial Balance
October 31, 2017
ILLUSTRATION 3-34 Sierra Corporation trial balance
▼ HELPFUL HINT Note that the order of presentation in the trial balance is:
Assets Liabilities Stockholders’ equity Revenues Expenses
LIMITATIONS OF A TRIAL BALANCE
A trial balance does not prove that all transactions have been recorded or that the ledger is correct. Numerous errors may exist even though the trial balance column totals agree. For example, the trial balance may balance even when any of the following occurs: (1) a transaction is not journalized, (2) a correct journal entry is not posted, (3) a journal entry is posted twice, (4) incorrect accounts are
ETHICS NOTE An error is the result of an unintentional mistake. It is neither ethical nor unethical. An irregularity is an intentional misstatement, which is viewed as unethical.
▼
JOURNALIZEANALYZE POST ADJUSTING
ENTRIES
ADJUSTED TRIAL
BALANCE
FINANCIAL STATEMENTS
CLOSING ENTRIES
POST-CLOSING TRIAL BALANCE
ADAA E
Prepare a trial balance
120 3 The Accounting Information System
used in journalizing or posting, or (5) offsetting errors are made in recording the amount of a transaction. In other words, as long as equal debits and credits are posted, even to the wrong account or in the wrong amount, the total debits will equal the total credits. Nevertheless, despite these limitations, the trial balance is a useful screen for fi nding errors and is frequently used in practice.
KEEPING AN EYE ON CASH
The Cash account shown below reflects all of the inflows and outflows of cash that occurred during October for Sierra Corporation (see Illustrations 3-21 to 3-31). We have also provided a description of each transaction that affected the Cash account.
1. Oct. 1 Issued stock for $10,000 cash. 2. Oct. 1 Issued note payable for $5,000 cash. 3. Oct. 2 Purchased equipment for $5,000 cash. 4. Oct. 2 Received $1,200 cash in advance from customer. 5. Oct. 3 Received $10,000 cash for services performed. 6. Oct. 3 Paid $900 cash for October rent. 7. Oct. 4 Paid $600 cash for one-year insurance policy. 8. Oct. 20 Paid $500 cash dividend to stockholders. 9. Oct. 26 Paid $4,000 cash salaries.
The Cash account and the related cash transactions indicate why cash changed during October. However, to make this information useful for analysis,
it is summarized in a statement of cash flows. The statement of cash flows classifies each transaction as an operating activity, an investing activity, or a financing activity. A user of this statement can then determine the amount of net cash provided by operating activities, the amount of cash used for investing purposes, and the amount of cash provided by financing activities. Operating activities are the types of activities the company per- forms to generate profits. Sierra is an outdoor guide business, so its operating activities involve providing guide services. Activities 4, 5,
6, 7, and 9 relate to cash received or spent to directly support its guide services. Investing activities include the purchase or sale of long-lived assets used in operating the business, or the purchase or sale of investment securities (stocks and bonds of companies other than Sierra). Activity 3, the purchase of equip- ment, is an investing activity. The primary types of financing activities are borrowing money, issuing shares of stock, and paying dividends. The financing activities of Sierra are Activities 1, 2, and 8.
Cash
Oct. 1 10,000 Oct. 2 5,000 1 5,000 3 900 2 1,200 4 600 3 10,000 20 500 26 4,000
Bal. 15,200
5▼ Trial BalanceDO IT! The following accounts come from the ledger of SnowGo Corporation at December 31, 2017.
Equipment $88,000 Common Stock $20,000 Dividends 8,000 Salaries and Wages Payable 2,000 Accounts Payable 22,000 Notes Payable (due in 3 months) 19,000 Salaries and Wages Expense 42,000 Utilities Expense 3,000 Accounts Receivable 4,000 Prepaid Insurance 6,000 Service Revenue 95,000 Cash 7,000
Prepare a trial balance in good form.
Using Decision Tools 121
SOLUTION Action Plan ✔ Determine normal
balances and list accounts in the order they appear in the ledger.
✔ Accounts with debit balances appear in the left column, and those with credit balances in the right column.
✔ Total the debit and credit columns to prove equality.
Debit Credit
Cash $ 7,000 Accounts Receivable 4,000 Prepaid Insurance 6,000 Equipment 88,000 Notes Payable $ 19,000 Accounts Payable 22,000 Salaries and Wages Payable 2,000 Common Stock 20,000 Dividends 8,000 Service Revenue 95,000 Utilities Expense 3,000 Salaries and Wages Expense 42,000
$158,000 $158,000
SNOWGO CORPORATION Trial Balance
December 31, 2017
Related exercise material: BE3-11, BE3-12, DO IT! 3-5, E3-13, E3-15, E3-16, E3-17, E3-18, E3-19, E3-20, E3-21, and E3-22.
The Kansas Farmers’ Vertically Integrated Cooperative, Inc. (K-VIC) was formed by over 200 northeast Kansas farmers in the late 1980s. Its purpose is to process raw materials, primarily grain and meat products grown by K-VIC’s members, into end-user food products and then to distribute the products nationally. Profi ts not needed for expansion or investment are returned to the members annually, on a pro rata basis, according to the fair value of the grain and meat products received from each farmer. Assume that the following trial balance was prepared for K-VIC.
USING DECISION TOOLS—KANSAS FARMERS’ VERTICALLY INTEGRATED COOPERATIVE, INC.