CHAPTER 1
Introduction to Financial Statements
Learning Objectives
1. Identify the forms of business organization and the uses of accounting information.
2. Explain the three principal types of business activity.
3. Describe the four financial statements, and how they are prepared.
Summary of Questions by Learning Objectives and Bloom’s Taxonomy
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Questions
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Brief Exercises
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2.
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11.
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3.
2
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Do It! Exercises
1.
1
C
2.
2
K
3a.
3
AP
3b.
3
K
Exercises
1.
1, 2, 3
K
5.
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9.
3
AN
12.
3
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15.
AP
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Problems: Set A
1.
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4.
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5.
AN
ASSIGNMENT CHARACTERISTICS TABLE
Problem
Number
Description
Difficulty
Level
Time
Allotted (min.)
1A
Determine forms of business organization.
Simple
15–20
2A
Identify users and uses of financial statements.
Simple
15–20
3A
Prepare an income statement, retained earnings
statement, and balance sheet; discuss results.
Moderate
40–50
4A
Determine items included in a statement of cash flows,
prepare the statement, and comment.
Moderate
30–40
5A
Comment on proper accounting treatment and prepare
a corrected balance sheet.
Moderate
40–50
ANSWERS TO QUESTIONS
1. The three basic forms of business organizations are (1) sole proprietorship, (2) partnership, and
(3) corporation.
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA BB: Legal/Regulatory Perspective
2. Advantages of a corporation are limited liability (stockholders not being personally liable for cor–
porate debts), easy transferability of ownership, and ease of raising funds. Disadvantages of a
corporation are increased taxation and government regulations.
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA BB: Legal/Regulatory Perspective
3. Proprietorships and partnerships receive favorable tax treatment compared to corporations and are
easier to form than corporations. They are also owner controlled. Disadvantages of proprietorships
and partnerships are unlimited liability (proprietors/partners are personally liable for all debts) and
difficulty in obtaining financing compared to corporations.
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA BB: Legal/Regulatory Perspective
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.
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
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, forecasts of cash needs for the
next year, and financial statements.
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
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, regu–
latory agencies, labor unions, customers, and economic planners).
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
7. The three types of business activities 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.
LO 2 BT: K Diff: M TOT: 2 min. AACSB: None AICPA FC: Reporting
8. (a) Income statement. (d) Balance sheet.
(b) Balance sheet. (e) Balance sheet.
(c) Income statement. (f) Balance sheet.
LO 3 BT: K Diff: M TOT: 2 min. AACSB: None AICPA FC: Reporting
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
company’s ability to make debt payments at risk.
LO 3 BT: AN Diff: M TOT: 2 min. AACSB: Reflective Thinking AICPA BB: Critical Thinking
10. Yes. Net income does appear on the income statement—it is the result of subtracting expenses
from revenues. In addition, net income appears in the retained earnings statement—it 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.
LO 3 BT: C Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
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.
LO 3 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
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 activities.
LO 3 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
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.
LO 3 BT: C Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
14. The basic accounting equation is Assets = Liabilities + Stockholders’ Equity.
LO 3 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
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 net assets.
(b) The items that affect stockholders’ equity are common stock, retained earnings, dividends,
revenues, and expenses.
LO 3 BT: K Diff: E TOT: 2 min. AACSB: None AICPA FC: Reporting
16. The liabilities are (b) Accounts payable and (g) Salaries and wages payable.
LO 3 BT: C Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
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.
LO 3 BT: C Diff: M TOT: 2 min. AACSB: None AICPA FC: Reporting
18. The purpose of the management discussion and analysis section is to provide management’s
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.
LO 3 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
19. An unqualified opinion shows that, in the opinion of an independent auditor, the financial state–
ments 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.
LO 3 BT: C Diff: E TOT: 2 min. AACSB: None AICPA FC: Reporting
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 uncertain–
ties and contingencies, and statistics and details too voluminous to be reported in the financial
statements.
LO 3 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
21. Using dollar amounts, Apple’s accounting equation is:
Assets
=
Liabilities
+
Stockholders’ Equity
$231,839,000
$120,292,000
$111,547,000
LO 3 BT: AP Diff: E TOT: 2 min. AACSB: Analytic AICPA FC: Reporting
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 1-1
(a) P Shared control, tax advantages, increased skills and resources.
BRIEF EXERCISE 1-2
(a) 4 Investors in common stock
BRIEF EXERCISE 1-3
O (a) Cash received from customers.
BRIEF EXERCISE 1-4
E (a) Advertising expense
R (b) Service revenue
BRIEF EXERCISE 1-5
KAROL COMPANY
Balance Sheet
December 31, 2017
Assets
Cash ……………………………………………………………………… $22,000
Accounts receivable ………………………………………………. 71,000
BRIEF EXERCISE 1-6
IS (a) Income tax expense
BS (b) Inventory
BRIEF EXERCISE 1-7
IS (a) Revenue during the period.
BRIEF EXERCISE 1-8
(a) $90,000 + $230,000 = $320,000 (Total assets)
BRIEF EXERCISE 1-9
(a) ($800,000 + $150,000) – ($500,000 – $80,000) = $530,000
(Stockholders’ equity)
[(Assets ± Change in assets) – (Liabilities ± Change in liabilities) = Stockholders’ equity]
BRIEF EXERCISE 1-10
A (a) Accounts receivable
BRIEF EXERCISE 1-11
SOLUTIONS TO DO IT! EXERCISES
DO IT! 1-1
(a) Easier to transfer ownership: corporation
(b) Easier to raise funds: corporation
DO IT! 1-2
(a) Issuance of ownership shares is classified as common stock.
(b) Land purchased is classified as an asset.
DO IT! 1-3a
GRAY CORPORATION
Income Statement
For the Year Ended December 31, 2017
Revenues
Service revenue …………………………………….. $25,000
Expenses
Rent expense ………………………………………… $10,000
GRAY CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 2017
Retained earnings, January 1 …………………………….. $ –0–
Add: Net income …………………………………………….. 9,300
9,300
GRAY CORPORATION
Balance Sheet
December 31, 2017
Assets
Cash …………………………………………………………………. $ 3,100
Accounts receivable ………………………………………….. 2,000
Liabilities and Stockholders’ Equity
Liabilities
Notes payable …………………………………………….. $ 7,000
Account payable ………………………………………… 5,000
DO IT! 1-3b
(a) Description of ability to pay near-term obligations: MD&A
(b) Unqualified opinion: auditor’s report
SOLUTIONS TO EXERCISES
EXERCISE 1-1
(a) 8. Auditor’s opinion
(b) 1. Corporation
EXERCISE 1-2
(a) Answers will vary.
Financing
Investing
Operating
Abitibi Consolidated
Inc.
Sale of stock
Purchase long-term
investments
Sale of
newsprint
Cal State—Northridge
Stdt Union
Borrow money
from a bank
Purchase office
equipment
Payment of
wages and
benefits
Sportsco Investments
Payment of
Purchase hockey
Payment for
Grant Thornton LLP
Distribute
earnings to
Purchase
computers
Bill clients for
professional
services
EXERCISE 1-2 (Continued)
(b) Financing
Sale of stock is common to all corporations. Borrowing from a bank is
Investing
Purchase and sale of property, plant, and equipment would be common
to all businesses—the types of assets would vary according to the type
Operating
The general activities identified would be common to most businesses,
LO 2 BT: C Difficulty: Easy TOT: 3.0 min. AACSB: None AICPA FC: Measurement & Reporting
EXERCISE 1-3
Accounts payable
L
Accounts receivable
A
Equipment
A
Sales revenue
R
Service revenue
R
Inventory
A
Mortgage payable
L
Supplies expense
E
Rent expense
E
Salaries and wages expense
E
EXERCISE 1-4
BENSER CO.
Income Statement
For the Year Ended December 31, 2017
Revenues
Service revenue ……………………………………………… $58,000
Expenses
Salaries and wages expense …………………………... $30,000
BENSER CO.
Retained Earnings Statement
For the Year Ended December 31, 2017
Retained earnings, January 1 ………………………………………………….. $67,000
[Revenues – Expenses = Net income or (loss)]
EXERCISE 1-5
(a) MERCK AND CO.
Income Statement
For the Year Ended December 31, 2017
(in millions)
Revenues
Sales revenue ………………………………………….. $38,576.0
Expenses
Cost of goods sold …………………………………… $ 9,018.9
MERCK AND CO.
Retained Earnings Statement
For the Year Ended December 31, 2017
(in millions)
Retained earnings, January 1 …………………………... $43,698.8
Add: Net income ……………………………………………. 12,901.3
(b) The short-term implication would be a decrease in expenses of $2,922.5
($5,845 X 50%) resulting in a corresponding increase in income (ignoring
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. Pharma–
EXERCISE 1-6
ZHENG INC.
Retained Earnings Statement
For the Year Ended December 31, 2017
Retained earnings, January 1 ……………………………. $130,000
Add: Net income …………………………………………….. 225,000*
355,000
EXERCISE 1-7
(a) Lee Corporation is distributing nearly all of this year’s net income as
(b) Steele Corporation is not generating sufficient cash provided by
LO 3 BT: AP Difficulty: Medium TOT: 4.0 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 1-8
(a)
A
Cash
SE
Retained earnings
E
Cost of goods sold
E
Salaries and wages expense
A
A
Inventory
A
Accounts receivable
R
Sales revenue
L
Accounts payable
R
Service revenue
E
Interest expense
EXERCISE 1-8 (Continued)
(b) LONYEAR INC.
Income Statement
For the Year Ended December 31, 2017
Revenues
Sales revenue ………………………………… $584,951
Service revenue …………………………….. 4,806
EXERCISE 1-9
First note that the retained earnings statement shows that (b) equals $27,000.
Accounts payable + Common stock + Retained earnings = Total liabilities and stockholders’ equity
$5,000 + a + $27,000 = $62,000
Beginning retained earnings + Net income – Dividends = Ending retained earnings
$12,000 + e – $5,000 = $27,000
EXERCISE 1-9 (Continued)
From above, we know that net income (d) equals $20,000.
Revenue – Cost of goods sold – Salaries and wages expense = Net income
EXERCISE 1-10
(a) Service revenue ……………………………………… $132,000
Sales revenue ………………………………………… 25,000
(b) OTAY LAKES PARK
Retained Earnings Statement
For the Year Ended December 31, 2017
Retained earnings, January 1 …………………………………………. $ 5,000
Add: Net income ………………………………………………………….. 31,000