Chapter Preview

If you own a business, how do you determine whether it is making or losing money? How should you finance expansion—should you borrow, should you issue stock, should you use your own funds? How do you convince banks to lend you money or investors to buy your stock? Success in business requires making countless decisions, and decisions require financial information.

The purpose of this chapter is to show you what role accounting plays in providing financial information.

Feature Story

Chapter Outline

Forms of Business Organization

What organizational form should you choose for your business? You have three choices—sole proprietorship, partnership, or corporation.

Sole Proprietorship

You might choose the sole proprietorship form for your outdoor guide service.

• A business owned by one person is a sole proprietorship.
• It is simple to set up and gives you control over the business.

Small owner-operated businesses such as barber shops, law offices, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

Partnership

Another possibility is for you to join forces with other individuals to form a partnership.

• A business owned by two or more persons associated as partners is a partnership.
• Partnerships often are formed because one individual does not have enough economic resources or other unique skills or resources to initiate or expand the business.

You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants), often organize as partnerships.

Corporation

As a third alternative, you might organize as a corporation.

• A business organized as a separate legal entity owned by stockholders is a corporation.
• Investors in a corporation receive shares of stock to indicate their ownership claim.

Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money (see Alternative Terminology).

Alternative Terminology notes present synonymous terms that you may come across in practice.

Therefore, it is easier for corporations to raise funds compared to sole proprietorships or partnerships. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate.

Other factors to consider in deciding which organizational form to choose are taxes and legal liability. Sole proprietorships or partnerships, generally receive more favorable tax treatment than corporations. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter.

Users and Uses of Financial Information

The purpose of financial information is to provide inputs for decision-making.

• Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users.
• Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, managers must answer many important questions, as shown in Illustration 1.1.

To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized financial information in the form of financial statements.

Accounting Across the Organization boxes show applications of accounting information in various business functions.

External Users

There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors, such as suppliers and bankers, use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1.2.

The information needs and questions of other external users vary considerably.

• Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws.
• Customers are interested in whether a company like Tesla will be able to honor product warranties and otherwise support its product lines.
• Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and benefits.
• Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules.

For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record profits at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to investigate the energy traders to make sure that the profits were earned by legitimate and fair practices.

Data Analytics

Accounting software systems collect vast amounts of data about a company’s economic events as well as its suppliers and customers. Business decision-makers take advantage of this wealth of data by using data analytics to gain insights and therefore make more informed business decisions.

• Data analytics involves analyzing data, often employing both software and statistics, to draw inferences.
• As both data access and analytical software improve, the use of data analytics to support decisions is becoming increasingly common at virtually all types of companies (see Helpful Hint).

Helpful Hints further clarify concepts being discussed.

Illustration 1.3 shows the four most common types of data analytics that help answer questions ranging from what happened and why did it happen, to what is likely to happen and what should we do about it? Analytics range from simple analysis that can be performed using spreadsheets with tools like pivot tables and graphs, to complex statistical software and even artificial intelligence. More complex analysis provides greater value to the business.

Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, corporate social responsibility, and data analytics.

Ethics in Financial Reporting

People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t “play” the stock market if they think stock prices are rigged. At one time, major financial scandals at Enron, WorldCom, HealthSouth, and AIG led to a mistrust of financial reporting in general.

A Wall Street Journal article noted that “repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. A well-functioning economy depends on accurate and reliable financial reporting.

U.S. regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting.

• Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals (see Ethics Note).
• As a result of SOX, top management must now certify the fairness of financial information.
• In addition, penalties for fraudulent financial activity are much more severe.
• Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate financial statements and the oversight role of boards of directors.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

Effective financial reporting depends on sound ethical behavior. When analyzing ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1.4.

Financing Activities

It takes money to make money. Financing activities involve raising money from outside sources. The two primary sources of outside funds for corporations are borrowing money (debt financing) and issuing (selling) shares of stock in exchange for cash (equity financing).

Columbia Sportswear may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom Columbia owes money are its creditors.

• Amounts owed to creditors—in the form of debt and other obligations—are called liabilities.
• Specific names are given to different types of liabilities, depending on their source. Columbia may have a note payable to a bank for the money borrowed to purchase delivery trucks.
• Debt securities sold to investors that must be repaid at a particular date some years in the future are bonds payable.

Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase.

The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a payment schedule (e.g., payment at the end of three months). As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may legally force the company to sell property to pay its debts. In the case of financial difficulty, creditor claims must be paid before stockholders’ claims.

Stockholders, on the other hand, have no claim to corporate cash until the claims of creditors are satisfied. Suppose you buy a company’s stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company’s creditors are paid amounts currently due. However, many corporations make payments to stockholders on a regular basis as long as there is sufficient cash to cover required payments to creditors. These cash payments to stockholders are called dividends.

Investing Activities

Once the company has raised cash through financing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. Resources owned by a business are called assets. A growing company purchases many assets, such as computers, delivery trucks, furniture, and buildings.

• Different types of assets are given different names; Columbia Sportswear’s sewing equipment is a type of asset referred to as property, plant, and equipment (see Alternative Terminology).
• Cash is one of the more important assets owned by Columbia or any other business.
• If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations, a type of asset referred to as investments.

Operating Activities

Once a business has the assets it needs to get started, it begins operating activities. Operating activities are the day-to-day actions taken by a company to produce and sell a product, or provide a service. Columbia Sportswear is in the business of selling outdoor clothing and footwear. It sells TurboDown jackets, Millennium snowboard pants, Sorel^® snow boots, Bugaboots™, rainwear, and anything else you might need to protect you from the elements. We call amounts earned from the sale of these products revenues.

• Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business; Columbia records revenue when it sells a footwear product.
• Revenues arise from different sources and are identified by various names depending on the nature of the business; Columbia’s primary source of revenue is the sale of sportswear (but it also generates interest revenue on debt securities held as investments).
• Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue.

The company purchases its longer-lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operating activities.

• Supplies are assets used in day-to-day operations (rather than sold to customers).
• Goods available for future sales to customers are assets called inventory.
• The right to receive money in the future is called an account receivable. If Columbia sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future.

Before Columbia can sell a single Sorel^® boot, it must purchase wool, rubber, leather, metal lace loops, laces, and other materials. It then must process, wrap, and ship the finished product. It also incurs costs like salaries, rents, and utilities. All of these costs, referred to as expenses, are necessary to produce and sell the product.

• In accounting language, expenses are the cost of assets consumed or services used in the process of generating revenues.
• Expenses take many forms and are identified by various names depending on the type of asset consumed or service used.

For example, Columbia keeps track of these types of expenses: cost of goods sold (such as the cost of materials), selling expenses (such as the cost of salespersons’ salaries), marketing expenses (such as the cost of advertising), administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corporate office), interest expense (amounts of interest paid on various debts), and income tax expense (corporate taxes paid to the government).

Columbia may also have liabilities arising from these expenses.

• For example, Columbia may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable.
• Additionally, Columbia may have interest payable on the outstanding amounts owed to the bank.
• It may also have wages payable to its employees and sales taxes payable, property taxes payable, and income taxes payable to the government.

Columbia compares the revenues of a period with the expenses of that period to determine whether it earned a profit. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.

Income Statement

The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time (see Decision Tools). To indicate that its income statement reports the results of operations for a specific period of time, Sierra Corporation dates the income statement “For the Month Ended October 31, 2025.” The income statement lists the company’s revenues followed by its expenses. Finally, Sierra determines the net income (or net loss) by deducting expenses from revenues. Sierra’s income statement is shown in Illustration 1.5 (see Helpful Hint). Congratulations, you are already showing a profit!

Decision Tools that are useful for business decision-making are highlighted throughout the text. A summary of the Decision Tools is also provided in each chapter.

Why are financial statement users interested in net income?

• Investors are interested in a company’s past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company’s future performance. If investors believe that Sierra will be successful in the future and that this will result in a higher stock price, they will buy its stock.
• Creditors use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn’t think it would be repaid, it wouldn’t loan the money. Therefore, prior to making the loan the bank loan officer uses the income statement as a source of information to predict whether the company will be profitable enough to repay its loan.

Thus, reporting a strong profit will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing.

Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (see Illustration 1.8), nor does it regard as a business expense the $500 of dividends paid (see Illustration 1.6) (see Ethics Note).

Retained Earnings Statement

If Sierra Corporation is profitable, at the end of each period it must decide what portion of profits to pay to shareholders in dividends. In theory, it could pay all of its current-period profits, but few companies do this. Why? Because they want to retain part of the profits to allow for further expansion. High-growth companies, such as Google and Facebook, often pay no dividends. Retained earnings is the net income retained in the corporation.

The retained earnings statement shows the amounts and causes of changes in retained earnings for a specific time period (see Decision Tools). The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the first line of the statement. Then, the company adds net income and deducts dividends to determine the retained earnings at the end of the period. If a company has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1.6 presents Sierra’s retained earnings statement (see Helpful Hint).

By monitoring the retained earnings statement, financial statement users can evaluate dividend payment practices.

• Some investors seek companies, such as Dow Chemical, that have a history of paying high dividends.
• Other investors seek companies, such as Amazon.com, that reinvest earnings to increase the company’s growth instead of paying dividends.
• Lenders monitor their corporate customers’ dividend payments because any money paid in dividends reduces a company’s ability to repay its debts.

Balance Sheet

The balance sheet reports assets and claims to assets at a specific point in time (see Decision Tools). Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. The owners’ claim to assets is called stockholders’ equity.

Illustration 1.7 shows the relationship among the categories on the balance sheet in equation form.

• This equation is referred to as the basic accounting equation.
• This relationship is where the name “balance sheet” comes from. Assets must balance with the claims to assets.

As you can see from looking at Sierra Corporation’s balance sheet in Illustration 1.8, the balance sheet presents the company’s financial position as of a specific date—in this case, October 31, 2025 (see Helpful Hint). It lists assets first. Assets are listed in the order of their liquidity, that is, how quickly they could be converted to cash.

Assets are followed by liabilities and stockholders’ equity (see Alternative Terminology). Stockholders’ equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the company sells new shares of stock; retained earnings is the net income retained in the corporation. Sierra has common stock of $10,000 and retained earnings of $2,360, for total stockholders’ equity of $12,360.

Creditors analyze a company’s balance sheet to determine the likelihood that they will be repaid.

• Creditors carefully evaluate the nature of the company’s assets and liabilities.
• In operating Sierra’s guide service, the balance sheet will be used to determine whether cash on hand is sufficient for immediate cash needs.
• The balance sheet will also be used to evaluate the relationship between debt and stockholders’ equity to determine whether the company has a satisfactory proportion of debt and common stock financing.

Statement of Cash Flows

The primary purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time (see Decision Tools). To help investors, creditors, and others in their analysis of a company’s cash position, the statement of cash flows reports the cash effects of a company’s operating, investing, and financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the amount of cash at the end of the period.

Users are interested in the statement of cash flows because they want to know what is happening to a company’s most important resource. The statement of cash flows provides answers to these simple but important questions:

• Where did cash come from during the period?
• How was cash used during the period?
• What was the change in the cash balance during the period?

The statement of cash flows for Sierra Corporation, in Illustration 1.9, shows that cash increased $15,200 during the month (see Helpful Hint). This increase resulted because operating activities (services to clients) increased cash $5,700, and financing activities increased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment.

Interrelationships of Statements

Illustration 1.10 shows the financial statements of Sierra Corporation (see Helpful Hints). Because the results on some financial statements become inputs to other statements, the statements are interrelated. These interrelationships can be seen in Sierra’s financial statements, as follows.

1. The retained earnings statement uses the results of the income statement. Sierra reported net income of $2,860 for the period. Net income is added to the beginning amount of retained earnings to determine ending retained earnings.
2. The balance sheet and retained earnings statement are also interrelated. Sierra reports the ending amount of $2,360 on the retained earnings statement as the retained earnings amount on the balance sheet.
3. The statement of cash flows relates to information on the balance sheet. The statement of cash flows shows how the Cash account changed during the period. It shows the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the $15,200 of cash at the end of the period. The ending amount of cash shown on the statement of cash flows must agree with the amount of cash on the balance sheet.

Study these interrelationships carefully. To prepare financial statements, you must understand the sequence in which these amounts are determined and how each statement impacts the next.

Elements of an Annual Report

Publicly traded U.S. companies must provide shareholders with an annual report. The annual report always includes the financial statements introduced in this chapter. The annual report also includes other important information such as a management discussion and analysis section, notes to the financial statements, and an independent auditor’s report. No analysis of a company’s financial situation and performance is complete without a review of these items.

Management Discussion and Analysis

The management discussion and analysis (MD&A) section presents management’s views on the company’s:

• Ability to pay near-term obligations.
• Ability to fund operations and expansion.
• Results of operations.

Management must highlight favorable or unfavorable trends and identify significant events and uncertainties that affect these three factors. This discussion obviously involves a number of subjective estimates and opinions. A brief excerpt from the MD&A section of a recent Columbia Sportswear annual report, which addresses its liquidity requirements, is presented in Illustration 1.11.

Columbia Sportswear Company Management’s Discussion and Analysis of Seasonality and Variability of Business
	Our business is affected by the general seasonal trends common to the industry, including discretionary consumer shopping and spending patterns, as well as seasonal weather. Our products are marketed on a seasonal basis, and our sales are weighted substantially toward the third and fourth quarters, while our operating costs are more equally distributed throughout the year.

Notes to the Financial Statements

Explanatory notes and supporting schedules accompany every set of financial statements and are an integral part of the statements. The notes to the financial statements clarify the financial statements and provide additional detail. Information in the notes does not have to be quantifiable (numeric). Examples of notes are:

• Descriptions of the significant accounting policies and methods used in preparing the statements.
• Explanations of uncertainties and contingencies.
• Various statistics and details too voluminous to be included in the statements.

The notes are essential to understanding a company’s operating performance and financial position.

Illustration 1.12 is an excerpt from the notes to recent Columbia Sportswear financial statements. It describes the methods that the company uses to account for revenues.

Columbia Sportswear Company Notes to Financial Statements Revenue Recognition
	Revenues are recognized when our performance obligations are satisfied as evidenced by transfer of control of promised goods to our customers, in an amount that reflects the consideration we expect to be entitled to receive in exchanges for those goods or services. Within our wholesale channel, control generally transfers to the customer upon shipment to, or upon receipt by, the customer depending on the terms of sale with the customer. Within our DTC channel, control generally transfers to the customer at the time of sale within our retail stores and concession-based arrangements and upon shipment to the customer with respect to e-commerce transactions.

Auditor’s Report

An auditor’s report is prepared by an independent outside auditor. It states the auditor’s opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles.

An auditor is an accounting professional who conducts an independent examination of a company’s financial statements. Only accountants who meet certain criteria and thereby attain the designation certified public accountant (CPA) may certify audits.

• If the auditor is satisfied that the financial statements provide a fair representation of the company’s financial position and results of operations in accordance with generally accepted accounting principles, then the auditor expresses an unqualified opinion.
• If the auditor expresses anything other than an unqualified opinion, then readers should only use the financial statements with caution.
• That is, without an unqualified opinion, we cannot have complete confidence that the financial statements give a fair picture of the company’s financial health.
• A new auditing standard requires the auditor to report any critical audit matters. These are items that are material in size that involve challenging, subjective, or complex auditor judgment.

For example, Blockbuster once dominated movie rentals in the United States with over 9,000 stores. But it faltered when the upstart Netflix rapidly took over the movie-rental business. Blockbuster’s auditor then stated that its financial situation raised “substantial doubt about the Company’s ability to continue as a going concern.” Shortly after that, the company filed for bankruptcy.

Illustration 1.13 is an excerpt from the auditor’s report from Columbia Sportswear’s 2019 annual report. Columbia received an unqualified opinion from its auditor, Deloitte & Touche.

Columbia Sportswear Company Excerpt from Auditor’s Report
	We have audited the accompanying consolidated balance sheets of Columbia Sportswear Company and subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive income, equity, and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and schedule listed in the Index at Item 15 (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America.

Using the Decision Tools comprehensive exercises ask you to apply business information and the decision tools presented in the chapter. Most of these exercises are based on the companies highlighted in the Feature Story.

“Show Me the Money”

How much can a new accountant make? Take a look at the average salaries for college graduates in public and private accounting shown in Illustration 1A.2.¹ Keep in mind if you also have a CPA license, you’ll make 10–15% more when you start out.

Illustration 1A.3 lists some examples of upper-level salaries for managers in corporate accounting. Note that geographic region, experience, education, CPA certification, and company size each play a role in determining salary.

Learning Objectives Review

A sole proprietorship is a business owned by one person. A partnership is a business owned by two or more people associated as partners. A corporation is a separate legal entity for which evidence of ownership is provided by shares of stock.

Internal users are managers who need accounting information to plan, organize, and run business operations. The primary external users are investors and creditors. Investors (stockholders) use accounting information to decide whether to buy, hold, or sell shares of a company’s stock. Creditors (suppliers and bankers) use accounting information to assess the risk of granting credit or loaning money to a business. Other groups who have an indirect interest in a business are taxing authorities, customers, labor unions, and regulatory agencies.

Financing activities involve collecting the necessary funds to support the business. Investing activities involve acquiring the resources necessary to run the business. Operating activities involve putting the resources of the business into action to generate a profit.

An income statement presents the revenues and expenses of a company for a specific period of time. A retained earnings statement summarizes the changes in retained earnings that have occurred for a specific period of time. A balance sheet reports the assets, liabilities, and stockholders’ equity of a business at a specific date. A statement of cash flows summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time.

Assets are resources owned by a business. Liabilities are the debts and obligations of the business. Liabilities represent claims of creditors on the assets of the business. Stockholders’ equity represents the claims of owners on the assets of the business. Stockholders’ equity is subdivided into two parts: common stock and retained earnings. The basic accounting equation is Assets = Liabilities + Stockholders’ Equity.

Within the annual report, the management discussion and analysis provides management’s interpretation of the company’s results and financial position as well as a discussion of plans for the future. Notes to the financial statements provide additional explanation or detail to make the financial statements more informative. The auditor’s report expresses an opinion as to whether the financial statements present fairly the company’s results of operations and financial position.

Accounting offers many different jobs in fields such as public and private accounting, governmental, and forensic accounting. Accounting is a popular major because there are many different types of jobs, with unlimited potential for career advancement.

Decision Tools Review

Glossary Review

Accounting

The information system that identifies, records, and communicates the economic events of an organization to interested users.

Annual report

A report prepared by corporate management that presents financial information including financial statements, a management discussion and analysis section, notes, and an independent auditor’s report.

Assets

Resources owned by a business.

*Auditing

The examination of financial statements by a certified public accountant in order ro express an opinion as to the fairness of presentation.

Auditor’s report

A report prepared by an independent outside auditor stating the auditor’s opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles.

Balance sheet

A financial statement that reports the assets and claims to those assets at a specific point in time.

Basic accounting equation

Assets = Liabilities + Stockholders’ Equity.

Certified public accountant (CPA)

An individual who has met certain criteria and is thus allowed to perform audits of corporations.

Common stock

Term used to describe the total amount paid in by stockholders for the shares they purchase.

Corporation

A business organized as a separate legal entity owned by stockholders.

Data analytics

The evaluation of data, often employing both software and statistics, to draw inferences.

Dividends

Payments of cash from a corporation to its stockholders.

Expenses

The cost of assets consumed or services used in the process of generating revenues.

*Forensic accounting

An area of accounting that uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud.

Income statement

A financial statement that reports a company’s revenues and expenses and resulting net income or net loss for a specific period of time.

Liabilities

Amounts owed to creditors in the form of debts and other obligations.

*Management consulting

An area of public accounting ranging from development of accounting and computer systems to support services for marketing projects and merger and acquisition activities.

Management discussion and analysis (MD&A)

A section of the annual report that presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations.

Net income

The amount by which revenues exceed expenses.

Net loss

The amount by which expenses exceed revenues.

Notes to the financial statements

Notes that clarify information presented in the financial statements and provide additional detail.

Partnership

A business owned by two or more persons associated as partners.

Retained earnings

The amount of net income retained in the corporation.

Retained earnings statement

A financial statement that summarizes the amounts and causes of changes in retained earnings for a specific time period.

Revenue

The increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business.

Sarbanes-Oxley Act (SOX)

Regulations passed by Congress to reduce unethical corporate behavior.

Sole proprietorship

A business owned by one person.

Statement of cash flows

A financial statement that provides financial information about the cash receipts and cash payments of a business for a specific period of time.

Stockholders’ equity

The owners’ claim to assets.

*Taxation

An area of public accounting involving tax advice, tax planning, preparing tax returns, and representing clients before governmental agencies.

Practice Multiple-Choice Questions

Practice Brief Exercises

Practice Exercises

Practice Problems

Questions

Brief Exercises

Describe forms of business organization.

BE1.1 (LO 1), K Match each of the following forms of business organization with a set of characteristics: sole proprietorship (SP), partnership (P), and corporation (C).

1. _____ Shared control, tax advantages, increased skills and resources.
2. _____ Simple to set up and maintains control with owner.
3. _____ Easier to transfer ownership and raise funds, no personal liability.

Identify forms of business organization.

E1.2 (LO 1), C Consider the following statements.

Instructions

Complete the above by indicating if each of the statements is normally true (T) or false (F) for each type of business organization: sole proprietorship, partnership, and corporation.

Identify users of accounting information.

E1.3 (LO 1), C The following list presents different types of evaluations made by various users of accounting information.

1. Determining if the company can pay for purchases made on account.
2. Determining if the company has complied with income tax regulations.
3. Determining if the company might afford a 1% hourly wage increase.
4. Determining if an advertising campaign was cost-effective.
5. Determining if the company’s net income might result in a share price increase.
6. Determining if the company should use debt or equity financing.

Instructions

Complete the following by indicating (a) the number of the evaluation (1 to 6) that the user would most likely make, and (b) if the user is internal or external.

Match items with descriptions.

E1.4 (LO 1, 2, 3), K The following terms or phrases are discussed in this chapter.

1. Certified public accountant (CPA).
2. Management discussion and analysis (MD&A).
3. Revenue.
4. Dividends.
5. Stockholders’ equity.
6. Net loss.
7. Sole proprietorship.
8. Basic accounting equation.
9. Expenses.
10. Liabilities.
11. Sarbanes-Oxley Act (SOX).

Instructions

Match each term or phrase to its description below.

1. ______ Assets = Liabilities + Stockholders’ Equity.
2. ______ An individual who has met certain criteria and is thus allowed to perform audits of corporations.
3. ______ Payments of cash from a corporation to its stockholders.
4. ______ The cost of assets consumed or services used in the process of generating revenues.
5. ______ Amounts owed to creditors in the form of debts and other obligations.
6. ______ A section of the annual report that presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations.
7. ______ The amount by which expenses exceed revenues.
8. ______ The increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business.
9. ______ Regulations passed by Congress to reduce unethical corporate behavior.
10. ______ A business owned by one person.
11. ______ The owners’ claim to assets.

Identify business activities.

E1.5 (LO 2), C All businesses are involved in three types of activities—financing, investing, and operating. Listed below are the names and descriptions of companies in several different industries.

1. Abitibi-Consolidated Inc.—manufacturer and marketer of newsprint
2. California State University—Northridge Student Union—university student union
3. Oracle Corporation—computer software developer and retailer
4. Aquilini Investment Group—owner of the Vancouver Canucks ice hockey team
5. Grant Thornton LLP—professional accounting and business advisory firm
6. Southwest Airlines—low-cost airline

Instructions

1. For each of the above companies, provide examples of (1) a financing activity, (2) an investing activity, and (3) an operating activity that the company likely engages in.
2. Which of the activities that you identified in (a) are common to most businesses? Which activities are not?

Classify business activities.

E1.6 (LO 2), K Consider the following business activities that occur at a Colorado ski area.

1. ______ Cash receipts from customers paying for daily ski passes.
2. ______ Payments made to purchase additional snow-making equipment.
3. ______ Payments made to repair the snow-grooming machines.
4. ______ Receipt of funds from the bank to finance the purchase of additional snow-making equipment.
5. ______ Issue of shares to raise funds for a planned expansion.
6. ______ Repayment of a portion of the bank loan (see item 4).
7. ______ Payment of salaries to the ski-lift operators.
8. ______ Payment of dividend to shareholders.

Instructions

Classify each of the above items by type of business activity: operating (O), investing (I), or financing (F).

Classify accounts.

E1.7 (LO 2, 3), C The Bonita Vista Golf & Country Club details the following accounts in its financial statements.

Instructions

Classify each of the accounts as an asset (A), liability (L), stockholders’ equity (SE), revenue (R), or expense (E) item.

Identify financial statements.

E1.8 (LO 3), K Consider the following typical accounts and statement items.

1. ______ Interest income.
2. ______ Cash
3. ______ Cash provided by operating activities.
4. ______ Service revenue.
5. ______ Common stock.
6. ______ Dividends.
7. ______ Retained earnings, beginning of period.
8. ______ Accounts receivable.
9. ______ Inventory.
10. ______ Income tax expense.
11. ______ Interest expense.
12. ______ Net cash used by investing activities.
13. ______ Equipment.
14. ______ Total stockholders’ equity.
15. ______ Bank loan payable.

Instructions

Indicate on which statement—income statement (IS), balance sheet (BS), retained earning statement (RE), and/or statement of cash flows (SCF)—you would find each of the above accounts or items.

Prepare income statement and retained earnings statement.

E1.9 (LO 3), AP This information relates to Benser Co. for the year 2025.

Instructions

Prepare an income statement and a retained earnings statement for the year ending December 31, 2025.

Prepare income statement and retained earnings statement.

E1.10 (LO 3), AP Suppose the following information was taken from the 2025 financial statements of pharmaceutical giant Merck & Co. (All dollar amounts are in millions.)

Instructions

1. After analyzing the data, prepare an income statement and a retained earnings statement for the year ending December 31, 2025.
2. Suppose that Merck decided to reduce its research and development expense by 50%. What would be the short-term implications? What would be the long-term implications? How do you think the stock market would react?

Prepare a retained earnings statement.

E1.11 (LO 3), AP Presented here is information for Zheng Inc. for 2025.

Instructions

Prepare the 2025 retained earnings statement for Zheng Inc.

Prepare a balance sheet.

E1.12 (LO 3), AP The following information is available for Randall Inc.

Instructions

Using the information above, prepare a balance sheet as of December 31, 2025. (Hint: Solve for the missing retained earnings amount after first determining total assets and total liabilities.)

Interpret financial data.

E1.13 (LO 3), AN Consider each of the following independent situations.

1. The retained earnings statement of Lee Corporation shows dividends of $68,000, while net income for the year was $75,000.
2. The statement of cash flows for Steele Corporation shows that cash provided by operating activities was $10,000, cash used in investing activities was $110,000, and cash provided by financing activities was $130,000.

Instructions

For each company, provide a brief discussion interpreting these financial data. For example, you might discuss the company’s financial health or its apparent growth philosophy.

Identify financial statement components and prepare income statement.

E1.14 (LO 3), AP The following items and amounts were taken from Lonyear Inc.’s 2025 income statement and balance sheet.

Instructions

1. In each, case, identify on the blank line whether the item is an asset (A), liability (L), stockholders’ equity (SE), revenue (R), or expense (E) item.
2. Prepare an income statement for Lonyear Inc. for the year ended December 31, 2025.

Identify financial statement components and prepare income statement.

E1.15 (LO 3), AP The following items and amounts were taken from Familia Inc.’s 2025 income statement and balance sheet, the end of its first year of operations.

Instructions

1. In each case, identify on the blank line whether the item is an asset (A), liability (L), stockholders’ equity (SE), revenue (R), or expense (E) item.
2. Prepare an income statement for Familia Inc. for December 31, 2025.

Calculate missing amounts.

E1.16 (LO 3), AN Here are incomplete financial statements for Donavan, Inc.

Instructions

Calculate the missing amounts.

Calculate missing amounts.

E1.17 (LO 3), AN Here are incomplete financial statements for Oway Corporation.

Instructions

Calculate the missing amounts.

Compute net income and prepare a retained earnings statement and balance sheet.

E1.18 (LO 3), AP Otay Lakes Park is a private camping ground near the Mount Miguel Recreation Area. It has compiled the following financial information as of December 31, 2025.

Instructions

1. Determine Otay Lakes Park’s net income for 2025.
2. Prepare a retained earnings statement and a balance sheet for Otay Lakes Park as of December 31, 2025.
3. Upon seeing this income statement, Walt Jones, the campground manager, immediately concluded, “The general store is more trouble than it is worth—let’s get rid of it.” The marketing director isn’t so sure this is a good idea. What do you think?

Identify financial statement components and prepare an income statement.

E1.19 (LO 3), AP Kellogg Company is the world’s leading producer of ready-to-eat cereal and a leading producer of grain-based convenience foods such as frozen waffles and cereal bars. Suppose the following items were taken from its 2025 income statement and balance sheet. (All dollars are in millions.)

Instructions

1. In each case, identify whether the item is an asset (A), liability (L), stockholders’ equity (SE), revenue (R), or expense (E).
2. Prepare an income statement for Kellogg Company for the year ended December 31, 2025.

Prepare a statement of cash flows.

E1.20 (LO 3), AP This information is for Williams Corporation for the year ended December 31, 2025.

Instructions

1. Prepare the 2025 statement of cash flows for Williams Corporation.
2. Suppose you are one of Williams’ creditors. Referring to the statement of cash flows, evaluate Williams’ ability to repay its creditors.

Prepare a statement of cash flows.

E1.21 (LO 3), AP Suppose the following data are derived from the 2025 financial statements of Southwest Airlines. (All dollars are in millions.) Southwest has a December 31 year-end.

Instructions

1. After analyzing the data, prepare a statement of cash flows for Southwest Airlines for the year ended December 31, 2025.
2. Discuss whether the company’s net cash provided by operating activities was sufficient to finance its investing activities. If it was not, how did the company finance its investing activities?

Correct an incorrectly prepared balance sheet.

E1.22 (LO 3), AP Wayne Holtz is the bookkeeper for Beeson Company. Wayne has been trying to get the balance sheet of Beeson Company to balance. It finally balanced, but now he’s not sure it is correct.

Instructions

Prepare a correct balance sheet.

Classify items as assets, liabilities, and stockholders’ equity, and prepare accounting equation.

E1.23 (LO 3), AP Suppose the following items were taken from the balance sheet of Nike, Inc. (All dollars are in millions.)

Instructions

Perform each of the following.

1. Classify each of these items as an asset (A), liability (L), or stockholders’ equity (SE) item.
2. Determine Nike’s accounting equation by calculating the value of total assets, total liabilities, and total stockholders’ equity.
3. To what extent does Nike rely on debt versus equity financing?

Use financial statement relationships to determine missing amounts.

E1.24 (LO 3), AN The summaries of data from the balance sheet, income statement, and retained earnings statement for two corporations, Walco Corporation and Gunther Enterprises, are presented as follows for 2025.

Instructions

Determine the missing amounts. Assume all changes in stockholders’ equity are due to changes in retained earnings.

Classify various items in an annual report.

E1.25 (LO 3), K The annual report provides financial information in a variety of formats, including the following.

Management discussion and analysis (MD&A)

Financial statements

Notes to the financial statements

Auditor’s opinion

Instructions

For each of the following, state in what area of the annual report the item would be presented. If the item would probably not be found in an annual report, state “Not disclosed.”

1. The total cumulative amount received from stockholders in exchange for common stock.
2. An independent assessment concerning whether the financial statements present a fair depiction of the company’s results and financial position.
3. The interest rate that the company is being charged on all outstanding debts.
4. Total revenue from operating activities.
5. Management’s assessment of the company’s results.
6. The names and positions of all employees hired in the last year.

Classify accounts and prepare balance sheet.

E1.26 (LO 3), AP The following list of accounts, in alphabetical order, is for Aventura Inc. at November 30, 2025.

Instructions

1. For each of the above accounts, identify whether it is an asset (A), liability (L), or stockholders’ equity (SE) item.
2. Prepare a balance sheet at November 30, 2025.

Identify users and uses of financial statements.

P1.2 (LO 3), C Financial decisions often place heavier emphasis on one type of financial statement over the others. Consider each of the following hypothetical situations independently.

1. The North Face is considering extending credit to a new customer. The terms of the credit would require the customer to pay within 30 days of receipt of goods.
2. An investor is considering purchasing common stock of Amazon.com. The investor plans to hold the investment for at least 5 years.
3. JPMorgan Chase is considering extending a loan to a small company. The company would be required to make interest payments at the end of each year for 5 years, and to repay the loan at the end of the fifth year.
4. The president of Campbell Soup is trying to determine whether the company is generating enough cash to increase the amount of dividends paid to investors in this and future years, and still have enough cash to buy equipment as it is needed.

Instructions

In each situation, state whether the decision-maker would be most likely to place primary emphasis on information provided by the income statement, balance sheet, or statement of cash flows. In each case provide a brief justification for your choice. Choose only one financial statement in each case.

Prepare an income statement, retained earnings statement, and balance sheet; discuss results.

P1.3 (LO 3), AP On June 1, 2025, Elite Service Co. was started with an initial investment in the company of $22,100 cash. Here are the assets, liabilities, and common stock of the company at June 30, 2025, and the revenues and expenses for the month of June, its first month of operations:

During June, the company issued no additional stock but paid dividends of $1,400.

Check figures provide a key number to let you know you are on the right track.

Instructions

1. Prepare an income statement and a retained earnings statement for the month of June and a balance sheet at June 30, 2025.

   Net income	$3,800
   	Ret. earnings	$2,400
   	Tot. assets	$37,000

2. Briefly discuss whether the company’s first month of operations was a success.
3. Discuss the company’s decision to distribute a dividend.

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

P1.4 (LO 3), AP Reese Inc., a provider of consulting services, was founded on October 1, 2025. At the end of the first month of operations, the company decided to prepare an income statement, retained earnings statement, and balance sheet using the following information.

Instructions

Using the information, prepare an income statement and retained earnings statement for the month of October 2025 and a balance sheet as of October 31, 2025.

Determine items included in a statement of cash flows, prepare the statement, and comment.

P1.5 (LO 3), AP Presented below is selected financial information for Rojo Corporation for December 31, 2025.

Instructions

1. prepare the statement of cash flows for Rojo Corporation.

   Net cash increase

   $31,000

2. Comment on the adequacy of net cash provided by operating activities to fund the company’s investing activities and dividend payments.

Comment on proper accounting treatment and prepare a corrected balance sheet.

P1.6 (LO 3), AN Micado Corporation was formed on January 1, 2025. At December 31, 2025, Miko Liu, the president and sole stockholder, decided to prepare a balance sheet, which appeared as follows.

Miko willingly admits that she is not an accountant by training. She is concerned that her balance sheet might not be correct. She has provided you with the following additional information.

1. The boat actually belongs to Miko, not to Micado Corporation. However, because she thinks she might take customers out on the boat occasionally, she decided to list it as an asset of the company. To be consistent, she also listed as a liability of the corporation her personal loan that she took out at the bank to buy the boat.
2. The inventory was originally purchased for $25,000, but due to a surge in demand Miko now thinks she could sell it for $36,000. She thought it would be best to record it at $36,000.
3. Included in the accounts receivable balance is $10,000 that Miko loaned to her brother 5 years ago. Miko included this in the receivables of Micado Corporation so she wouldn’t forget that her brother owes her money.

Instructions

1. Comment on the proper accounting treatment of the three items above.
2. Provide a corrected balance sheet for Micado Corporation. (Hint: To get the balance sheet to balance, adjust stockholders’ equity.)

   Tot. assets

   $85,000

Cookie Creations

The Cookie Creations case starts in Chapter 1 and continues in every chapter. Complete case details and instructions are available in Wiley Course Resources.

CCC1 Natalie Koebel spent much of her childhood learning the art of cookie-making from her grand mother. They spent many happy hours mastering every type of cookie imaginable and later devised new recipes that were both healthy and delicious. Now at the start of her second year in college, Natalie is investigating possibilities for starting her own business as part of the entrepreneurship program in which she is enrolled.

A long-time friend insists that Natalie has to include cookies in her business plan. After a series of brainstorming sessions, Natalie settles on the idea of operating a cookie-making school. She will start on a part-time basis and offer her services in people’s homes. Now that she has started thinking about it, the possibilities seem endless. During the fall, she will concentrate on holiday cookies. She will offer group sessions (which will probably be more entertainment than education) and individual lessons. Natalie also decides to include children in her target market. The first difficult decision is coming up with the perfect name for her business. She settles on “Cookie Creations,” and then moves on to more important issues.

Instructions

1. What form of business organization—proprietorship, partnership, or corporation— do you recommend that Natalie use for her business? Discuss the benefits and weaknesses of each form that Natalie might consider.
2. Will Natalie need accounting information? If yes, what information will she need and why? How often will she need this information?
3. Identify specific asset, liability, revenue, and expense accounts that Cookie Creations will likely use to record its business transactions.
4. Should Natalie open a separate bank account for the business? Why or why not?
5. Natalie expects she will have to use her car to drive to people’s homes and to pick up supplies, but she also needs to use her car for personal reasons. She recalls from her first-year accounting course something about keeping business and personal assets separate. She wonders what she should do for accounting purposes. What do you recommend?

Financial Reporting Problem: Apple Inc.

CT1.1 The financial statements of Apple Inc. are presented in Appendix A.

Instructions

Refer to Apple’s financial statements and answer the following questions.

1. What were Apple’s total assets at September 26, 2020? At September 28, 2019?
2. How much cash (and cash equivalents) did Apple have on September 26, 2020?
3. What amount of accounts payable did Apple report on September 26, 2020? On September 28, 2019?
4. What were Apple’s net sales in the year ending September 26, 2020? In the year ending September 28, 2019? In the year ending September 29, 2018?
5. What is the amount of the change in Apple’s net income from 2019 to 2020?

Comparative Analysis Problem: Columbia Sportswear Company vs. Under Armour, Inc.

CT1.2 Columbia Sportswear Company’s financial statements are presented in Appendix B. Financial statements of Under Armour, Inc. are presented in Appendix C.

Instructions

1. Based on the information in these financial statements, determine the following for each company.
   1. Total liabilities at December 31, 2020.
   2. Net property, plant, and equipment at December 31, 2020.
   3. Net cash provided or (used) in investing activities for 2020.
   4. Net income for 2020.
2. What conclusions concerning the two companies can you draw from these data?

Comparative Analysis Problem: Amazon.com, Inc. vs. Walmart Inc.

CT1.3 Amazon.com, Inc.’s financial statements are presented in Appendix D. Financial statements of Walmart Inc. are presented in Appendix E.

Instructions

1. Based on the information contained in these financial statements, determine the following for each company.
   1. Total assets at December 31, 2020, for Amazon and for Walmart at January 31, 2021.
   2. Receivables (net) at December 31, 2020, for Amazon and for Walmart at January 31, 2021.
   3. Net sales (product only) for the year ended in 2020 (2021 for Walmart).
   4. Net income for year ended in 2020 (2021 for Walmart).
2. What conclusions concerning these two companies can be drawn from these data?

Interpreting Financial Statements

CT1.4 Xerox was not having a particularly pleasant year. The company’s stock price had already fallen in the previous year from $60 per share to $30. Just when it seemed things couldn’t get worse, Xerox’s stock fell to $4 per share. The following data were taken from the statement of cash flows of Xerox. (All dollars are in millions.)

Instructions

Analyze the information and then answer the following questions.

1. If you were a creditor of Xerox, what reaction might you have to the above information?
2. If you were an investor in Xerox, what reaction might you have to the above information?
3. If you were evaluating the company as either a creditor or a stockholder, what other information would you be interested in seeing?
4. Xerox decided to pay a cash dividend. This dividend was approximately equal to the amount paid in the previous year. Discuss the issues that were probably considered in making this decision.

Real-World Focus

CT1.5 You can easily search the Internet to find summary information about companies. This information includes basic descriptions of the company’s location, activities, industry, financial health, and financial performance.

Instructions

Go to the Yahoo! Finance website, type in a company name, and then use the links (such as Financials) to locate the information necessary to answer the following questions.

1. What is the company’s net income? Over what period was this measured?
2. What is the company’s total sales? Over what period was this measured?
3. What is the company’s industry?
4. What are the names of four companies in this industry?
5. Choose one of the competitors. What is this competitor’s name? What is its total sales? What is its net income?

CT1.6 The Wall Street Journal published an article by Michael Rapoport entitled “Coming Soon: What Auditors Really Think About Company Numbers.” It provides a discussion about changes to be made to the auditor’s report.

Instructions

Read the article and then answer the following questions.

1. What did the old auditor’s report primarily focus on?
2. What does the new report provide beyond the old report? What are some examples of items that might be discussed?
3. How do the requirements of the new report compare to the requirements of auditor reports in other countries?
4. What criteria must be met in other for an item to be disclosed in the new report?

Decision-Making Across the Organization

CT1.7 Sylvia Ayala recently accepted a job in the production department at Johnson & Johnson. Before she starts work, she decides to review the company’s annual report to better understand its operations.

The content and organization of corporate annual reports have become fairly standardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional financial portions of the annual report.

• Financial Highlights
• Letter to the Stockholders
• Management’s Discussion and Analysis
• Financial Statements
• Notes to the Financial Statements
• Management’s Responsibility for Financial Reporting
• Management’s Report on Internal Control over Financial Reporting
• Report of Independent Registered Public Accounting Firm
• Selected Financial Data

The official SEC filing of the annual report is called a Form 10-K, which often omits the public relations pieces found in most standard annual reports.

Instructions

Search the Internet to find Johnson & Johnson’s 10-K report dated for the year ended January 3, 2021, to answer the following questions.

1. What CPA firm performed the audit of Johnson & Johnson’s financial statements?
2. What was the amount of Johnson & Johnson’s basic earnings per share for the year ended January 3, 2021?
3. What are the company’s net sales in foreign countries during the year ended January 3, 2021?
4. What were net sales during the year ended December 30, 2018?
5. How many shares of common stock have been authorized?
6. How much cash was spent on capital expenditures during the year ended January 3, 2021?
7. Over what life does the company depreciate its buildings?
8. What was the value of inventory on December 29, 2019?

Communication Activities

CT1.8 Marci Ling is the bookkeeper for Samco Company, Inc. Marci has been trying to get the company’s balance sheet to balance. She finally got it to balance, but she still isn’t sure that it is correct.

Instructions

Explain to Marci Ling in a memo (a) the purpose of a balance sheet, and (b) why this balance sheet is incorrect and what she should do to correct it.

Ethics Cases

CT1.9 Rules governing the investment practices of individual certified public accountants prohibit them from investing in the stock of a company that their firm audits. The Securities and Exchange Commission (SEC) became concerned that some accountants were violating this rule. In response to an SEC investigation, PricewaterhouseCoopers (PwC) fired 10 people and spent $25 million educating employees about the investment rules and installing an investment tracking system.

Instructions

Answer the following questions.

1. Why do you think rules exist that restrict auditors from investing in companies that are audited by their firms?
2. Some accountants argue that they should be allowed to invest in a company’s stock as long as they themselves aren’t involved in working on the company’s audit or consulting. What do you think of this idea?
3. Today, a very high percentage of publicly traded companies are audited by only four very large public accounting firms. These firms also do a high percentage of the consulting work that is done for publicly traded companies. How does this fact complicate the decision regarding whether CPAs should be allowed to invest in companies audited by their firm?
4. Suppose you were a CPA and you had invested in IBM when IBM was not one of your firm’s clients. Two years later, after IBM’s stock price had fallen considerably, your firm won the IBM audit contract. You will be involved in working with the IBM audit. You know that your firm’s rules require that you sell your shares immediately. If you do sell immediately, you will sustain a large loss. Do you think this is fair? What would you do?
5. Why do you think PwC took such extreme steps in response to the SEC investigation?

CT1.10 Ethical behavior is fundamental to communications between investors and companies. However, it is difficult for company founders to control their enthusiasm in discussions related to their company, such that sometimes new companies overstate their potential for future success, either intentionally or unintentionally, in order to generate investor interest.

For example, Nikola Corporation, a pioneer in electric semi-trucks, was investigated by U.S. securities regulators because critics claimed that the company’s chairperson made false claims about the company’s progress in his efforts to make Nikola “the Tesla of semi-trucks.” Shortly after its stock began trading publicly, the company was estimated to be worth $30 billion, even though it had yet to produce its first electric truck. Similarly, Tesla’s founder and CEO, Elon Musk, has been investigated by the Securities and Exchange Commission a number of times regarding the accuracy of his communications, including Tweets.

Instructions

In groups, discuss the following topics.

1. Should companies be held accountable for the fairness of their communications, or instead should it be the responsibility of investors to determine whether company statements are true and fair?
2. Suppose that you founded a new company. What steps would you take to ensure that your communications were accurate, while still generating enthusiasm with investors?
3. Search the Internet to find information about the allegations and any results of regulatory investigations regarding the accuracy of Elon Musk’s communications about Tesla. Provide a brief summary of your findings.
4. What are the potential costs to society of inaccurate company communications to investors?

All About You

CT1.11 Some people are tempted to make their finances look worse to get financial aid. Companies sometimes also manage their financial numbers in order to accomplish certain goals. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. In managing earnings, companies’ actions vary from being within the range of ethical activity, to being both unethical and illegal attempts to mislead investors and creditors.

Instructions

Provide responses for each of the following questions.

1. Discuss whether you think each of the following actions (adapted from the FinAid website) to increase the chances of receiving financial aid is ethical.
   1. Spend down the student’s assets and income first, before spending parents’ assets and income.
   2. Accelerate necessary expenses to reduce available cash. For example, if you need a new car, buy it before applying for financial aid.
   3. State that a truly financially dependent child is independent.
   4. Have a parent take an unpaid leave of absence for long enough to get below the “threshold” level of income.
2. What are some reasons why a company might want to overstate its earnings?
3. What are some reasons why a company might want to understate its earnings?
4. Under what circumstances might an otherwise ethical person decide to illegally overstate or understate earnings?

FASB Codification Activity

CT1.12 The FASB has developed the Financial Accounting Standards Board Accounting Standards Codification (or more simply “the Codification”). The FASB’s primary goal in developing the Codification is to provide in one place all the authoritative literature related to a particular topic. To provide easy access to the Codification, the FASB also developed the Financial Accounting Standards Board Codification Research System (CRS). CRS is an online, real-time database that provides easy access to the Codification. The Codification and the related CRS provide a topically organized structure, subdivided into topic, subtopics, sections, and paragraphs, using a numerical index system.

You may find this system useful in your present and future studies, and so we have provided an opportunity to use this online system as part of the Expand Your Critical Thinking section.

Instructions

Academic access to the FASB Codification is available through university subscriptions, obtained from the American Accounting Association. This subscription covers an unlimited number of students within a single institution. Once this access has been obtained by your school, you should log in and familiarize yourself with the resources that are accessible at the FASB Codification site.

Considering People, Planet, and Profit

CT1.13 Although Clif Bar & Company is not a public company, it does share its financial information with its employees as part of its open-book management approach. Further, although it does not publicly share its financial information, it does provide a different form of an annual report to external users. In this report, the company provides information regarding its sustainability efforts.

Instructions

Go to the “Who We Are” page at the Clif Bar website and then identify the company’s five aspirations.

The following are the key similarities and differences between GAAP and IFRS as related to accounting fundamentals.

Similarities

• The basic techniques for recording business transactions are the same for U.S. and international companies.
• Both international and U.S. accounting standards emphasize transparency in financial reporting. Both sets of standards are primarily driven by meeting the needs of investors and creditors.
• The three most common forms of business organizations, proprietorships, partnerships, and corporations, are also found in countries that use international accounting standards.

Differences

• International standards are referred to as International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board. Accounting standards in the United States are referred to as generally accepted accounting principles (GAAP) and are developed by the Financial Accounting Standards Board.
• IFRS tends to be simpler in its accounting and disclosure requirements; some people say it is more “principles-based.” GAAP is more detailed; some people say it is more “rules-based.”
• The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation.

IFRS Practice

Answers to IFRS Self-Test Questions

1. d2. c3. a

Just Fooling Around?

Two early pioneers in providing investment information online to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare’s As You Like It. The fool in Shakespeare’s play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st-century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders.

The Motley Fool’s online bulletin board enables investors to exchange information and insights about companies. (Similar services are provided by TikTok, Twitter, Reddit, Facebook, and others.) Critics of these bulletin boards contend that they are simply high-tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.

Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.

Current Assets

Current assets are defined as follows.

• Assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2.2, Franklin Corporation had current assets of $22,100.
• For most businesses, the cutoff for classification as current assets is one year from the balance sheet date.

For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.

Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year.

• The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers.
• For most businesses, this cycle takes less than a year, so they use a one-year cutoff.
• But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year.

Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term.

Companies list current assets in order of liquidity, that is, the order in which they expect to convert them into cash (follow this rule when doing your homework). Common types of current assets, listed in order of liquidity, are:

1. Cash.
2. Investments (such as short-term U.S. government securities).
3. Receivables (accounts receivable, notes receivable, and interest receivable).
4. Inventories.
5. Prepaid expenses (insurance and supplies).

Why are receivables considered more liquid than inventory? Inventory must be sold before it is converted to cash (and is often sold on account), whereas receivables are converted to cash upon collection.

As explained later in the chapter, a company’s current assets are important in assessing its short-term debt-paying ability.

Long-Term Investments

Long-term investments generally include the following (see Alternative Terminology).

• Investments in stocks and bonds of other corporations that are held for more than one year.
• Long-term assets such as land or buildings that a company is not currently using in its operating activities.
• Long-term notes receivable.

In Illustration 2.2, Franklin Corporation reported total long-term investments of $7,200 on its balance sheet.

Property, Plant, and Equipment

Property, plant, and equipment is defined as follows.

• Assets with relatively long useful lives that are currently used in operating the business (see Alternative Terminology).
• This category includes land, buildings, equipment, delivery vehicles, and furniture.

In Illustration 2.2, Franklin Corporation reported property, plant, and equipment of $29,000.

Notice that in Illustration 2.2, Franklin Corporation subtracts $5,000 in Accumulated Depreciation—Equipment from the Equipment account. Depreciation is the systematic allocation of the cost of an asset to expense over number of years (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation, often referred to as book value. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life.

In Illustration 2.2, Franklin Corporation reported accumulated depreciation of $5,000, so the book value of the equipment is $19,000 ($24,000 – $5,000). In your homework, present each accumulated depreciation account immediately below the related plant asset, as shown in Illustration 2.2 for Franklin Corporation.

Intangible Assets

Many companies have assets that do not have physical substance and yet often are very valuable:

• We call these assets intangible assets (see Helpful Hint).
• One common intangible is goodwill.
• Other intangibles include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specified period of time.

In Illustration 2.2, Franklin Corporation reported intangible assets of $3,100.

Current Liabilities

In the liabilities and stockholders’ equity section of the balance sheet, the first grouping is current liabilities.

• Current liabilities are obligations that the company is to pay within the next year or operating cycle, whichever is longer.
• Common examples are accounts payable, salaries and wages payable, notes payable, unearned revenue, interest payable, and income taxes payable.
• Also included as current liabilities are current maturities of long-term obligations—payments to be made within a year of the balance sheet date on long-term obligations.

In Illustration 2.2, Franklin Corporation reported five different types of current liabilities, for a total of $16,050.

Long-Term Liabilities

Long-term liabilities (long-term debt) are:

• Obligations that a company expects to pay after one year.
• Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities.

Many companies report long-term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the financial statements. Others list the various types of long-term liabilities. In Illustration 2.2, Franklin Corporation reported long-term liabilities of $11,300.

Stockholders’ Equity

Stockholders’ equity consists of two parts: common stock and retained earnings.

• Companies record as common stock the investments of assets into the business by the stockholders (see Alternative Terminology).
• They record as retained earnings the income retained for use in the business.
• These two parts, combined, make up stockholders’ equity on the balance sheet.

In Illustration 2.2, Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.

Ratio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary financial statements, we classify ratios as shown in Illustration 2.3.

A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:

1. Intracompany comparisons covering two years for the same company.
2. Industry-average comparisons based on average ratios for particular industries.
3. Intercompany comparisons based on comparisons with a competitor in the same industry.

Next, we use some ratios and comparisons to analyze the financial statements of Best Buy.

Using the Income Statement

Best Buy generates profits for its stockholders by selling electronics.

• The income statement reveals how successful the company is at generating a profit from its sales.
• The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses).

Illustration 2.4 shows a simplified income statement for Best Buy. From this income statement, we can see that Best Buy’s net income increased from $1,464 million to $1,541 million.

Best Buy Co., Inc. Income Statements For the Year Ended February 1, 2020, and the Year Ended February 2, 2019 (in millions)
		2020	2019
	Revenues
	Net sales and other revenue	$43,686	$42,940
	Expenses
	Cost of goods sold	33,590	32,918
	Selling, general, and administrative expenses and other	8,103	8,134
	Income tax expense	452	424
	Total expenses	42,145	41,476
	Net income (loss)	$1,541	$1,464

hhgregg was a competitor of Best Buy. hhgregg was much smaller than Best Buy. At one time, hhgregg operated 228 stores in 20 states. Then, one year it reported a net loss of $54,879,000. The next year, it filed for bankruptcy. Just because a company has a net loss does not mean it is about to go bankrupt. However, because net losses are not sustainable over the long-term, they are worthy of investigation.

To evaluate the profitability of Best Buy, we will use ratio analysis. Profitability ratios, such as earnings per share, measure the operating success of a company for a given period of time.

Using a Classified Balance Sheet

You can learn a lot about a company’s financial health by also evaluating the relationship between its various assets and liabilities. Illustration 2.6 provides a simplified balance sheet for Best Buy.

Best Buy Co., Inc. Balance Sheets (in millions)
			February 1, 2020		February 3, 2019
	Assets
	Current assets
	Cash and cash equivalents		$2,229		$1,980
	Receivables		1,149		1,015
	Merchandise inventories		5,174		5,409
	Other current assets		305		466
	Total current assets		8,857		8,870
	Property and equipment		9,228		9,200
	Less: Accumulated depreciation		6,900		6,690
	Net property and equipment		2,328		2,510
	Other assets		4,406		1,521
	Total assets		$15,591		$12,901
	Liabilities and Stockholders’ Equity
	Current liabilities
	Accounts payable		$ 5,288		$ 5,257
	Unredeemed gift card liabilities		281		290
	Accrued compensation payable		410		482
	Other current liabilities		2,081		1,484
	Total current liabilities		8,060		7,513
	Long-term liabilities
	Long-term debt		1,257		1,332
	Other long-term liabilities		2,795		750
	Total long-term liabilities		4,052		2,082
	Total liabilities		12,112		9,595
	Stockholders’ equity
	Common stock		26		27
	Retained earnings and other		3,453		3,279
	Total stockholders’ equity		3,479		3,306
	Total liabilities and stockholders’ equity		$15,591		$12,901

The Standard-Setting Environment

How does Best Buy decide on the type of financial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP).

Standard-setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.

• The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies.
• The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States.
• The Public Company Accounting Oversight Board (PCAOB) determines U.S. auditing standards and reviews the performance of auditing firms.
• The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States (see International Note). Foreign companies that wish to have their shares traded on U.S. stock exchanges do not have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. Illustration 2.10 shows a global view of the accounting standard-setting bodies and guidance.

Qualities of Useful Information

The FASB and IASB use a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2.11.

Enhancing Qualities

In addition to the two fundamental qualities of relevance and faithful representation, the FASB also describes a number of enhancing qualities of useful information. These include comparability, consistency, verifiability, timeliness, and understandability, as shown in Illustration 2.12.

Assumptions in Financial Reporting

To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2.13 (see Ethics Note). These include assumptions about the monetary unit, economic entity, periodicity, and going concern.

Cost Constraint

Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

Illustration 2.14 summarizes aspects of the conceptual framework.

Learning Objectives Review

In a classified balance sheet, companies classify assets as current assets; long-term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long-term. A stockholders’ equity section shows common stock and retained earnings.

Ratio analysis expresses the relationship among selected items of financial statement data. Profitability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time.

Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the ability of a company to survive over a long period.

Generally accepted accounting principles are a set of rules and practices recognized as a general guide for financial reporting purposes. The basic objective of financial reporting is to provide information that is useful for decision-making.

To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, useful information is comparable, consistent, verifiable, timely, and understandable.

The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identified with a particular unit of accountability. The periodicity assumption states that the economic life of a business can be divided into artificial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.

The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose sufficient details regarding circumstances and events that would make a difference to financial statement users.

The cost constraint weighs the cost that companies incur to provide a type of information against its benefit to financial statement users.