CHAPTER 1

Introduction to Financial Statements

Study Objectives
1.
2.
3.
4.
5.
6.

Describe the primary forms of business organization.

Identify the users and uses of accounting information.
Explain the three principal types of business activity.
Describe the content and purpose of each of the financial statements.
Explain the meaning of assets, liabilities, and stockholders equity, and state the basic
accounting equation.
Describe the components that supplement the financial statements in an annual report.

ANSWERS TO QUESTIONS
1.

The three basic forms of business organizations are (1) sole proprietorship, (2) partnership, and
(3) corporation.

2.

Advantages of a corporation are limited liability (stockholders not being personally liable for corporate debts), easy transferability of ownership, and easier to raise funds. Disadvantages of a
corporation are increased taxation and government regulations.

3.

Proprietorships and partnerships receive favorable tax treatment compared to corporations and
are easier to form than corporations. Disadvantages of proprietorships and partnerships are unlimited liability (proprietors/partners are personally liable for all debts) and difficulty in obtaining
financing compared to corporations.

4.

Yes. A person cannot earn a living, spend money, buy on credit, make an investment, or pay taxes without receiving, using, or dispensing financial information. Accounting provides financial information to interested users through the preparation and distribution of financial statements.

5.

Internal users are managers who plan, organize, and run a business. To assist management,
accounting provides timely internal reports. Examples include financial comparisons of operating
alternatives, projections of income from new sales campaigns, and forecasts of cash needs for
the next year.

6.

External users are those outside the business who have either a present or potential direct
financial interest (investors and creditors) or an indirect financial interest (taxing authorities,
regulatory agencies, labor unions, customers, and economic planners).

7.

The three types of business activity are financing activities, investing activities, and operating activities. Financing activities include borrowing money and selling shares of stock. Investing activities
include the purchase and sale of property, plant, and equipment. Operating activities include selling
goods, performing services, and purchasing inventory.
1-1

8.

(a) Income statement.

(b) Balance sheet.
(c) Income statement.

(d) Balance sheet.

(e) Balance sheet.
(f) Balance sheet.

9.

When a company pays dividends it reduces the amount of assets available to pay creditors.
Therefore banks and other creditors monitor dividend payments to ensure they do not put a companys ability to pay debt payments at risk.

10.

Yes. Net income does appear on the income statementit is the result of subtracting expenses
from revenues. In addition, net income appears in the retained earnings statementit is shown
as an addition to the beginning-of-period retained earnings. Indirectly, the net income of a company is also included in the balance sheet. It is included in the retained earnings account which
appears in the stockholders equity section of the balance sheet.

11.

The primary purpose of the statement of cash flows is to provide financial information about the
cash receipts and cash payments of a business for a specific period of time.

12.

The three categories of the statement of cash flows are operating activities, investing activities,
and financing activities. The categories were chosen because they represent the three principal
types of business activity.

13.

Retained earnings is the net income retained in a corporation. Retained earnings is increased by
net income and is decreased by dividends and a net loss.

14.

The basic accounting equation is Assets = Liabilities + Stockholders Equity.

15.

(a) Assets are resources owned by a business. Liabilities are amounts owed to creditors. Put
more simply, liabilities are existing debts and obligations. Stockholders equity is the ownership claim on total assets.
(b) The items that affect stockholders equity are common stock, retained earnings, dividends,
revenues, and expenses.

16.

The liabilities are (b) Accounts payable and (g) Salaries payable.

17.

(a) Net income from the income statement is reported as an increase to retained earnings on
the retained earnings statement.
(b) The ending amount on the retained earnings statement is reported as the retained earnings
amount on the balance sheet.
(c) The ending amount on the statement of cash flows is reported as the cash amount on the
balance sheet.

18.

The purpose of the management discussion and analysis section is to provide managements
views on its ability to pay short-term obligations, its ability to fund operations and expansion, and
its results of operations. The MD&A section is a required part of the annual report.

19.

An unqualified opinion shows that, in the opinion of an independent auditor, the financial statements have been presented fairly, in conformity with generally accepted accounting principles.
This gives investors more confidence that they can rely on the figures reported in the financial
statements.

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20.

Information included in the notes to the financial statements clarifies information presented in the
financial statements and includes descriptions of accounting policies, explanations of uncertainties and contingencies, and details too voluminous to be reported in the financial statements.

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 1-1
(a)

(b)

SP

(c)

Shared control, tax advantages, increased skills and resources.

Simple to set up and maintains control with founder.
Easier to transfer ownership and raise funds, no personal liability.

BRIEF EXERCISE 1-2

(a)
(b)
(c)
(d)
(e)

4
3
2
5
1

Investors in common stock

Marketing managers
Creditors
Chief Financial Officer
Internal Revenue Service

BRIEF EXERCISE 1-3

O
F
F
O
I

(a)
(b)
(c)
(d)
(e)

Cash received from customers.

Cash paid to stockholders (dividends).
Cash received from issuing new common stock.
Cash paid to suppliers.
Cash paid to purchase a new office building.

BRIEF EXERCISE 1-4

E
R
E
E
D
R
E

(a)
(b)
(c)
(d)
(e)
(f)
(g)

Advertising expense
Service revenue
Insurance expense
Salaries expense
Dividends
Rent revenue
Utilities expense
1-3

NSE
C

(h) Paid cash to purchase equipment

(i) Received cash from investors in exchange for common stock.

BRIEF EXERCISE 1-5

GIDGET COMPANY
Balance Sheet
December 31, 2007
Assets
Cash ................................................................................................
Accounts receivable.......................................................................
Total assets .............................................................................

$ 32,000
81,000
$113,000

Liabilities and Stockholders Equity

Liabilities
Accounts payable ...................................................................
Stockholders equity
Common stock ........................................................................
Total liabilities and stockholders equity.......................

$ 85,000
28,000
$113,000

BRIEF EXERCISE 1-6

IS
BS
BS
BS
BS
IS
IS
BS
BS
IS

(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)

Income tax expense

Inventories
Accounts payable
Retained earnings
Property, plant, and equipment
Net sales
Cost of goods sold
Common stock
Receivables
Interest expense

BRIEF EXERCISE 1-7

I
B
C
B

(a)
(b)
(c)
(d)

Revenue during the period.

Supplies on hand at the end of the year.
Cash received from issuing new bonds during the period.
Total debts outstanding at the end of the period.
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BRIEF EXERCISE 1-8

(a) $90,000 + $230,000 = $320,000 (Total assets)
(b) $170,000 $90,000 = $80,000 (Total liabilities)
(c) $700,000 0.5($700,000) = $350,000 (Stockholders equity)

BRIEF EXERCISE 1-9

(a) ($900,000 + $150,000) ($500,000 $80,000) = $630,000
(Stockholders equity)
(b) ($500,000 + $100,000) + ($900,000 $500,000 $70,000) = $930,000
(Assets)
(c) ($900,000 $90,000) ($900,000 $500,000 + $110,000) = $300,000
(Liabilities)
BRIEF EXERCISE 1-10
A
L
A
A
SE
L

(a)
(b)
(c)
(d)
(e)
(f)

Accounts receivable
Salaries payable
Equipment
Office supplies
Common stock
Notes payable

BRIEF EXERCISE 1-11

(d) All of these are required.

1-5

SOLUTIONS TO EXERCISES
EXERCISE 1-1
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)

8.
1.
6.
7.
3.
2.
5.
4.

Auditors opinion
Corporation
Common stock
Accounts payable
Accounts receivable
Creditor
Stockholder
Partnership

EXERCISE 1-2
(a)

Answers will vary.

Financing
Abitibi Consolidated Sale of stock
Inc.
Cal State
Borrow monNorthridgeStdt
ey from
Union
a bank
Oracle Corporation Sale of bonds

Sportsco
Investments
Grant Thornton LLP

Southwest Airlines

Payment of
dividends to
stockholders
Distribute
earnings to
partners
Sale of stock

Investing
Purchase longterm investments
Purchase office
equipment

Operating
Sale of
newsprint
Payment of
wages and
benefits
Purchase other
Payment of
companies
research
expenses
Purchase hockey Payment for
equipment
rink rentals
Purchase
computers
Purchase
airplanes

1-6

Bill clients for

professional
services
Payment for
jet fuel

EXERCISE 1-2 (Continued)

(b)
Financing
Sale of stock is common to all corporations. Borrowing from a bank is
common to all businesses. Payment of dividends is common to all corporations. Sale of bonds is common to large corporations.
Investing
Purchase and sale of property, plant, and equipment would be common to
all businessesthe types of assets would vary according to the type of
business and some types of businesses require a larger investment in
long-lived assets. A new business or expanding business would be more
apt to acquire assets.
Operating
The general activities identified would be common to most businesses,
although the service or product might change.
EXERCISE 1-3

Accounts payable and accrued liabilities

Accounts receivable
Property, plant, and equipment
Food and beverage operations revenue
Golf course operations revenue
Inventory
Long-term debt
Office and general expense
Professional fees expense
Wages and benefits expense

1-7

(a)
L
A
A
R
R
A
L
E
E
E

(b)
O
O
I
O
O
O
F
O
O
O

EXERCISE 1-4
CONNOR CO.
Income Statement
For the Year Ended December 31, 2007
Revenues
Service revenue .....................................................
Expenses
Salaries expense ....................................................
Rent expense .........................................................
Utilities expense ....................................................
Advertising expense ..............................................
Total expenses ...............................................
Net income .....................................................................

$58,000
$30,000
10,400
2,400
1,800
44,600
$13,400

CONNOR CO.
Retained Earnings Statement
For the Year Ended December 31, 2007
Retained earnings, January 1 ..........................................................
Add: Net income .............................................................................
Less: Dividends ...............................................................................
Retained earnings, December 31 ....................................................

1-8

$64,000
13,400
77,400
6,000
$71,400

EXERCISE 1-5
(a)

MERCK and CO.

Income Statement
For the Year Ended December 31, 2004
(in millions)

Revenues
Sales revenue .........................................................
Other revenue .........................................................
Total revenue .......................................................
Expenses
Marketing and administrative expense .................
Materials and production expense ........................
Research and development expense ....................
Tax expense ............................................................
Total expenses ....................................................
Net income ......................................................................

$22,938.6
1,352.2
24,290.8
$7,346.3
4,959.8
4,010.2
2,161.1
18,477.4
$ 5,813.4

MERCK and CO.

Retained Earnings Statement
For the Year Ended December 31, 2004
(in millions)
Retained earnings, January 1 ........................................
Add: Net income .............................................................
Less: Dividends ..............................................................
Retained earnings, December 31 ..................................

$34,142.0
5,813.4
39,955.4
3,329.1
$36,626.3

(b) The short-term implication would be a decrease in expenses of $2,005.1

($4,010.2 X 50%) resulting in a corresponding increase in income (ignoring income taxes). If all other revenues and expenses remain unchanged,
decreasing research and development expenses would produce 34.5%
more net income ($2,005.1 $5,813.4).

1-9

EXERCISE 1-5 (Continued)

The long-term implications would be more difficult to quantify but it is
safe to predict that a reduction in research and development expenses
would probably result in lower sales revenues in the future. Pharmaceutical companies are usually able to charge higher prices for newly
developed products while lower cost generic versions usually replace
older products. Decreasing research and development activities will
probably mean fewer new products.
The stock markets initial reaction might be positive since Mercks net
income would increase dramatically. Such a reaction would probably
be very short-lived as more knowledgable investors reviewed Mercks
financial statements and discovered the cause of the increase.

EXERCISE 1-6
ANNE CHARLOTTE INC.
Retained Earnings Statement
For the Year Ended December 31, 2007
Retained earnings, January 1 .................................
Add: Net income ....................................................

$130,000
240,000*
370,000
82,000
$288,000

Less: Dividends ......................................................

Retained earnings, December 31 ...........................
*Revenue from legal services .................................
*Total expenses .......................................................
*Net income..............................................................

$410,000
170,000
$240,000

EXERCISE 1-7
(a) Motzek Corporation is distributing nearly all of this years net income as
dividends. This suggests that Motzek is not pursuing rapid growth. Companies that have a lot of opportunities for growth pay low dividends.
(b) Cheung Corporation is not generating sufficient cash provided by operating activities to fund its investing activities. Instead it generates additional cash through financing activities. This is common for companies
in their early years of existence.
1-10

EXERCISE 1-8
First note that the retained earnings statement shows that (b) equals $29,000.
Accounts payable + Common stock + Retained earnings = Total liabilities and stockholders equity

$5,000 + a + $29,000 = $60,000

a + $34,000 = $60,000
a = $26,000
Beginning retained earnings + Net income Dividends = Ending retained earnings

$10,000 + e $5,000 = $29,000

$5,000 + e = $29,000
e = $24,000
From above, we know that net income (d) equals $24,000.
Revenue Cost of goods sold Administrative expenses = Net income

$80,000 c $10,000 = $24,000

$70,000 c = $24,000
c = $46,000

1-11

EXERCISE 1-9
(a) Camping fee revenue ..............................................................
General store revenue ..........................................................
Total revenue ...................................................................
Expenses .................................................................................
Net income ..............................................................................
(b)

$137,000
25,000
162,000
129,000
$ 33,000

SLEEP CHEAP
Retained Earnings Statement
For the Year Ended December 31, 2007
Retained earnings, January 1 ................................................
Add: Net income ...................................................................

$ 5,000
33,000
38,000
9,000
$29,000

Less: Dividends .....................................................................

Retained earnings, December 31 ...........................................
SLEEP CHEAP
Balance Sheet
December 31, 2007
Assets
Cash ....................................................................
Supplies ..............................................................
Equipment ..........................................................
Total assets ................................................

8,500
2,500
119,000
$130,000

Liabilities and Stockholders Equity

Liabilities
Notes payable .............................................
Accounts payable.......................................
Total liabilities .....................................
Stockholders equity
Common stock ...........................................
Retained earnings ......................................
Total liabilities and stockholders
equity ................................................

1-12

$50,000
11,000
$ 61,000
40,000
29,000

69,000
$130,000

EXERCISE 1-9 (Continued)

(c) The income statement indicates that revenues from the general store
were only about 15% ($25,000 $162,000) of total revenue which tends
to support Terrys opinion. In order to decide if the store is more trouble than it is worth, I would need to know the amount of expenses
attributable to the general store. The income statement reports all expenses in a single category rather than separating them into camping
and general store expenses to correspond with revenues. A break
down into two categories would help me decide if the general store is
generating a profit or loss.
Even if the general store is operating at a loss, I might recommend
retaining it if campers indicated that the convenience of having a general store on site was an important amenity in selecting a camp ground.

1-13

EXERCISE 1-10
(a)

(b)

SE
E
E
A
L
E
L
A
R
L
SE
E
E

Retained earnings
Cost of goods sold
Selling and administrative expenses
Cash
Notes payable
Interest expense
Long-term debt
Inventories
Net sales
Accounts payable
Common stock
Income tax expense
Other expense
KELLOGG COMPANY
Income Statement
For the Year Ended December 31, 2004
(in millions)

Revenues
Net sales ...................................................
Expenses
Cost of goods sold ...................................
Selling and administrative expenses ......
Income tax expense .................................
Interest expense .......................................
Other expense ..........................................
Total expenses ..................................
Net income .......................................................

1-14

$9,613.9
$5,298.7
2,634.1
475.3
308.6
6.6
8,723.3
$ 890.6

EXERCISE 1-11
(a)

CAMPO CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2007

Cash flows from operating activities

Cash received from customers............................
Cash paid to suppliers .........................................
Net cash provided by operating activities ..........
Cash flows from investing activities
Cash paid for new equipment ..............................
Net cash used by investing activities..................
Cash flows from financing activities
Cash received from lenders .................................
Cash dividends paid .............................................
Net cash provided by financing activities ...........
Net increase in cash.....................................................
Cash at beginning of period ........................................
Cash at end of period...................................................

$65,000)
(18,000)
$47,000)
(35,000)
(35,000)
20,000
(6,000)
14,000)
) 26,000
12,000
$38,000

(b) As a creditor, I would feel confident that Campo has the ability to repay
its lenders. During 2007, Campo generated $47,000 of cash from its
operating activities. This amount more than covered its expenditures
for new equipment and dividends. The excess could have been used to
repay debt.

1-15

EXERCISE 1-12
(a)

SOUTHWEST AIRLINES
Statement of Cash Flows
For the Year Ended December 31, 2004
(in millions)

Cash flows from operating activities

Cash received from customers .............................
Cash paid for goods and services ........................
Net cash provided by operating activities ...........
Cash flows from investing activities
Cash paid for property and equipment ................
Net cash used by investing activities ...................
Cash flows from financing activities
Cash received from issuance of long-term debt...
Cash paid for repurchase of common stock ........
Cash paid for repayment of debt ...........................
Cash received from issuance of common stock ..
Cash paid for dividends .........................................
Net cash provided by financing activities .............
Net decrease in cash .....................................................
Cash at beginning of period .........................................
Cash at end of period ....................................................

$6,455
(5,298)
$1,157
(1,850)
(1,850)
$512
(246)
(207)
88
(14)
133
(560)
1,865
$1,305

(b) Southwest reported $1,157,000,000 cash from operating activities but

spent $1,850,000,000 to invest in new property and equipment. Its cash
from operating activities was not sufficient to finance its investing
activities. Southwest supplemented the cash from operating activities
by issuing long-term debt and additional shares of common stock but
used much of this cash to repurchase stock, pay down debt, and pay
dividends. In total, it generated less cash from operating and financing
activities than it paid for investing activities resulting in a net decrease
in cash for 2004.

1-16

EXERCISE 1-13
GABELLI COMPANY
Balance Sheet
December 31, 2007
Assets
Cash ..............................................................................
Accounts receivable ....................................................
Supplies ........................................................................
Equipment.....................................................................
Total assets ...........................................................

$18,500
12,000
9,500
40,000
$80,000

Liabilities and Stockholders Equity

Liabilities
Accounts payable .................................................
Stockholders equity
Common stock ......................................................
Retained earnings.................................................
Total liabilities and stockholders equity ....
*$34,000 $10,000

1-17

$16,000
$40,000
24,000*

64,000
$80,000

EXERCISE 1-14
All dollars are in millions.
(a) Assets
Cash ...........................................................................................
Accounts receivable .................................................................
Inventories.................................................................................
Property, plant, and equipment ...............................................
Other assets ..............................................................................
Total assets ..................................................................

$ 828.0
2,120.2
1,633.6
1,586.9
1,722.9
$7,891.6

Liabilities
Notes payable ...........................................................................
Accounts payable .....................................................................
Income taxes payable ...............................................................
Other liabilities ..........................................................................
Total liabilities ..............................................................

$ 146.0
763.8
118.2
2,081.9
$3,109.9

Stockholders Equity
Common stock ..........................................................................
Retained earnings .....................................................................
Total stockholders equity ...........................................
(b)

Assets
$7,891.6

Liabilities
$3,109.9

$ 890.6
3,891.1
$4,781.7

Stockholders Equity
$4,781.7

(c) Nike has relied more heavily on equity than debt to finance its assets.
Debt (liabilities) financed 39% of its assets ($3,109.9 $7,891.6) compared to equity financing of 61% ($4,781.7 $7,891.6).

1-18

SOLUTIONS TO PROBLEMS
PROBLEM 1-1A

(a) The concern over legal liability would make the corporate form a better
choice over a partnership. Also, the corporate form will allow the business to raise cash more easily, which may be of importance in a rapidly
growing industry.
(b) Andrew should run his business as a sole proprietor. He has no real
need to raise funds, and he doesnt need the expertise provided by
other partners. The sole proprietorship form would provide the easiest
form. One should avoid a more complicated form of business unless
the characteristics of that form are needed.
(c) The fact that the combined business expects that it will need to raise
significant funds in the near future makes the corporate form more
desirable in this case.
(d) It is likely that this business would form as a partnership. Its needs for
additional funds would probably be minimal in the foreseeable future.
Also, the three know each other well and would appear to be contributing equally to the firm. Service firms, like consulting businesses,
are frequently formed as partnerships.
(e) One way to ensure control would be for Liam to form a sole proprietorship. However, in order for this business to thrive it will need a
substantial investment of funds early. This would suggest the corporate form of business. In order for Liam to maintain control over the
business he would need to own more than 50 percent of the voting
shares of common stock. In order for the business to grow, he may
have to be willing to give up some control.

1-19

PROBLEM 1-2A

(a) In deciding whether to extend credit for 30 days you would be most
interested in the balance sheet because the balance sheet shows the
assets on hand that would be available for settlement of the debt in the
near-term.
(b) In purchasing an investment that will be held for an extended period,
the investor must try to predict the future performance of Amazon.com.
The income statement provides the most useful information for predicting future performance.
(c) In extending a loan for a relatively long period of time the lender is most
interested in the probability that the company will generate sufficient income to meet its interest payments and repay its principal. The lender
would therefore be interested in predicting future net income using the
income statement. It should be noted, however, that the lender would also be very interested in both the balance sheet and statement of cash
flowsthe balance sheet because it would show the amount of debt the
company had already incurred, as well as assets that could be liquidated
to repay the loan. And the company would be interested in the statement
of cash flows because it would provide useful information for predicting
the companys ability to generate cash to repay its obligations.
(d) The individual would probably be most interested in the statement of
cash flows since it shows how much cash the company generates and
how that cash is used. The statement of cash flows can be used to
predict the companys future cash-generating ability.

1-20