CHAPTER 1

Introduction to Financial Statements

ASSIGNMENT CLASSIFICATION TABLE
Study Objectives

Questions

Brief
Exercises

Exercises

1.

Describe the primary

forms of business organization.

1, 2, 3

1A

1B

2.

Identify the users and

uses of accounting information.

4, 5, 6

2A

2B

3.

Explain the three principal types of business

activity.

4.

Describe the content

and purpose of each of
the financial statements.

8, 9, 10,
11, 12, 13

3, 4, 5, 6,
7

1, 2, 3, 4,
5, 7, 10, 11

2A, 3A, 4A,

5A

2B, 3B, 4B,

5B

5.

Explain the meaning of

assets, liabilities, and
stockholders equity and
state the basic accounting
equation.

14, 15, 16,

17

3, 5, 6, 8,
9, 10

6, 7, 8,
9, 10, 11,
12, 13

2A, 3A, 4A

2B, 3B, 4B,

5B

6.

Describe the components that supplement

the financial statements in
an annual report.

18, 19, 20

11

1, 14

7.

Explain the basic assumptions and principles

underlying financial
statements.

21, 22, 23

12

15, 16

6A

5B, 6B

A
Problems

B
Problems

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.

Moderate

40-50

4A

Determine items included in a statement of cash flows and

prepare the statement.

Moderate

30-40

5A

Comment on proper accounting treatment and prepare

a corrected income statement.

Moderate

40-50

6A

Indentify the assumption or principle violated.

Simple

10-15

1B

Determine forms of business organization.

Simple

15-20

2B

Identify users and uses of financial statements.

Simple

15-20

3B

Prepare an income statement, retained earnings statement, and balance sheet.

Moderate

40-50

4B

Determine items included in a statement of cash flows and

prepare the statement.

Moderate

30-40

5B

Comment on proper accounting treatment and prepare

a corrected balance sheet.

Moderate

40-50

6B

Indentify the assumption or principle violated.

Simple

10-15

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 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.

8.

(a) Income statement.

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

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.

(d) Balance sheet.

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

Questions Chapter 1 (Continued)

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 claims of creditors against assets.
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.

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.

21.

The going concern assumption lends credibility to the cost principle; otherwise items would be
reported at liquidation value.

22.

Cost is used because it can be easily verified from transactions between two parties. Market value
is not used because it is often subjective.

23.

The economic entity assumption states that economic events can be identified with a particular unit
of accountability. This assumption requires that the activities of the entity be kept separate and distinct from (1) the activities of its owners and (2) all other economic entities. An owner of a company
charging personal living costs as expenses of the company is an example of a violation of the economic entity assumption.

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
NSE
C

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

Advertising expense
Service revenue
Insurance expense
Salaries expense
Dividends
Rent revenue
Utilities expense
Paid cash to purchase equipment
Received cash from investors in exchange for common stock.

BRIEF EXERCISE 1-5

HERBERT COMPANY
Balance Sheet
December 31, 2004
Assets
Cash..................................................................................................
Accounts receivable........................................................................
Total assets ..............................................................................

$ 35,500
81,000
$116,500

Liabilities and Stockholders Equity

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

$ 85,000
31,500
$116,500

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.

BRIEF EXERCISE 1-8

(a) $90,000 + $300,000 = $390,000 (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) ($800,000 + $150,000) ($500,000 $80,000) = $530,000
(Stockholders equity)
(b) ($500,000 + $100,000) + ($800,000 $500,000 $70,000) = $830,000
(Assets)
(c) ($800,000 $90,000) ($800,000 $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.
BRIEF EXERCISE 1-12
(c) Financial statements should disclose all events and circumstances that
would matter to users of financial statements.

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
ROSE CO.
Income Statement
For the Year Ended December 31, 2004
Revenues
Service revenue ......................................................
Expenses
Salaries expense.....................................................
Rent expense...........................................................
Utilities expense......................................................
Advertising expense...............................................
Total expenses ................................................
Net income ......................................................................

$58,000
$28,000
10,400
2,400
1,800

42,600
$15,400

ROSE CO.
Retained Earnings Statement
For the Year Ended December 31, 2004
Retained earnings, January 1...........................................................
Add: Net income..............................................................................
Less: Dividends ................................................................................
Retained earnings, December 31 .....................................................
8

$64,000
15,400
79,400
7,000
$72,400

EXERCISE 1-3
MERCK and CO.
Income Statement
For the Year Ended December 31, 2001
(in millions)
Revenues
Sales revenue..........................................................
$47,715.7
Other revenue..........................................................
685.9
Total revenue .......................................................
48,401.6
Expenses
Materials and production expense ........................ $28,976.5
Marketing and administrative expense .................
6,224.4
Research and development expense ....................
2,456.4
Other expense .........................................................
341.7
Tax expense ............................................................
3,120.8
Total expenses ....................................................
41,119.8
Net income ......................................................................
$ 7,281.8
MERCK and CO.
Retained Earnings Statement
For the Year Ended December 31, 2001
Retained earnings, January 1........................................
Add: Net income .............................................................
Less: Dividends ..............................................................
Retained earnings, December 31 ..................................

$31,489.6
7,281.8
38,771.4
$ 2,905.7
$35,865.7

EXERCISE 1-4
PATRICK REID INC.
Retained Earnings Statement
For the Year Ended December 31, 2004
Retained earnings, January 1..................................
Add: Net income.....................................................

$150,000
215,000*
365,000
82,000
$283,000

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

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

$410,000
195,000
$215,000

EXERCISE 1-5
(a) Stasik Corporation is distributing nearly all of this years net income as
dividends. This suggests that Stasik is not pursuing rapid growth. Companies that have a lot of opportunities for growth pay low dividends.
(b) Royal Cruise Corporation is not generating sufficient cash provided by
operating activities to fund its investing activities. This is common for
companies in their early years of existence.

10

EXERCISE 1-6
KILTIE CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2004
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 ...............................
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 ....................................................

11

$65,000)
(20,000)
45,000)
(50,000)
$20,000)
(6,000)

14,000)
) 9,000
12,000
$21,000

EXERCISE 1-7
First note that the retained earnings statement shows that (b) equals $33,000.
Accounts payable + Common stock + Retained earnings = Total liabilities and stockholders equity

$5,000 + a + $33,000 = $65,000

a + $38,000 = $65,000
a = $27,000
Beginning retained earnings + Net income Dividends = Ending retained earnings

$10,000 + e $5,000 = $33,000

$5,000 + e = $33,000
e = $28,000
From above, we know that net income (d) equals $28,000.
Revenue Cost of goods sold Administrative expenses = Net income

$80,000 c $10,000 = $28,000

$70,000 c = $28,000
c = $42,000

12

EXERCISE 1-8
LANDS END
Statement of Cash Flows
For the Year Ended February 1, 2002
(in thousands)
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 new buildings and equipment........
Cash flows from financing activities
Cash received from issuance of common stock..
Cash paid for repayment of debt ...........................
Net cash provided by financing activities ............
Net increase in cash .......................................................
Cash at beginning of period ..........................................
Cash at end of period .....................................................

13

$1,575,573
(1,502,068)
73,505
(40,514)
$14,520
(771)

13,749
46,740
75,351
$122,091

EXERCISE 1-9
SWANN COMPANY
Balance Sheet
December 31, 2004
Assets
Cash................................................................................
Accounts receivable......................................................
Supplies..........................................................................
Equipment ......................................................................
Total assets ............................................................

$18,500
10,000
8,000
40,000
$76,500

Liabilities and Stockholders Equity

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

$16,000
$40,000*
20,500*

60,500
$76,500

*$27,500 $7,000

EXERCISE 1-10
(a) Camping fee revenue...............................................................
General store revenue ...........................................................
Total revenue ....................................................................
Expenses ..................................................................................
Net income................................................................................

14

$137,000
25,000
162,000
138,000
$ 24,000

EXERCISE 1-10 (Continued)

(b)

ERIK PARK INC.

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

$11,000
24,000
35,000
4,000
$31,000

ERIK PARK INC.

Balance Sheet
December 31, 2004
Assets
Cash .....................................................................
Supplies ...............................................................
Equipment ...........................................................
Total assets .................................................

$ 10,500
2,500
119,000
$132,000

Liabilities and Stockholders Equity

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

15

$50,000
11,000
40,000
31,000

$ 61,000
71,000
$132,000

EXERCISE 1-11
(a)

(b)

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

Retained earnings
Cost of goods sold
Selling and administrative expenses
Cash
Notes payable
Interest expense
Other expense
Long-term debt
Inventories
Net sales
Accounts payable
Common stock
Income tax expense
KELLOGG COMPANY
Income Statement
For the Year Ended December 31, 2001
(in millions)

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

16

$8,853.3
$4,128.5
3,523.6
351.5
54.0
322.1

8,379.7
$ 473.6

EXERCISE 1-12
All dollars are in millions.
(a) Assets
Cash ............................................................................................
Accounts receivable ..................................................................
Inventories..................................................................................
Property, plant, and equipment ................................................
Other assets ...............................................................................
Total assets ...................................................................

$ 304.0
1,621.4
1,424.1
1,618.8
851.3
$5,819.6

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

$ 860.7
432.0
21.9
1,010.5
$2,325.1

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

Assets
$5,819.6

Liabilities
$2,325.1

17

$ 300.2
3,194.3
$3,494.5

Stockholders Equity
$3,494.5

EXERCISE 1-13
(a)

Assets
$90,000
$10,000

=
=
=

Liabilities
$80,000
(a)

+
+

Stockholders Equity
(a)

(b)

Assets
(b)
(b)

=
=
=

Liabilities
$120,000
$160,000

+
+

Stockholders Equity
40,000

(c)

Beginning
Stockholders
Equity
$10,000(a)

Revenues

Expenses

Dividends

215,000
$60,000

165,000
(c)
(c)

(c)

=
=
=

Ending
Stockholders
Equity
$40,000
$40,000
$20,000

(d)

Assets
$130,000
(d)

=
=
=

Liabilities
(d)
$ 35,000

+
+

Stockholders Equity
95,000

(e)

Assets
$180,000
(e)

=
=
=

Liabilities
$ 55,000
$125,000

+
+

Stockholders Equity
(e)

(f)

Beginning
Stockholders
Equity
$95,000
(f)

Revenues

Expenses

Dividends

+
=

(f)
$115,000

80,000

5,000

18

Ending
Stockholders
Equity
$125,000(e)

EXERCISE 1-14
(a)
(b)
(c)
(d)
(e)
(f)

Financial statements
Auditors opinion
Notes to the financial statements
Financial statements
Management discussion and analysis
Not disclosed

EXERCISE 1-15
(a)
(b)
(c)
(d)
(e)
(f)

2.
6.
3.
4.
5.
1.

Going concern assumption

Economic entity assumption
Monetary unit assumption
Time period assumption
Cost principle
Full disclosure principle

EXERCISE 1-16
(a) This is a violation of the cost principle. The inventory was written up to
its market value when it should have remained at cost.
(b) This is a violation of the economic entity assumption. The treatment of
the transaction treats Issam Mere and Mere Co. as one entity when they
are two separate entities.
(c) This is a violation of the time period assumption. This assumption
states that the economic life of a business can be divided into artificial
time periods (months, quarters or a year). By adding two more weeks to
the year, Mere Co. would be misleading financial statement readers. In
addition, 2004 results would not be comparable to previous years
results.

19

SOLUTIONS TO PROBLEMS
PROBLEM 1-1A

(a) Ann should run her business as a sole proprietor. She has no real need
to raise funds, and she 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.
(b) 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.
(c) 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.
(d) One way to ensure control would be for Michelle 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 Michelle to maintain control over the
business she would need to own more than 50 percent of the voting
shares of common stock. In order for the business to grow, she may
have to be willing to give up some control.
(e) 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 two know each other well and would appear to be contributing
equally to the firm. Service firms, like consulting businesses, are frequently formed as partnerships.

20

PROBLEM 1-2A

(a) In purchasing an investment that will be held for an extended period, the
investor must try to predict the future performance of Bally Total Fitness. The income statement provides the most useful information for
predicting future performance.
(b) In deciding whether to extend credit for 60 days Boeing 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.
(c) 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.
(d) 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 income using the income statement. It should be noted, however, that the lender would also
be very interested in both the balance sheet and the 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.

21

PROBLEM 1-3A

NEXT DAY DELIVERY

Income Statement
For the Month Ended May 31, 2004
Revenues
Service revenue .........................................................
Expenses
Fuel expense ..............................................................
Rent expense..............................................................
Advertising expense..................................................
Insurance expense.....................................................
Repair expense ..........................................................
Total expenses ...................................................
Net income .........................................................................

$9,600
$3,400
1,200
900
400
700

6,600
$3,000

NEXT DAY DELIVERY

Retained Earnings Statement
For the Month Ended May 31, 2004
Retained earnings, May 1...................................................................
Add: Net income...............................................................................
Less: Dividends .................................................................................
Retained earnings, May 31.................................................................

22

0
3,000
3,000
1,700
$1,300

PROBLEM 1-3A (Continued)

NEXT DAY DELIVERY
Balance Sheet
May 31, 2004
Assets
Cash.................................................................................
Accounts receivable.......................................................
Equipment .......................................................................
Total assets .............................................................

$ 7,200
11,200
60,300
$78,700

Liabilities and Stockholders Equity

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

23

$30,000
2,400
45,000
1,300

$32,400
46,300
$78,700

PROBLEM 1-4A

Johnson Corporation should include the following items in its statement of

cash flows:
Cash paid to suppliers
Cash dividends paid
Cash paid to purchase equipment
Cash received from customers
JOHNSON CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2004
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 to purchase equipment ........................................
Cash flows from financing activities
Cash dividends paid ...............................................................
Net increase in cash .......................................................................

24

$168,000)
(89,000)
79,000)
(26,000)
(7,000)
$ 46,000)

PROBLEM 1-5A

(a) 1.

The $7,000 of revenue that the company earned in 2003 should not
be included in the 2004 revenues. Including the $7,000 in the current years income statement would violate the time period assumption. Instead, the $7,000 should be added to the beginning
balance of retained earnings.

2.

Since the corporation did not incur or pay the $18,000 of rent expense, it should not be included in the income statement. Including
the $18,000 as an expense misstates the corporations net income
and presents misleading results.

3.

Including the $2,000 as vacation expense misstates the corporations net income. It would also be a violation of the economic
entity assumption.

(b)

MONTANA CORPORATION
Income Statement
For the Year Ended December 31, 2004
Revenue ......................................................................................
Expenses
Insurance expense .............................................................
Net income..................................................................................

25

$53,000
5,000
$48,000

PROBLEM 1-6A

(a) This is a violation of the full disclosure principle. All circumstances and
events that would make a difference to financial statement users must
be disclosed. The existence of a pending lawsuit would certainly make
a difference to users of financial statements.
(b) This is a violation of the monetary unit assumption. Only things that can
be expressed in money are included in the accounting records. Since
people cannot be assigned a value in terms of money, they are excluded
from a balance sheet.
(c) This is a violation of the cost principle. All assets must be recorded at
their cost. The inventory cost $75,000 and must be reported as such
rather than its current value.
(d) This is a violation of the time period assumption. The life of a business
must be divided into artificial time periods in order to prepare useful
reports. Operating a business for five years without preparing reports
violates the annual reporting requirement.
(e) This violates the economic entity assumption. Personal transactions
must be identified and reported separately from those of ones business.
Purchasing a computer for personal use should be treated as a personal
transaction. Using company funds to do so would result in compensation expense for the company and earnings for Steph.

26

PROBLEM 1-1B

(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) Geoff 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 Mark 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 Mark 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.

27

PROBLEM 1-2B

(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.

28

PROBLEM 1-3B

MEDIOCRE SERVICE CO.

Income Statement
For the Month Ended June 30, 2004
Revenues
Revenue ......................................................................
Expenses
Supplies expense.......................................................
Gas and oil expense ..................................................
Advertising expense..................................................
Utilities expense.........................................................
Total expenses ...................................................
Net income .........................................................................

$8,000
$1,200
900
500
300

2,900
$5,100

MEDIOCRE SERVICE CO.

Retained Earnings Statement
For the Month Ended June 30, 2004
Retained earnings, June 1 .................................................................
Add: Net income...............................................................................
Less: Dividends .................................................................................
Retained earnings, June 30 ...............................................................

29

0
5,100
5,100
2,200
$2,900

PROBLEM 1-3B (Continued)

MEDIOCRE SERVICE CO.
Balance Sheet
June 30, 2004
Assets
Cash.................................................................................
Accounts receivable.......................................................
Supplies...........................................................................
Equipment .......................................................................
Total assets .............................................................

$ 6,000
4,000
2,400
32,000
$44,400

Liabilities and Stockholders Equity

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

30

$14,000
1,300
26,200
2,900

$15,300
29,100
$44,400

PROBLEM 1-4B

Beverly Corporation should include the following items in its statement of

cash flows:
Cash paid to suppliers
Cash dividends paid
Cash paid to purchase equipment
Cash received from customers
BEVERLY CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2004
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 to purchase equipment ........................................
Cash flows from financing activities
Cash dividends paid ...............................................................
Net increase in cash .......................................................................

31

$137,000)
(100,000)
(37,000)
(15,000)
(13,000)
$ 9,000)

PROBLEM 1-5B

(a) 1.

The economic entity assumption states that economic events can

be identified with a particular unit of accountability. Since the boat
actually belongs to Ed Murphynot to Kohlenberg Corporationit
should not be reported on the corporations balance sheet. Likewise, the boat loan is a personal loan of Edsnot a liability of
Kohlenberg Corporation.

2.

The cost principle dictates that assets are recorded at their original cost. Therefore, reporting the inventory at $30,000 would be
improper and violates the cost principle. The inventory should be
reported at $15,000.

3.

Including the personal loan Ed made to his brother would be a violation of the economic entity assumption. The $10,000 receivable is
not an asset of Kohlenberg Corporationit is a personal asset of
Ed Murphy.

(b)

KOHLENBERG CORPORATION
Balance Sheet
December 31, 2004
Assets
Cash ..........................................................................................
Accounts receivable ................................................................
Inventory...................................................................................
Total assets ......................................................................

$20,000*
45,000*
15,000*
$80,000*

Liabilities and Stockholders Equity

Liabilities
Accounts payable................................................................
Notes payable ......................................................................
Total liabilities ..................................................................
Stockholders equity................................................................
Total liabilities and stockholders equity .......................
*$80,000 $55,000 (Total assets minus total liabilities)

32

$40,000*
15,000*
$55,000*
25,000*
$80,000*

PROBLEM 1-6B

(a) This is a violation of the monetary unit assumption. Only those things
that can be expressed in money are included in the accounting records.
Since the impact of the death of the president cannot be recorded in
dollars, it should not be included in the financial statements.
(b) This is a violation of the time period assumption. The life of a business
must be divided into artificial time periods in order to prepare useful reports. All companies must report at least annually.
(c) This is violation of the economic entity assumption. Personal transactions should not be mixed with those of a business. A boat used primarily for personal use should not be recorded as a company asset.
(d) This is a violation of the cost principle. Assets must be recorded at their
cost rather than current value. The flood sale price should be used to
record the equipment at $200,000.

33

BYP 1-1

FINANCIAL REPORTING PROBLEM

(a) Tootsie Rolls total assets at December 31, 2001 were $618,676,000 and
at December 31, 2000 were $562,442,000.
(b) Tootsie Roll had $106,532,000 of cash at December 31, 2001.
(c) Tootsie Roll had accounts payable totaling $9,223,000 on December
31, 2001 and $10,296,000 on December 31, 2000.
(d) Tootsie Roll reported sales revenue in 2001 of $423,496,000 and in 2000
of $427,054,000.
(e) Tootsie Rolls net income decreased by $10,050,000 from 2000 to 2001,
from $75,737,000 to $65,687,000.
(f)

Tootsie Rolls accounting equation is:

Assets
$618,676,000

Liabilities
$110,215,000

34

Stockholders Equity
$508,461,000

BYP 1-2

(a)

COMPARATIVE ANALYSIS PROBLEM

(amounts in thousands)
1. Total assets
2. Accounts receivable
3. Net sales
4. Net income

Tootsie Roll
Industries, Inc.
$618,676
$ 20,403
$423,496
$ 65,687

Hershey Foods
Corporation
$3,247,430
$ 361,726
$4,557,241
$ 207,156

(b) Both companies are profitable. Hersheys total assets and net sales suggest that it is a substantially bigger company than Tootsie Roll. Hersheys total assets are more than five times as big as those of Tootsie
Roll and its total sales are nearly 11 times as big as those of Tootsie
Roll.

35

BYP 1-3

RESEARCH CASE

(a) There is a concern that these payments create the appearanceif not
the realitythat accounting firms will go easy on the audit to hold on to
the more-lucrative consulting business. Possible solutions that have
been proposed are that auditors should not do anything other than
audits for their clients. A more extreme solution proposed is that auditors should not do anything other than auditsperiod. That is, auditors
shouldnt do consulting whether it is for audit clients or non-audit clients.
(b) At the time of this article the accounting profession policed itself. That
is, oversight and disciplinary actions were done by panels that were
created by accounting industry associations. The SEC proposed creating a new oversight organization that would be independent of the profession, and which would be comprised largely of non-accountants.
(c) Some criticisms of the FASB that were cited in the article are that (1) few
people attend the FASB hearings (2) the board is comprised primarily of
accounting industry insiders (3) the rules that the FASB issues are too
complex (4) the FASB is too slow in issuing new rules to deal with new
issues, thus creating situations where little guidance exists for important new problems.
(d) The article suggests that companies need to provide better and more
detailed disclosure about how they determine their financial numbers,
that auditors need to provide more detailed information regarding how
much they get paid for various services, and that the SEC needs to provide better disclosure about its correspondence with companies that it
thinks are too aggressive in their accounting practices.

36

BYP 1-4

INTERPRETING FINANCIAL STATEMENTS

(a) Creditors lend money to companies with the expectation that they will
be repaid at a specified point in time in the future. If a company is generating cash from operations in excess of its investing needs, it is more
likely that it will be able to repay its creditors. Not only did Xerox actually have negative cash from operations, but most of the cash it received
in order to meet its cash deficiency was from issuing new debt. Both of
these facts would be of concern to the companys creditors, since it
would suggest it will be less likely to be able to repay its debts.
(b) Stockholders are interested in the long-term performance of a company
and how that translates into its stock price. Often during the early years
of a companys life its cash provided by operations is not sufficient to
meet its investment needs, so the company will have to get cash from
outside sources. However, in the case of Xerox, the company has operated for many years and has a well established name brand. The negative cash from operations might suggest operating deficiencies.
(c) The statement of cash flows reports information on a cash basis. An
investor cannot get the complete story on the companys performance
and financial position without looking at the income statement and balance sheet. Also, investors would want to look at more than one years
worth of data. The current year might not be representative of past or future years.
(d) Xerox is a well known company. It has a past record of paying dividends.
Its management probably decided to continue to pay a dividend to demonstrate confidence in the companys future. They may have felt that by
canceling the dividend for the year they would send a negative message
to investors. However, by choosing to pay a cash dividend the company
obviously weakened its cash position, and decreased its ability to repay
its debts as they come due.

37

BYP 1-5

A GLOBAL FOCUS

(a) Nestl follows the standards issued by the International Accounting

Standards Committee. Tootsie Roll and Hershey Foods are U.S. companies and therefore they follow the standards issued by the Financial Accounting Standards Board. To the extent that these standards
differ, the comparison may be difficult.
(b) There are at least two issues here. First, Nestls financial reports are
prepared under the historical cost convention. As noted in the chapter,
the cost principle underlies U.S. accounting standards. Thus, this would
assist comparison. The second issue relates to the full disclosure principle discussed in the chapter. It is noted that Nestl provides disclosures as required by the 4th and 7th European Union company law
directives. To the extent that these disclosure requirements differ from
U.S. disclosure requirements, comparison may be impeded.
(c) The primary concern here relates to the monetary unit assumption. In
the U.S., financial statements are prepared in terms of U.S. dollars.
Nestl prepares its statements in terms of Swiss francs. While conversion from francs to dollars is possible, it will not necessarily capture
the full economic situation.

38

BYP 1-6

FINANCIAL ANALYSIS ON THE WEB

Answers to this question will differ depending on the companies chosen by

the student, and the year. We provide the following solution for Tootsie Roll.
(a) You must read the description of ttm to see the period that net income
and sales were measured over. During the twelve months ended June
30, 2002, Tootsie Roll reported net income of $64.5 million.
(b) During the twelve months ended June 30, 2002, Tootsie Roll reported
sales of $423.8 million.
(c) The Industry label on the left side of the profile box tells us that Tootsie Roll is in the Food Processing industry.
(d) Four companies also in this industry would include Del Monte Foods,
Campbell Soup, Starbucks, and Tyson Foods. Clearly this covers a broad
spectrum of businesses.
(e) We chose Tyson Foods. During the twelve months ended June 30, 2002,
Tyson reported sales of $22.8 billion and net income of $347.0 million.

39

BYP 1-7

FINANCIAL ANALYSIS ON THE WEB

Answers will vary depending on firm chosen and date. A sample solution for
Deloitte & Touche as of August 2002 is provided:
(a) Description of the services provided

Accounting
Assurance and advisory
Tax
Management, financial, and human capital consulting

(b) Revenues: Total U.S. revenue in 2001 was $6.13 billion

(c) Personnel: 30,000 (as of August, 2002)

40

BYP 1-8

GROUP DECISION CASE

(a) The Report of Independent Accountants indicates that PriceWaterhouse

Coopers LLP performed the audit of Tootsie Rolls financial statements.
(b) The Consolidated Statement of Earnings, Comprehensive Earnings and
Retained Earnings states that its earnings per share were $1.30 in 2001.
(c) Note 12 indicates that total assets in Mexico and Canada were
$22,373,000 in 2001.
(d) Managements Discussion and Analysis of Financial Condition and Results of Operations states that the increases were due to further gains
in distribution and successful promotions.
(e) Per the Five Year Summary of Earnings and Financial Highlights, Net
Sales in 1998 were $389 million.
(f)

The Shareholders Equity section of the Consolidated Statement of Financial Position states that 40,000 shares were authorized.

(g) Per the Consolidated Statement of Cash Flows, $14,148,000 was spent
on capital expenditures.
(h) Note 1 states that depreciation is based on useful lives of 20 to 35 years
for buildings.
(i)

The Advertising and Public Relations section of To Our Shareholders

gives tootsie.com as the website.

(j)

Per the Consolidated Statement of Financial Position, raw materials and

supplies were $16,906,000 in 2000.

41

BYP 1-9

GROUP DECISION CASE

(a) (1) Clearly an expense of the business.

(2) The donation of the gladiolas was an expense of the business; the
planting of the gardens was likely on the employees own time and
therefore any costs incurred were personal expenses of the employees.
(3) Clearly a business expense, since the payment is made by Kelly
Services to the charity.
(4) Also an expense of the business, since the donation of the employees time is made by Kelly Services. The employees still receive
their pay, but the employer is not required to pay Kelly. Of course,
if the employees donated their own time, these would be personal
expenses. However, that is not likely.
(5) Clearly a personal expense.
(b) (1) Advertising Expense is the most likely category of those listed because the companys name was on all the gifts. It might be a Charitable Contribution Expense, but since the gifts were of a general
nature and contained the name of the donor, rather than the recipient, it is not as likely.
(2) Charitable Contribution Expense is the most likely. It is not Grounds
Maintenance Expense because the grounds maintained are not
those of the company. The employees time is not recorded in the
company records, of course, since the time was volunteered.
(3) Clearly Charitable Contribution Expense.
(4) Most likely Employee Wages Expense, although it might be categorized as Charitable Contribution Expense since the time was
donated.
(5) Not recorded in the companys records at all.
42

BYP 1-10

To:

Karen Lloyd

From:

Student

COMMUNICATION ACTIVITY

I have received the balance sheet of James Company, Inc. as of December

31, 2004. The purpose of a balance sheet is to report a companys financial
position at a point in time. It reports what the company owns (assets) and
what it owes (liabilities) and the net amount attributed to owners (equity). A
number of items in this balance sheet are not properly reported. They are:
1.

The balance sheet should be dated as of a specific date, not for a period
of time. Therefore, it should be stated December 31, 2004.

2.

Equipment should be below Supplies on the balance sheet.

3.

Accounts receivable should be shown as an asset and reported between

Cash and Supplies on the balance sheet.

4.

Accounts payable should be shown as a liability, not an asset. The note

payable is also a liability and should be reported in the liability section.

5.

Liabilities and stockholders equity should be shown separately on the

balance sheet. Common stock, Retained earnings, and Dividends are not
liabilities.

6.

Common stock, Retained earnings, and Dividends are part of stockholders equity. The Dividends account is not reported on the balance sheet
but is subtracted from Retained earnings to arrive at the ending balance.

A correct balance sheet is as follows:

43

BYP 1-10 (Continued)

JAMES COMPANY, INC.
Balance Sheet
December 31, 2004
Assets
Cash..............................................................................
Accounts receivable....................................................
Supplies........................................................................
Equipment ....................................................................
Total assets ..........................................................

$ 10,500
3,000
2,000
20,500
$36,000

Liabilities and Stockholders Equity

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

*Retained earnings ......................................................

*Less: Dividends........................................................
*Ending retained earnings ..........................................

44

$12,000
5,000
17,000
$11,000
8,000*

$10,000
2,000
$ 8,000

19,000
$36,000

BYP 1-11

ETHICS CASE

(a) Investors rely on auditors to perform an independent assessment of a

company. If the auditor owns stock in that company, he or she might not
be able to act in an independent and impartial manner.
(b) There are pros and cons to this argument. On the positive side, it could
be argued that as long as a person in no way has a direct relationship
with a client company, that person will not influence the findings of the
work. However, a counter argument is that an influential partner within
a firm, who had a investment in a client that he or she didnt work on,
might be tempted to try to influence the findings of the audit if he or she
feared that the findings were going to negatively affect the value of his
or her investment.
(c) The fact that four firms have become so big means that the current rules
prohibit employees (or even relatives of those employees) of those firms
from buying stock in roughly 25% of publicly traded firms. Some would
argue that this creates an undue hardship, and unfairly restricts the investment options of these people. They also argue that in such a large
organization it is increasingly unlikely that an individual who doesnt
work on a particular audit will be able to influence the outcome of the
audit.
(d) Answers to this question will vary. This is a particularly difficult issue
since the rule effectively eliminates the individuals control over their investment portfolio. They did nothing wrong when they bought the
shares, but now they are being forced to sell when it is not advantageous.
(e) The management of PricewaterhouseCoopers noted that auditor independence is vitally important to the audit function. If investors dont
think the auditor is independent of the client they will lose faith in
auditing, which would have dire consequences for our securities markets. Therefore, it was important that the firm make a bold, unambiguous
response to address this problem.

45

46