Business:

Wholt
lt AllAbout?

Here'sWhereYou'reGoing
doesond
whoto business
Chopter1, youshouldunderstond
Whenyoufinishstudying
tronsoctions.
oboutbusiness
how thefinonciolstotements
reflectinformotion

/,ea.nniry QSteeftves
When you are finished studying this chapter, you should be able to:
1- Describe what a businessdoes and the various ways a businesscan be organrzed.
2. Classify businesstransactionsas operating, investing, or financing activities,
3- Describewho usesaccountinginformation and why accountinginformaiion is important to them.
4. Identify the elementsand explain the purposeof the four basic financial statements
and be able use basic transactionanalysisto prepareeach statement-the income
statement,the statementof changesin shareholders'equity, the balancesheet,and
the statementof cash flows. .
5. Identify the elementsof a real company's financial statements.
6. Describe the risks associatedwith being in businessand the part that ethics plays
in business.

CHAPTER1 . BUSI NESS:

W HAT' S lT ALL ABO U T ?

ffiff*t*s ;W{r*ffeye
When you are askedto do somethingyou believemay be unethical,askyourselfthe following questions:(1) ls it legal?(2)Will it
harm anyone?(3)Would you mind readingabout your decisionin
the morning newspaper?
In 2005, a documentarycalled "The SmartestGuys in the
Room" was nominatedfor an AcademyAward. lt is the story of
the rise and fall of Enron,the energy giant that filed for bankru p tc y i n 2 0 0 1 . Al though the symptoms of the scandal w ere fraudul ent financ i a l s ta te m e n ts and accounti ng fai l ures, at the heart of E nron' s fai l ure was a
l a c k o f e th i c s .T h e unethi cal deci si onsand acti ons of some of E nron' sman ager s
a n d e x e c u ti v e sp aved the w ay for one of the l argest bankruptci es i n U .5. histo ry . In Ma y 2 0 0 6, E nron' sfounder, K en Lay,and C E OJeffrey S ki l l i ng w ere bot h
fo u n d g u i l ty o f conspi ri ng to defraud sharehol ders.In Jul y 2006, K en Lay died
b e fo re h e c o u l d be sentenced. In October 2006, Jeff S ki l l i ng w as senten ced t o
2 4 y e a rs i n p ri s o n.

Photo of Bernie Ebbers

testifying before Congress. . . .

L .[} . 1
Describewhat a business
d o esand t he v ar io u sw a y sa
b u sinescsan be or g a n i z e d .

Capitalis the name for the

resources
usedto start and
run a business.

Have you ever heardof Enron?WorldCom? Sarbanes-Oxley?Much of the businesspressin

the past few years has focused on the Sarbanes-OxleyAct of 2002. The law was motivated
by the financial scandalsand businessfailures-such as Enron andWorldCom-in the early
part of the decade.The U.S. Congressfelt the needto passnew businessregulationsto help
can remain ignorant
restoreconfidencein the capital markets.No respectablebusinessperson
to
accounting.
In
the
investigation
and
trial of Bernard
about this law and its relationship
quoted
Ebbers
as
saying
that
he
did not know fiwas
Ebbers,the former CEO of WorldCom,
prison
long
sentencetell us that
nanceand he did not know accounting.His conviction and
in
something
about accounting.
this is no longer acceptable.Everyone businessmust know
has
a
television
or reads a newsDo you think accounting is important? Anyone who
of
the
importance
of
accounting.
Now
more than ever,
paper is reminded almost every day
you will
In
this
chapter,
it is crucial for people in businessto understandbasic accounting.
a
and
why the
start with a simple businessto learn the basic ideas of how businessworks
you
learn about accountfinancial reporting for a businessis so important to its success.As
ing, you will understandmore and more about what has been happeningin companiessuch
as Enron, Xerox, Tyco, HealthSouth,Adelphia, and others that have been caught "cooking
the books." Before you can understand how and why these companies are cooking the
('!esks"-a
company's accountingrecords-and about fibooks, you must learn about *1e
nancial statements.But even before that, vou must understandwhat businessis all about.

of a Business
Purpose
andOrganization
Tom Phillips loved to play basketball.He also wanted to start his own business.One day he
had an inspiration that put both ideastogether-T-shirts for casualplayers like himself, not
for players on a team. Tom polled the friends he played with regularly; they all liked the
idea, agreeingthat they would buy such a T-shirt, perhapswith a "no-look" passon it, if it
were available. Six years after Tom had this idea, he is president of a successfulcompany,
Tom's Wear, with saleslast year of $15 million.
How does a businessget started and, once started,how does it succeed?Generally, a
businessis formed to provide goods or servicesfor the purpose of making a profit for its
owner or owners.It begins by obtaining financial resources-and that meansmoney.Tom's
Wear beganas a businesswith $5,000 of Tom's own money and a $500 loan from his mother.
The financial resourcesto start a business-called capital--come from the owners of the
business(like Tom), who areinvestors,or from creditors (like Tom's mom), who arelenders.
Why buy a T-shirt from Tom rather than from the manufacturerof plain T:shirts? It's
all about value. We order clothes from Lands' End becausethe company provides added

A N D O R G A N I Z A T I O NO F A B U S I N E SS
1 . PURPOSE
CHAPTER

value to us. Instead of going to the mall to buy our clothes, we may prefer the convenience
of mail-order delivery. Lands' End customershnd value in this service.What all businesses
have in common is that they provide their customerswith something of value. A business
may start from scratch and create something of value or it may simply add value to an existing product or service.For some customers,the value that Lands'End adds to the product may be its easyorder and delivery procedures.For other customers,the addedvalue may
be in the monogram the company will put on shirts or towels to personalize them. Businessescreateor add value to earn money for the owners.
An enterprise-another name for a businessorganization-with this goal is called a
for-profit firm. In contrast, a firm that provides goods or servicesfor the sole purpose of
helping people instead of making a profit is called a not-for-profit organization. A notfor-profit organizationis more likely to be called an organizationor agencythan a business.
Even though it is called not-for-profit, this type of organization does not mind making a
profit. The difference is that a not-for-profit organization uses any profit to provide more
goods and servicesto the people it servesrather than distributing profits to its owners.Both
for-profit organizations and not-for-profit organizations provide value. Throughout this
book, we will be dealing primarily with for-profit organizations-businesses.
To be a viable business,Tom's Wear neededto provide customerswith something of
value.Tom purchasedT-shirtswith his speciallogo and then provided them to his customers.

A for-profit firm has the goal

of making a profit for its
owners,
A not-for-profit firm hasthe
goal of providinggoodsor
to its clients.
services

AllAbout?
Whatls Business
A simple model of the firm is shown in Exhibit 1.1. The inputs in a firm include capital,
equipment, inventory, supplies, and labor. The firm acquires goods and servicesand pays
for them. The firm then takes theseinputs and convertsthem into outputs by adding value.
The outputs of a firm are its products or services.As the firm carries out theseactivitiesacquiring inputs, converting them to outputs, and providing those outputs to customersinformation about these activities is recorded in the company's information system. Both
insiders-the owners and the firm's employees-and outsiders-the creditors, governmental agencies,and potential investors-use the information.
A businessmust successfullyplan, control, and evaluateits activities. If it does these
activities well, the businesswill survive. If it does them very well, it will make a profit.
Profit is the difference between the revenue-the amount a businessearnsfor the goods it
sells or the servicesit provides-and the expensesof selling those goods or providing those
seryices.The complexity of a company's planning, control, and evaluation processesdepends on the type, size, and structure of the business.You will seethis as we look at businessesin two ways: the nature of their operationsand who owns them.

Operations
TheNatureof Business
The operation of a businessdependson what the businesshas been formed to do. From that
perspective,there are four types ofbusinesses:service,merchandising,manufacturing,and
financial services.Although most businessescan be classified as one of these four types,
many large businessesare a combination of two or more.
A service company provides a service-it does something for you, rather than sells
something to you. Services range from activities you cannot see, such as the advice provided by lawyers or tax consultants,to activities you can see,such as housecleaning or car
washing.During the pasttwo decades,our economy hasbeenproducing more servicesthan
goods. Google is an example of a service firm.

OUTPUTS

A servicecompany does
somethingfor its customers;

EXHIBIT1.1

T h e F irm
Productor Service

A firm takes inputs, adds value,

and provides the output to its
customers.

CHAPTER1 O BUSI NESS:

W HAT' S I T ALL ABO U T ?

Target is an example of a retail

firm. It buys goods and sells
themto the final consumer.

A merchandisingcompany
sellsa productto its
customers.

A merchandising company buys goods, adds value to them, and then sells them with
the addedvalue. It doesnot make the goods,and it doesnot buy them to use.Instead,a merchandising businessbuys the goods for the purpose of adding its own particular value to
them and, after adding value, sells them to another company or person.
There are two types of merchandisingcompames:
I
I

A manufacturingcompany
makesthe goods it sells.

Financialservicescomoantes
deal in servicesrelatedto
money.

Your Turn l-l

-$hc+,'"'*y:+
g;c,$'fl.,,.,l.ijF

a wholesalecompany,which buys goods,addsvalue, and sells them to other companies

a retail company,which buys goods,adds value, and sells them to customerswho consumethem-which is why you will seethesecustomersreferredto as "final consumers"

Both wholesale and retail merchandisingcompaniesadd value to the goods they buy.
Wholesale companiesare not familiar to us becausewe do not buy things from them. Prentice Hall, the publisher of this text, for example,sells textbooks to your school's bookstore.
When you need a book, you go to the bookstore-a retail business-to buy it. you do not
go to the wholesalecompany,PrenticeHall. You do not carewhat businesstransactionstake
place to get the book from the factory, where it is printed and the covers are put on, to the
bookstore.At the bookstore,the books are provided along with thousandsofothers, but in
a way that you can immediately and conveniently purchasethe one or two books you need.
The bookstore is an example of a retailer. Retail store is widely used to describe the companies we find in every shopping mall.
A manufacturing company makes the products it sells. Manufacturing companies
vary in size and complexity. Making clay pots and vasesin a spacenot larger than a garage
is a manufacturing business.Automobile giants such as Ford and General Motors, owned
by many thousandsof people and employing hundreds of thousandsof workers at all levels in enormousfactories all over the world, arclarge, complex, manufacturing businesses.
Financial services companies do not make tangible products, and they do not sell
products made by anothercompany.They deal in servicesrelated to money.Banks are one
kind of financial servicescompany; they lend money to borrowers to pay for cars, houses,
and furniture. Another type of financial servicescompany is an insurancecompany,which
provides some financial protection in the caseof loss of life or property.

1. What is the mainpurposeof a business?

2. Descibethe four generaltypesof businesses
and what eachdoes.

Ownership
Structureof a Business
No matter what type of product or service it provides, a businessmust have an owner or
owners. The governmentowns some businesses,but in the United States,an individual or
a group of individuals owns most businesses.Business ownership generally takes one of
three generalforms: a sole proprietorship, a partnership,or a corporation.

A N D O R G A N I Z A T I O NO F A B U S I N E S S
CHAPTE1
R . PURPOSE

il}Et4#usine
$\*
t]h:ffii
ST,fe,
ti$\d

ss

personnel,
licenses
and inmarketing,
dures,location,
plans
andfinancing
surance,
Haveyou everconsidered
startingyourown business?
iscompleted,
the foOncethe business
description
(SBA),
Administration
According
to the SmallBusiness
itemsfor the nextthreesections.
cusshiftsto soecific
"SmallBusiness
June2004,small
by the Numbers,"
plan,including
a start-up
A financral
management
with fewerthan 100employeesbusinesses-those
in
budget,mustbe prepared
budgetandan operatrng
prepared
basedon
are
statements
detail,Thefinancial
. represent
morethan99.7%of allemployers
a
significant
financial
statements
are
budgets.
The
the
. employhalfof all private-sector
workersand39ok
plan.
partof a business
jobs
of workersin high-tech
planaddresses
of
the functioning
The
management
. provide
60% to 80% of the netnewjobsannually
perof the
Strengths
andweaknesses
business
operations.
in 1953to assist
TheSBAwasestablished
byCongress
asa wholeshouldbe assessed.
sonnelandthe business
problems
SBA
potential
canbeaddressed
and
Inaddition
to themanycontributions
smallbusinesses.
Onceidentified,
goal
information solved.To succeedas a business,
management's
theSBAprovides
makes
to ongoingbusinesses,
witha busihappy,
a business.
lt allstarts
andcustomers
andguidance
for starting
shouldbeto keeptheemployees
in
planmustbecreated.
to beincluded
Themarfoursections
nessplan.TheSBAdescribes
Finally,
themarketing
plan:the business
the
By
description,
thebodyof thebusiness
to attractandkeepcustomers.
ketingplanisdesigned
plan,anda
plan,the management
getting
the
market
know
the
sector
of
financial
management
and
to
identifying
plan.
you want to serve,you can appealto its wantsand
marketing
andedThebusiness
is the foundationfor the
asage,sex,income,
description
needs.
Suchcharacteristics
plan.lt shouldgivetheformof your
restof the business
customers
canhelpyouprelevels
of potential
ucational
planto develop
a partnership, parea marketing
base.
soleproprietorship,
a customer
business
enterprise-a
planisessential
shouldalsodefor startinga sucdescription
or a corporation,
Thebusiness
A goodbusiness
meron theSBAand
scribe
thenatureof yourbusiness-manufacturing,
company.
Formoreinformation
cessful
plan,visitthe 5BA Web siteat
details
should
Then,morespecific
chandising,
or service.
creatinga business
gov/.
operatingprocebe explained-goals
and objectives,
Iine.sba.
www.sbaon

Plan
TheBusiness
StartingA New Business:

Sole Proprietorships. If a single person owns a business,like the clay pot maker in his
garage,it is a sole proprietorship. A new businessoften startsas a soleproprietorship.In the
course of running the business,a sole proprietorship accumulatesfinancial informationsuch as the cost of materials,equipment,rent, electricity, and income from sales-but is not
requiredby law to make any of that financial information availableto the public. That means
the averageperson is not privy to this information. Naturally, the Department of Revenuein
the stateswhere the company operateswill receive some of this information from the company's salestax returx.
A businessin the form of a sole proprietorship is not separatefrom its owner in terms
of responsibility and liability-the owner is personally responsible for all the decisions
made for the business.For example,the income from the businessis included as income on
the owner's individual income tax return. The businessdoes not have its own tax return.
Also, as a sole proprietor, you are responsible for your company's debts.Your company's bills are your bills; if there is not enoughmoney in your company's "pockets" to pay
its bills, then you must pay the bills from your pockets.Moreover, you own the company's
assets,and your personalassetsare the company's assets-even if those personalassetsare
the only way of paying your company's bills.
Even though the financial records of a business-the company's books-should always be kept separatefrom the owner's personalfinancial records,there is no separationof

A sole proprietorshipis a
companywith a singleowner.

CHAPTER1 o BU5|NE55:W HAT' S lT ALL ABO U T ?

the sole proprietorship's books and its owner's books for tax and legal purposes.For example, your businesschecking account should be separatefrom your personal checking account, but the income you earn from your businessand the income you earn from other
sourcesmust both be included on your individual, personaltax return.
You will seein Exhibit L2 thatthere a"remore sole proprietorshipsin the United States
than any other form of business.Notice, however, that profits for sole proprietorships do
not come close to the enormousprofits earnedby corporations.
A partnershipis a company
owned by two or more
individu als.

Partnerships. A businesspartnership is owned by two or more people,although it is similar to a sole proprietorship in the sensethat the income both partners earn (or lose) from
the businesspartnership is included on their own personal tax returns. When two or more
people form a businessas partners,they usually hire an attorneyto help them define the specifrc terms of their businessrelationship. Details regarding how much work each will do
and how they will divide the profits from the businessare specified in a document called a
partnership agreement.Like a sole proprietorship, the owners-each of the paftners-are
responsiblefor everything the company does.For example,if the company is suedfor violating an employee's civil rights, then the partners are legally liable. The company's assets
are the partners' assets,and the company's debts are the partners' debts.Even so, as with a

EXHIBIT1.2
Typesof Firms
and TheirProfits
Although over two-thirds of U.S.
firms are sole proprietorships.
more than two-thirds of firm
profits are made by corporations.
Soarce.IntemalRevenueService
Website(www.irs.gov)

Tfiles of Firms
I Sole Proprietorship
@ Partnership
I Coryoration

Corporation,
5.27million

Partnership,
2.38 million

Sole
Proprietorship,
19.71million

Profits by Tlpe ofFirm

SoIe
Proprietorship,
billion
$230.31

I Sole Proprietorship
@ Partnership
I Coryoration

Partnership,
$2.72billion

Corporation,
$1,053.10billion

A N D O R G A N I Z A T I O NO F A B U S I N E S S
CHAPTE1
R . PURPOSE

sole proprietorship, the financial records of a partnershipshould be separatefrom the partners' personal financial records.
Corporations. A corporation is legally separateand financially separatefrom its owners.
Individual statescontrol the rules for forming corporationswithin their boundaries.A company must have a coryorate charter that describesthe business,how the businessplans to
acquire frnancing, and how many owners it will be allowed to have. Ownership in a corporation is divided into units called shares of common stock, each representingownership
in a fraction of the corporation. An owner of sharesof stock in a corporation is called a
stockholder or a shareholder. Most corporationshave many shareholders,although there
is no minimum number of owners required.A corporation whose sharesof stock are owned
by a very small number of people is called a closely held corporation.
As legal entities, corporationsmay enter into contractsjust like individuals. A corporation pays taxes on its earnings.A corporation's owners do not include the corporation's
income in their personaltax returns-unlike the owner of a sole proprietorship or the partners in a partnership.Each individual corporation owner does not have individual legal responsibility for the corporation's actions, as is true for the owners of a sole proprietorship
or partnership.For example,a shareholdercannot be suedfor the illegal actions ofthe corporation. The managersare held responsiblefor the actions of the corporation, and only the
corporation's assetsare at risk.
Dell Inc. is one of America's best-knowncorporations.Dell was foundedin 1984by
Michael Dell, currently the computer industry's longest-tenuredchief executiveofficer, on
this simple concept: By selling computersdirectly to customers,Dell could get a clear picture of its customers'needsand then efficiently provide the most effective products to meet
those needs.The company has offered new sharesof stock to anyonewho is able and willing to investin the companyby making them availablefor saleon a stock exchange.A stock
exchange is a marketplacefor buying and selling sharesof a publicly traded corporation.
After the sharesareissued-sold for the first time to the public-investors who want to become ownersof a corporationmay purchasethe sharesfrom peoplewho want to sell the same
shares.The buyersand sellersget together,usually througha stockbroker,by using a stockexchange.Stockbrokersrepresentpeoplewho want to buy sharesand the peoplewho want to sell
sharesof a corporation. Stockbrokerswork for firms suchasMerrill Lynch and CharlesSchwab.
There are several stock exchanges-known collectively as the stock market-in the United
States;the New York Stock Exchangeis the largest.If you wantedto be one of the ownersof
Dell Corporation,you could purchasesharesby contactinga stockbroker.
Another way to buy or sell sharesof stock-also known as trading-is to use the Internet. Many companiesnow provide a way for investors to buy and sell stock without a
stockbroker.As Internet usagecontinuesto grow at an incredible pace,more and more people are taking advantageof electronic trading in sharesof stock.
Regulation Shareholdersusually hire people who are not owners of the corporation to
managethe businessof the corporation.This separationof ownership and managementcan
createproblems. For example,there may be a large number of owners, and they may be far
away from the location of the business.How can the owners be sure that the managersare
running the corporation the way the owners want it to be run? How do the owners monitor
the managersto be sure they are not taking advantageof the power of being a managerof
a large company,for example,buying expensiveitems like country club membershipsand
luxury cars for the business?
To protect the owners with respectto issueslike these,the governmentcreatedthe Securities and Exchange Commission (SEC) to monitor the activities and financial reporting of corporationsthat sell sharesof ownership on the stock exchanges.The SEC setsthe
rules for stock exchangesand for the financial reporting ofpublicly traded corporationsfor
the entire United States.The degreeofregulation for corporationsdependson the size and
natureof the business.A businessthat provides an essentialproduct or service,suchas electric power generating companies,has more rules to follow than a businessthat provides
something not essential,but discretionary,such as toys. Large companieshave more rules
than smaller companiesbecauselarge companiesprovide more opportunities for managers
to take advantaseof the owners.

A corporationis a speciallegal
form for a businessin which
the businessis a legal entity
seoaratefrom the owners.A
corporationmay havea single
owner or a large number of
owners.
Sharesof common stock are
the units of ownershipin a
corporatron.
Stockholdersor shareholders
are the ownersof the
corporalton.

A stock exchange-also
calledthe stock market -is a
marketplacewhere buyers
and sellersexchangetheir
sharesof stock.Buyingand
sellingsharesof stockcan also
be done on the lnternet.

The Securitiesand Exchange

Commission(SEC)is the
governmentalagencythat
monitorsthe stockmarket
and the financialreportingof
the firms that trade in the
market.

CHAPTER1 . BUSI NESS:

W HAT' S lT ALL ABO U T ?

Advantages of a Corporation Advantagesof the corporate structure of a businessorganization include:

I Investorscan diversify their financial risk. Being able to buy a small sharein a variety of corporationsmeansthat personsare able to balancethe risks they are taking as business owners. For example, an investor may own sharesin a soft drink company and also
own sharesin a coffee company.If coffee companieshave a bad year due to a shortageof
coffee beans,people will be likely to buy more soft drinks. By owning a little of each type
of company,an investor reducesoverall risk.
I Owners have limited liability. Individual owners risk only the amount of money
they have investedin the company.That is the amount they paid for the sharesof stock. If
the corporation is found legally responsiblefor injury to an employee or customer,or if the
businessfails, only the corporation's assetsare at risk-not the owner's personal property.
(In contrast,there is no limit to the legal liability of a sole proprietor or a partner.Both the
assetsofthe businessand the personal assetsofthe owner or owners are at risk.)
Disadvantages of a Corporation Disadvantagesof the corporate structure of a business
organization include:
I Separationof managementand ownership createsa difference in knowledge about
the operationsof the business.Supposeyou own 100 sharesof Dell Corporation stock. The
managersof Dell will know many details of the businessthat you do not know. For example, the managersare awareof all possibleinvestmentoptions for the company'sextra cash.
They may selectthe option that minimizes clerical work, whereasan owner might prefer an
option that involves more work but would securea higher return.
There are literally thousandsof such details that owners do not know, many of which
they do not even want to know. However, the owners want some assurancethat managers
are actingin the best interestsof the shareholders.Owners needinformation about how well
the businessis doing to assesshow the actions and decisionsof the managersare affecting
the business.The owners need some assurancethat managersare providing complete and
accurateinformation about the business.Both the individual statesand the SEC at the federal level set rules for the financial reporting ofcorporations. A corporation's type ofbusi-

WHATIS A LIMITEDLIABILtrW
WHATTSA LIMITEDLIABILIrY

ACTIVITIES
AND THEFLOWOF GOODSAND SERVICES
CHAPTER
1 . BUSINESS

nessand its size determinehow extensiveits reporting requirementsare.We will come back
to this subject many times throughout our discussionsof financial accounting.
I Corporateincome is taxed twice. Unlike a sole proprietorship or partnership,a corporation pays income taxes on its net income. After that net income (or at least a parl of
it) is divided by the number of shareholdersof the corporation and distributed among
shareholdersas dividends, the shareholdersmust include the dividend income on their
personal tax returns. This amounts to double taxation on the sameincome. The income of
the corporation-which is owned by shareholders-is taxed as corporation income, and
then the amountpassedon to owners as dividend income is again taxed, aspersonalincome.
(Current tax laws do allow some exemption for dividend income to the shareholder,so this
disadvantagecan be reducedby a changein the tax law.)

ownership?
1. What arethe differentformsof business
and disad2. Fromthe owners'point of view,what arethe advantages
vantagesof eachform of ownership?

Business
Activitiesandthe Flow
of GoodsandServices
A person who takes the risk of starting a businessis often called an entrepreneur.Our entrepreneur,Tom, starteda T-shirt business.Exhibit 1.3 showsthe eventsfor Tom's Wear that
followed. Identifying those events and analyzing the transactionsare the first stepsin understandinghow a businessworks.
We can classify each step in the process of developing a businessin terms of
exchanges-who gets what and who gives what in return. One of the important functions
of accountingis to provide information about theseeconomic exchanges,also known as
businesstransactions.In accounting, we often classify transactionsas operating activities,
investing activities, or financing activities. Operating activities are transactionsrelated to
the generaloperationsof a firm-what the firm is in businessto do. Investing activities are
transactionsrelated to buying and selling items that the firm will use for longer than a year.
Financing activities are those that deal with how a businessgets it funding-how it obtains
the capital neededto finance the business.
The first exchangestartsthe business-Tom investshis own $5,000in the business.From
the perspectiveofthe business,this is called a contribution.It is often calledcontributed capital. As with all transactions,we look at this from the point of view of the businessentity.This
transactionis the exchangeof cash for ownership in the business.Becausethis transaction
dealswith the way Tom's Wear is financed,it is classifiedas a financing transaction.
You may need to think about it to seethe give part of this exchange-it is the business
giving ownershipto Tom. BecauseTom has chosento organizehis businessfirm as a corporation, this shareof ownership is called stock. For a sole proprietorship or a partnership,the
ownershiphas no specialname.Tom has chosenthe corporateform of organizationbecause
of the limited legal liability of a corporation.The get part of the exchangeis the businessgetting the $5,000 cash.BecauseTom is the only shareholder,he owns 1007oof the stock.

EXH I B I T 1. 3

How a Business
Works
These businesstransactionsshow Tom's Wear's first month of business

Dividendsare the earningsof

a coroorationdistributedto
the ownersof the
corporaTron.

Your Turn | -2
sff

sTH
:_*rlb{..$.i..
rT,ii".+

L" O.2
Classifybusiness
transactionsas operating,
i nvesti ng,or fi nanci ng
activities.

Contributed capital is an
owner'sinvestmentin a
company.

10

CHAPTER1 . BUSI NESS:

W HAT' S lT ALL AB O U T ?

The principalof a loan is the

amount of money borrowed.
The interest is the cost of
borrowing that money-using
someoneelse'smoney.

The secondtransactionis betweenTom's Wear and Tom's mother.The businessborrows

$500 from her.Tom's Wear getsan economicresource----cash-andin exchangeTom's Wear
gives an I-owe-you (IOU). From the perspective of Tom's Wear, this transaction involves a
cashreceipt.Borrowing money to financea businessis the get side of the exchange.The give
side is the IOU to Mom. Technically,it is not really the give side until Tom repaysthe loan
with cash.The IOU is useful for describingthe timing differencebetweenthe time of the get
and give sidesof the exchange.We will seea lot of examplesof this type of timing difference
in accountingfor businessevents.Again, this transactionis a financing activity.
The next transactionis the company's purchaseof 100 T-shirts with a unique logo on
them. The get part of the exchangeis when Tom's Wear gets the shirts for the inventory. The
give part of the exchangeis when Tom's Wear givescashto the T:shirt manufacturer.Remember, the exchangeis seenthrough the eyesof Tom's Wear.The transactionwould look different if we took the perspectiveof the T-shitt manufacturer.In businessproblems,we take one
point of view throughout a problem or an analysis.This transactionis an operatingactivity.
The next transactionis the acquisition of a service. The economic resourcesexchangedin this transactionare advertising and cash.The get part is the acquisition or purchase of advertising. The give part is a cash disbursementtransaction. Again, this is an
operating activity.
Tom's Wear now sells the T-shirts, exchangingT-shirts for cash.Once again, the activity is an operating activity, precisely what Tom's Wear is in businessto do-sell T-shirts.
Finally, Tom's Wear repays the $500 loan from Tom's mother plus interest. The company gives the economic resourceof cash (amount of the loan, called the principal, plus
interest, a cost of borrowing the money) to Tom's mom. Recall that the actual get part of
this exchangeoccurred near the beginning of our story. The secondtransactionwas when
Tom's Wear took the cash,as a loan, from his mom. The IOU was a sort of marker, indicating that there would be a timing difference in the get and give parts of this transaction.Repayment of the principal of a loan is a financing activity. Repaymentof interest,on the other
hand, is consideredan operating activity.

Your Turn I -3

1. What arethe two sources

of financingfor a business,
both usedby
Tom'sWear?
2. What do you callthe costof usingsomeoneelse'smoney?

*N"'\*' -i{,il',tlw'lr-,wl.\l
r\31y-

{,.(}. ;l
Describewho uses
a c c ount inginf or m a ti o na n d
why ac c ount ing
i n for m at ionis im p o rta n tto
th e m .

Revenueis the amount the

companyhasearnedfrom
providinggoods or services
to
customers,
Expensesare the costs
incurredto generaterevenue.

Information
Needsfor Decision
Makingin Business
To start a new business,Tom had many decisionsto make. First, how would he finance it?
What organizationalform should it take? How many T:shirts should he buy? From whom
should he buy them? How much should he pay for advertising?How much should he charge
for the shirts?
After the first complete operating cycle, shown in Exhibit 1.4-beginning with cash,
converting cash to inventory, selling the inventory, and turning inventory sales back into
cash-Tom has more decisions to make. Should he buy T-shirts and do the whole thing
again?If so, should he buy more T-shirls than he bought the first time and from the same
vendor?To make thesedecisions,Tom must haveinformation. The kind of information usually provided by accountantswill provide the basisfor getting a good picture of the performanceof his business.
I

I
I
I

What was revenue from salesduring the accounting period? An accounting period is
any length of time that a company usesto evaluateits operating performance.It can be
a month, a quarter,or a year.
What expenseswere incurred so those salescould be made?
What goods does Tom's company have left at the end of the period?
Should he increasethe price ofthe T-shirts he sells or lower the price?

In addition to this kind of financial information, there is other information that can help
Tom make decisionsabout his business.For example.Tom would want information on the

1 . I N F O R M A T I O NN E E D SF O RD E C I S I O NM A K I N G I N B U S I N E S S
CHAPTER

11

EXHIBIT1.4
The Operating Cycle
The operating cycle shows how a
firm startswith cash and, after
providing goods to its customers,
ends uo with more cash.

reliability of different vendors and the quality of their merchandiseto decide which vendor
to use next time. Before the advancesin computer technology that have enabledus to collect, organize,and report huge quantities of information besides financial information, a
company had only the basic financial information to help make its businessdecisions.Today, financial information is just a part of a firm's information system.
A modern supermarketis a great example of a businessthat collects a tremendous
amount of information. With a simple, swift swipe of the grocery item bar code past the
checkout scanner,the store information system collects product data, recording and tracking information about vendors,product shelf life, customerpreferencesand buying habits,
and the usual, typical financial information such as price and quantity of eachitem sold. As
we look at businessprocessesand the information neededto run a business,we will pay attention to the information reflected in the basic financial statements-the income statement, the balancesheet,the statementof changesin shareholders'equity, and the statement
of cash flows. You will learn more about each of these statementssoon.

1. What are revenuesand expenses?

2. What arethe four basicfinancialstatements?
Who NeedsInformationAbout Transactions
of the Business?
No part of any businesscan operatewithout information. The functions of the managementof
a company are to plan, to confrol, and to evaluate the operation of the business.To perform
these functions effectively, managementmust have information about what the businesshas
done, about what it is currently doing, and about where it looks like it is going or should be

Your Turn | -4
',1'-'t.*.tt*t",+',+-

fT$Jif',f':$

12

CHAPTER1 o BUSI NESS:

W HAT' 5 lT ALL ABOU T ?

Generallyaccepted
accounting principles(GAAP)
are the guidelinesfor
financialreporting.
The FinancialAccounting
StandardsBoard (FASB)is the
group that setsaccounting
standards.lt gets its authority
from the SEC.
The PublicCompany
Accounting Oversight Board
(PCAOB)is a group formed to
overseethe auditing
professionand the auditsof
publiccompanies.lts creation
was mandatedby the
Sarbanes-Oxley
Act of 2002.

EXFilBtT1.5

going. Traditionally, the accounting infotmation system has provided only very general data
aboutthe pasttransactionsof a businessfirm. A businessfirm usedto keeptwo setsof records,
eachfor speciftcpurposes:one setfor financialreporthg andone setfor internaldecisionmaking. Now, with modern computers and software that can organizeinformation in a variety of
ways with a few simple commands, one information system can accumulate and organize all
data of a company.The managersof eachbusinessarea-usually referred to as a departmentcan obtain and use whateverinformation is relevantto the decisionsthey make.Accountants,
too, can obtain the information they needfor preparingthe basic financial statements.
The frnancial statementsare basedon a set ofguidelines called generally accepted accounting principles (GAAP). Theseguidelinesarenot exactrules.As you learn more about
accounting,you will seethat the amountson the financial statementsare not exact.To make
the hnancial statementsuseful, we needto understandthe guidelinesand the choicesusedto
constructthem. Who setsthe guidelinesfor financial reporting?As shown in Exhibit 1.5, at
the top of the authority chain is the Securities and Exchange Commission (SEC). In the
1930s,Congressestablishedthe SEC to set the rules for corporationsthat trade on the public stock exchanges.The SEC has delegatedmuch of the responsibility for setting financial
standardsto an independent group called the Financial Accounting Standards Board
(FASB). This is a group ofprofessional businesspeople,accountants,and accountingscholars who have the responsibility of setting current accounting standards.Accounting standardsdictatethe way businesseventsarereported,so it makessensethat businessesare very
interestedin what the FASB does. The newest player in the rule-setting game is a group
called the Public Company Accounting Oversight Board (PCAOB). Mandated by the
Sarbanes-OxleyAct in 2002, this independentboard was createdto overseethe auditing profession and public company audits.

Securities and Exchange Commission (SEC)

Who Setsthe Guidelines

for FinancialReporting?
The U.S. Congressestablished
the Securities and Exchange
Commission(SEC) in 1934.
Auditing standardsare set by the
Public Company Oversight
Board (PCAOB), and accounting
standards(GAAP) are set by the
Financial Accounting Standards
Board GASB).

Public Company
Accounting Oversight Board
(PCAOB)

In response to the 2001-2002

discovery of accounting
scandals, the SEC created the
PCAOB to oversee the
auditing profession and the
audit of public companies.

Financial Accounting
Standards Board
(FASB)

The SEC has delegated much

of the standards-setting responsibility
to the FASB. The SEC retains and
sometimes exercises the right
to set accountinq standards.

C H A P TE1R. OV E R V IE W
OFTH EF I N A N C I A LS T A T E M E N T S
In many industries,there are regulatory agenciesthat require speciltc information from
companies,particularly corporations.For example,the SEC requirescorporationsthat trade
on the stock exchangesto file many different kinds of reports about the company's transactions. We will come back to this topic near the end of the chapter when we turn our attention to real company financial statements.
For all businesses,payroll taxes and salestaxesmust be reported and paid to staterevenue agencies.The Internal Revenue Service (IRS) requiresinformation from businesses
concerningincome and expenses,evenif the income from the businessflows through to the
owners as it does for sole proprietorshipsand partnerships.
When a company wants to borrow money, creditors-the people and flrms who lend
money-require information about the company before they will lend money. Banks want
to be surethat the loans they make will be repaid. The creditworthiness-a term indicating
that a borrower has in the past made loan paymentswhen due (or failed to make them when
due)-of a businessmust be supportedwith information about the business.This information is usually very specific and very detailed.
Who else needs information about the business?Potential investors are information
consumers.SupposeTom wanted to find additional owners for his T-shirt business.That
means he would be looking for someonewho wanted to invest money in his T-shirt business in return for a portion of ownership in the company. A potential owner would want
some reliable information about the businessbefore making a financial investment. Publicly traded corporations-whose sharesare traded on the stock exchanges-invite anyone
willing and financially able to become an owner by offering for sale sharesof stock in the
corporation. Buying the stock of a corporation is investing in that corporation. Investors
want information about a companybefore they will buy that company's stock. The SEC requires that the information provided by companieswhose stock is publicly traded be accurate and reliable. That meansthe information in their financial statementsmust be audited.
Audited information means it has been examined by professional accountants, called
certified public accountants (CPAs). We will talk more about that when we turn our attention to real company financial statements.
Finally, current and potential vendors, customers,and employeesalso need useful information about the company. They need to evaluate a company's financial condition to
make decisionsabout working for, or doing businesswith, the company.

AccountingInformation:A Part of the Firm'sInformationSystem

Have you ever filed an addresschange with a company only to find later that one department usesyour new addresswhile another departmentof that same company continues to
the
use your old address?Even with suchcommon dataas customernamesand addresses,
information is often gatheredand maintained in severaldifferent placeswithin the sameorganization. As computers and databasesbecome more common, central data information
systemsare replacing departmentalsystemsand eliminating their inefficiencies.
Becauseaccountantshave traditionally been the recorders and maintainers of financial information, it makes sensethat they have expandedtheir role as the keepersof businessinformation systemsto include more than financial information. The cost of obtaining
businessinformation has decreasedrapidly in the past few years.The financial accounting
information a company reports is now just a part of the total available businessinformation. The accounting information is provided in four basic financial statementsand supportlng notes.

Overviewof the Financial

Statements
There are four financial statementsa company usesto report its financial condition and operationsfor a period of time.
1.
2.
3.
4.

Balancesheet
Income statement
Statementof changesin shareholders'equity
Statementof cash flows

13

The Internal RevenueService

(lRS)is the federal agency
responsible
for federal income
tax collection.

A certified public accountant

(CPA)is someonewho has met
soecificeducationand exam
requirementsset up by
individualstatesto make sure
that only individualswith the
appropriatequalificationscan
perform audits.To sign an
audit report, an accountant
must be a CPA.

} " #.,$
l denti fythe el ementsand
expl ai nthe purposeof t he
four basi cfi nanci al
statements,and be able to
prepareeachstatementthe incomestatement,the
statementof changesin
sharehol ders'
equi ty,th e
bal ancesheet,and the
statementof cashflows.

14

CHAPTER1 . BUSI NESS:

W HAT, SI T ALL AB O U T ?

Notes to the financial

statements are information
providedwith the four basic
statementsthat describesthe
company'smajor accounting
policiesand provideother
disclosures
to helo external
usersbetter understandthe
financialstatements.

A company's set of financial statementsincludes thesefour basic statementsas well as

an important section called notes to the linancial statements. Thesenotes, sometimesreferred to asfootnotes, are an integral part of the set of financial statements.The notes describe the company's major accounting policies and provide other disclosures to help
external usersbetter understandthe financial statements.As you learn about the four statements,rememberthat you will be able to frnd additional information about eachin the notes.
In this chapter,we will look at each financial statementbriefly. Later chapterswill go
into each in detail.

BalanceSheet
The balancesheet showsthe
accountingequation in detail.
The statement shows:

A balance sheet describesthe financial situation of a company at a specific point in time.

It is a snapshotthat capturesthe items of value the businesspossessesat a particular moment and how the company has financed them. A balance sheethas three parts:
I
I
I

Assets-economic resources
owned or controlledby the
business.

Liabilities-obligations of the
business
to creditors.
Shareholders'equity -the
owner'sclaimsto the assetsof
the company.Thereare two
types:contributedcapitaland
retainedearnings.

assets
liabilities
shareholders'equity

Assets are things of value owned or controlled by a business.Cash and equipment are
cornmon assets.When a businesshas an asset,someonehas the rights to, that is, a claim to,
that asset.There is a claim on every assetin a business.There are two groups who might
have claims to a company's assets-creditors and owners.
The claims of creditors are called liabilities. Liabilities are amountsthe businessowes
to others outside the business,those who have loaned money to the company and have not
yet been fully repaid. For example,the amount of a loan-like your car loan-is a liability.
The claims of the owner are called shareholders' equity. Stockholders' equity and
owners' equity are other names for the claims of the owners. Shareholders'equity is also
called net assetsbecauseit is the amount left over after the amount of the liabilities is subtracted from the amount of the assets,or liabilities are netted out of assets.
There are two ways for the owners to increasetheir claims to the assetsof the business.
One is by making contributions, and the other is by earning it. When the businessis successful, the equity that results from doing businessand is kept in the company is called
retained earnings. We will see the difference between contributed capital and retained
earningsmore clearly when we go through the first month of businessfor Tom's Wear.
Together,assets,liabilities, and shareholders'equitymake up the balancesheet,one of
the four basic financial statements.The following relationship, called the accountingequation, is the basis for the balance sheet:
Claims

ASSets

Assets

Liabilities

Shareholders'equity

Each transactionthat takesplace in a businesscan be recordedin the accountingequation, which is the basis of the balance sheet.In other words, every transactionis changing
the balance sheet;but the balance sheetmust stay in balance.Look at the transactionsfor
Tom's Wear for Januaryand seehow each one changesthe balance sheet.
Date

Transaction

J a n u a ry1

Tom contributes$5,000of his own money to start the businessin

exchangefor common stock.

J a n u a ry1

Tom'sWear borrows $500from Tom'smom for the business.

J a n u a ry5

Tom'sWear buys 100T-shirtsfor $400cash.

Tom'sWear paysa public relationsfirm $50 cashfor advertising.
Tom'sWear sells90 of the T-shirtsto Tom'sfriendsfor $10 each (cash).

J a n u a ry1 0
J a n u a ry2 0
J a n u a ry3 0
J a n u a ry3 1

Tom'sWear repaysTom'smom the $500 plus $5 interest.

T o m' sW ear decl aresand paysa $100di vi dend.

1 . O V E R V I E WO F T H E F I N A N C I A LS T A T E M E N T S
CHAPTER

15

Before the hrst transaction, there are no assets, no liabilities, and no equity. So the bal-

ancesheetequationis:
Assets
0

Liabilities
0

Shareholder'sequity
0

Tom startshis company as a corporation.That meansthe owner's equity will be called

shareholder'sequity, and his initial contribution will be classifiedas common stock.We will
discussthe details of equity in Chapter 9. This is how the first transaction affects the ac-

countingequation:
Assets
5.000cash

+
+

Liabilities
0

equity
Shareholder's
$5.000commonstock

Also on January 1, Tom's Wear borrows $500. This is how the secondtransaction affects the accounting equation:
Assets
500 cash

Liabilities
$500 notes payable

Shareholder'sequity

A balancesheetcan be preparedat any point in time to show the assets,liabilities, and

equity for the company. If Tom's Wear prepared a balance sheet on January 2, these two
transactionswould be reflected in the amountson the statement.Exhibit 1.6 showsthe balance sheetat that time. With every subsequenttransactionthe balance sheetwill change.
Thereare severalcharacteristicsofthe balancesheetthat you shouldnoticein Exhibit 1.6.
First, the heading on every financial statementspecifies three things:
I
I
I

the name of the company

the name of the financial statement
the date

The date on the balancesheetis one specific date. If the businessyear for Tom's Wear,
also known as its fiscal year, is from January 1 to December 31, the balance sheet at the
beginning of the first year of businessis empty. Until there is a transaction,there are no assets,no liabilities, and no equity.
The balance sheetin Exhibit 1.6 for Tom's Wear is dated January 2. Tom's Wear has
beenin businessfor only 2 days.Even though a businesswould be unlikely to preparea balance sheetjust 2 days after starting the business,this is what the balance sheet for Tom's
Wear would look like on January 2. The balance sheet shows the financial conditionassets,liabilities, and shareholder'sequity-at the close of businesson January 2. At this
time, Tom's Wear had received $5,000 from the owner, Tom, and had borrowed $500 from
Tom's mom. The total cash-$5,500-is shown as an asset,and the liability of $500 plus
the shareholders'equity of $5,000togethershow who has claim to the company'sassets.
Becausethe balancesheetgives the financial position of a company at a specific point
in time, a new, updatedbalance sheetcould be produced after every transaction.However,
no company would want that much information!When a companypresentsits revenuesand

A fiscalyear is a year in the

life of a business'lt may or
may not coincidewith the
calendaryear,

EXHIBIT1.6
Tom's Wear, Inc.
Balance Sheet
At January 2,2006
Assets

BalanceSheetfor Tom's
Wear at lanuary 2

Liabilities and Shareholder's Equity

Cash .

$b,b00

Totalassets

$5,500

Not ep a y a b l e
Common stock
Retained eamings
Total liabilities and
Shareholder's equity

..........

500
5,000
0

This shows a balance sheetafter

just two days of businessfor
Tom's Wear. Notice that the
accounting equation is in
balance: assets: liabilities *
shareholder'seouitv.

$5,500

t0m'sweal

16

W HAT' S lT ALL AB O U T ?
CHAPTER1 o BUSI NESS:

Comparativebalancesheets
are the balancesheetsfrom
consecutive
fiscalyearsfor a
singlecompany.

Your Turn l -5
.ffip'm-g:g
Wmnvs.

expensesfor an accounting period, the information makes up the income statement.The

company must show the balancesheetat the beginning of that period and the balancesheet
at the end of that period. Those two balancesheetsare called comparative balance sheets.
For Tom's Wear,the first balancesheetfor the fiscal year is empty. That is, at the beginning
of the day on January 1, the accountingequation was 0 : 0 * 0. Before we look at the balancesheetat January31, we needto seethe income statementfor the month of January.We
need the information on the income statementto see what happenedduring the time between the two balance sheets.

1. What are the two parts of shareholder'sequity?

2. What is a fiscalyear?
Before we prepare an income statement for January for Tom's Wear or a balance
sheetat January 31, we will look at eachtransactionthat took place in Januaryand seehow
each affects the accounting equation.This analysisis shown in Exhibit 1.7.
When a businessis started, it begins with an empty balance sheet.For Tom's Wear,
there are no assets,and therefore no claims, at the start ofbusiness on January 1. The first
two transactionsthat startedthe business,Tom's contribution of $5,000 and the loan from
Tom's mom for $500, occured on January 1. First, Tom's contribution increasesassetsby
$5,000 and shareholder'sequity by $5,000, becausethe owner, Tom, has claim to the new
asset.Then, Mom's loan increasesassetsby $500 and liabilities by $500. The company receivesan asset-cash-and a creditor-Tom's mom-has claim to it. Following thesetwo
beginning transactions,the operations of the businessbegin. Each transaction that takes
place during the month is shown as it affects the balance sheet.Study each transactionin
Exhibit 1.7 as you readthe following descriptionof each.
I On January5, cashis decreasedby $400 and inventory is increasedby $400. This is
called an assetexchange,becausethe company is simply exchangingone asset-cash-for
anotherasset-inventory. Notice the entire effect of this exchangeon the accountingequation is on one side ofthe equation.That is perfectly acceptable.Also notice an assetexchange
hasno effect on shareholder'sequity.Tom still has claim to the samedollar amountof assets.
I On January10, Tom pays $50 for advertising.This is a cost Tom's Wear has incurred to generaterevenue.Assets are decreased,and retained earnings, a component of
shareholder'sequity, is decreased.Why is retained earningsdecreased?Becausewhen assets are decreasedby $50, someone'sclaim must be reduced.In this case,the owner's
claims are reducedwhen assetsare decreased.Retainedearningsis the part of shareholder's
equity that reflects the amount ofequity the businesshas earned.(Throughout this book, as
you study the transactionsthat take place in a business,you will see that all revenuesincreaseretained earnings and all expensesdecreaseretained earnings.)
I On January20, Tom's Wear sells90 T-shirtsfor $10 each.This saleincreasesassetscash-by $900. Who has claim to this asset?The owner has this claim. Revenuesincrease
retainedearnings.At the time of the sale,an assetis reduced.The companyno longer has 90
of the original 100 T-shirts in the inventory.Becauseeachshirt cost $4 (and we recordedthe
T-shirts at their original cost), the firm now must reduce the assetinventory by $360. That
reductionin assetsis an expenseand so shareholder'sclaims-via retainedearnings-al'e reducedby the amount of that expense.
I On January30, Tom's Wear pays off the $500 loan with $5 interest.The repayment
of the $500 principal reducescashand elirninatesthe obligation that had beenrecordedas a
liability. In other words, that liability is settled.The $500 reduction in assetsis balancedin
the accountingequationwith a $500 reduction in the claims of creditors.However,the interest representsthe cost of borrowing money. For a business,that is called interest expense.
Like all expenses,it reducesthe shareholder'sclaims by reducing retainedearnings.
I On January31, Tom's Wear pays a $100 dividend.That reductionin cashreduces
the shareholder'sclaims to the assetsof the firm, shown by the decreasein retained earnings. The $100, after it is distributed, is now pafi of Tom's personalfinancial assets,which
are entirely separatefrom the business.

{a

(,

(.)
o

X
0)
ho
a
li

i.,

a
6

I
h
E
q)

a
o
o

ii

il

C)

I
a

F,"

FA
!-

FF

i
!

iT1
ac g
ho
- g+
=,Y
AA

\
=

g
E

xUI

tr)< !
-Y Io;
L,/
{A tr

va

c\]

ol

o
q) ^
a:

!H
vg+

eOIE d

?o

!!.!,

4
o

^l

Obo

fr
"4
:+i

>)d

5E k

i3E

-: . i

C\l

F XJ :
xil
xl
lo
H

b* r
dtr
A>

cd

c\l
i

C\l

o-

^\

^l

17

18

W HAT' S lT ALL AB O U T ?
CHAPTER1 . BUSI NESS:

EXHIBIT1.8

Assets = Liabilities + Shareholders'Equity

Balance Sheet

TheAccounting
Equation
+ Retained

This shows how the accounting

equationlorms the foundation
for the statements.

The books are a company's

accountingrecords.

Earnings

Statement of Changes in
Shareholders'Equity

Using the accounting equation to keep track of the transactionsof a businessis a useful way to see how the financial statementsare put together.Exhibit 1.8 shows how the
statementsare related to the basic accounting equation. The actual way a company keeps
track of its financial transactionsand its records-commonly called its books-can vary
from a simple manual record-keepingsystem to a complex computerized system.No matter how a company keeps its records, the financial statementswill look the same.The accounting equationis the basisfor accumulatingaccountinginformation and communicating
that information to decision makers.A company startsthe year with a balancesheet(empty
only at the start ofthe businessfirm), engagesin businesstransactionsduring the year, and
ends the year with a new, updatedbalance sheet.After a year of operations,the first statement a firm preparesis the income statement.

lncomeStatement
The income statement shows
all re ve nu esmin usa ll
expenses
for an accounting
period-a month, a quarteL
or a year.

I
I
I
I

The most well-known financial statementis the income statement, also known as the statement of earnings,or the statementof operations,or the profit and loss statement(P&L). The
income statementis a summary of all the revenues(from salesor services)a company earns
minus all the expenses(costsincurred in the earning process)associatedwith earning that
revenue.It describesthe performanceof a companyduring a specific period, which is called
a fiscal period. Most often, fiscal period is used to describethe businessyear, which may
or may not coincide with the calendaryear.A fiscal year (not physical year) for a company
may, for example,begin on July 1. That meansthe fiscal year of the businessruns from July
1 of one year to June 30 of the next calendar year. Sometimesa company will end a fiscal
yearat aspecif,rcpoint in time that may result in slightly different datesfor its year-endfrom
year to year. For example,Dell Computersdefines its fiscal year as the 52- or 53-week period ending on the SundaynearestJanuary31.
Recall, the balance sheetgives the amount of assets,the amount of liabilities, and the
amountof shareholder'sequity of a businessat a specificdate.However,the first statementa
firm preparesafter completing an accountingperiod is the income statement.The income
statementdescribesthe operatingperformanceof a companyduring a period. Look at the income statementfor Tom's Wear in Exhibit 1.9. It shows the amount of salesthe company
made during the month, from January l, 2006, through January 3I, 2006. The expenses

'hawsfhsA
revenue
by
discount
airlineincreased
a six-year-old
Inthefirstquarterof 2006,JetBlue,
quarposted
its
second
consecutive
Still,
the
company
31%.
million,
a
whopping
$349
to makea profit.lf costsaregreaterthan
terlyloss.lt takesmorethanstrongrevenue
profrevenue.
a firmwill havea net lossratherthana netincomeCheckout JetBlue's
dueto a majorwinterstorm.
itsfor the firstquarterof 2007,followingthe delays

CHAPTER
1 o O V E R V I E WO F T H E F I N A N C I A LS T A T E M E N T S

19

EXHIBIT1.9
Tom's Wear, Inc.
Income Statement
For the Month Ended January 31, 2006

Revenue
Sales
Expenses
Cost ofgoods sold . .
Advertising
Interest
Total expenses
Net income

Income Statement
for Tom's Wear
The income statementfor the
month of January shows all of
the revenueand all of the
expensesfor the month.

$ 900
$ 360
DU

tom'sweal
415
$ 485

shown are also for the same period. The difference between the revenuesand expensesis
called net income, or net earnings.
Notice seyeralthings about the income statement:
I First, only the cost of the T-shirts that were sold is included as an expense-cost of
goodssold, also calledcost of sales.The cost of the T-shirtsthat were not sold is shownas
an assetcalled inventory on the balance sheet.
I Second, the repayment of the loan from Tom's mom is not shown as an expense.
The only expenserelated to borrowing money is the interest owed to the lender.The repayment of principal is not an expense.
Also notice that dividends, a corporation's distribution to owners, are excluded from
the income statement.Tom could have paid himself a salary for running the business.That
salary would have been an oxpense,but he decided not to do that. Instead, he decided to
take cashout ofthe businessas a dividend.Dividendsarenot a componentofearnings;they
are a distribution of earnings.

The Differencebetweenthe BalanceSheetand the IncomeStatement

You should get a betteridea of the differencebetweenthe balancesheetand the income statement by thinking about your own personalfinances.Ifyou were askedto preparea personal
balancesheet,you would list all your assets,such as your cashon hand (no matter how little)
and the cost of your car, clothes,computer,and CD collection. Then, you would list all the
people to whom you owe money and how much money you owe to each.This might include
somecredit card companiesand perhapsa bank for a car loan. All theseassetsand liabilities
are measuredin dollars. The specific point of time associatedwith a balancesheetmust be
given. For example,if you were listing your assetsand liabilities on the last day of 2007, your
balancesheetdatewould be December31,2007. Rememberthe accountingequation:
Assets

Liabilities

Shareholders'equity

If you subtractthe amountof your liabilities-what you owe to others-from your assets,
the differenceis your equity. Shareholders'equityis sometimescalledthe residual,indicating
that it is the amount left over after the claims of creditors are deductedfrom a company's assets.
In contrast,if you constructeda personalincome statement,it would cover a period of
time. For example,what was your net income total during the year 2\\'l?Youwould list all
revenueyou received during the year and then subtract all your expensesduring the same
year.The difference would be your net income for the year.There is no equation to balance.
The income statementlists all ofyour sourcesofrevenue and subtractsthe related expenses,
leaving a difference, hopefully positive, called net income. If the subtraction of expenses
from revenuesresults in a negativenumber, that amount is called a net loss.

Net incomeequalsall
revenuesminusall expenses
for a specificperiod of time.

20

W HAT' S lT ALL AB O U T ?
CHAPTER1 . BUSI NESS:

Your Turn | -6

1. What is gross profit?

2. Describethe difference in the time periods captured by the income
statement and the balancesheet.

.Hmgee-F,geig,e

Equity
Statementof Changesin Shareholders'

The statement of changesin

shareholder'sequity
startswith the beginning
amount of contributedcapital
an d sho wsall cha ngesdur ing
the accountingperiod.Then
the statement showsthe
beginningbalancein retained
earningswith its changes.The
usualchangesto retained
earningsare the increasefrom
net incomeand the decrease
from dividendsoaid to
shareholders.
Retainedearningsis the total
of all net incomeamounts
minu sa ll divide nd soaid in t he
life of the company.lt is
descriptively
named-it is the
earningsthat have been kept
(retained)in the company.
The amount of retained
earningsrepresentsthe part
of the owner'sclaimsthat the
companyhas earned(i.e.,not
contributed).Retained
earningsis nof the sameas
casn.

As its name suggests,the statementof changesin shareholders'equity shows the changes

that have taken place in the amount of shareholders'equity during a period. For a corporation, the statementis called the statement of changes in shareholders' equity becausethe
owners are known as shareholders.(When there is only one owner, use the singular "shareholder's equity." When there are two or more owners,use the plural "shareholders'equity."
If you don't know the number of owners, using the plural is the acceptedpractice.) The
statementstarts with the amount of contributed capital on a given balance sheetdate and
summarizesthe additions and subtractionsfrom that amount during a specific period, usually a year. In this course,we will not seedeductionsfrom contributed capital. Contributed
capital is reducedin only very special circumstances,and those will be studied in more advancedaccounting courses.The secondpart of the statementstartswith the beginning balance in retained earnings and then shows the additions-net income is the most
common-and the deductions-dividends are the most common. Contributed capital and
retainedearningsare then addedto show the total amount of shareholder'sequity at the end
of the accounting period. For demonstrationpurposes,we will look at monthly financial
statementsfor Tom's Wear Inc. throughout this book.
The statementof changesin shareholder'sequity for Tom's first month of businessis
shown in Exhibit 1.10. The statementstarts with the shareholder'sequity-also called
stockholder'sor owner's equity-at the beginning of the month. Tom's Wear has nothing
on the first day of the month, becausethe company is just getting started.Then, capital
contributions-s1ryneJ'scontributionsto the business-made during the month are listed.
Tom contributed $5,000 to the business.In a corporation, contributions take the form of
sharesof stock.Next, the statementshowsbeginning retainedearnings,the equity that owners have as a result of the businessearning income, rather than from contributions. The beginning retained earnings balance is zero becauseJanuary was the company's first month
shown as an increaseto retained
of doing business.Net income for the period-$485-is
to
retained earnings.The amount
a
decrease
earnings.The dividends of $100 are shown as
to
contributed capital at the end
period
added
is then
of retained earnings at the end of the
the
end
of
the period.
of the period to give the total shareholder'sequity at
of changesin shareand
the
statement
After preparing the income statementfor the month
balance
prepare
end-of-the-month
you
the
will be able to
holder's equity for the samemonth,
format
as
shown
equation
accounting
sheet.If you set up the balance sheethorizontally in the
the
from
equity
and
shareholder's
in Exhibit 1.7,you can view the changesin assets,liabilities,

EXH|BIT1 .10
Statementof
Ch a n g e isn
Equity
Shareholder's
for Tom'sWear
This statementshows all of
the changesto shareholder's
equity that occurred during
the period.

[--

Tom's Wear,Inc.
Statement of Changesin Shareholder's Equity
For the Month Ended January 31, 2006

il

Beginning contributed capital

Stock issued during the month .
Ending contributed capital .
Beginningretainedearnings
Net income for the month
Dividends
Ending retained eamings
Total shareholders' equity

0
5,000

0
5
(100)

$ 5,000
.......

385
$ 5,385

CHAPTER
1 . O V E R V I E WO F T H E F I N A N C I A LS T A T E M E N T S

21

EXHIBTT1.11
Tom's Wear,Inc.
Balance Sheet
At January 31, 2006
Assets
Cash .
Inventory

BalanceSheet for Tom's

Wear at January31

Liabilities and Shaxeholder's equity

$5,345
40

Not e s p a y a b l e

..........

Common stock .
Retained eamings

Totalassets

$5,385

Total liabilities and

Shareholder's equity

5,000
385
.

After a month of transactions,

this is the balance sheetfor
Tom's Wear. Notice how all the
information from the income
statementand statementof
changesin shareholder'sequity
is incorporated in the totals
shown on the balance sheet.

$5,385

beginning to the end of the month, with each transaction keeping the accounting equation in
balance.The balancesheetfor Tom's Wear Inc. at Januarv31 is shownin Exhibit 1.11.

t0m'swGal

Statementof CashFlows
The statement of cash flows is neededto form a complete picture of the financial position of a company. This statementis, in theory, the easiestto understand;and many people consider it the most important. It is a list of all the cash that has come into a
business-its cash receipts-and all the cash that has gone out of the business-its cash
disbursements-during a specific period. In other words, it shows all the cash inflows and
all the cash outflows for a fiscal period. Compare the cash inflows and cash outflows for
a specific period with the revenuesand expensesfor the same specific period on the income statement.Accountants measurerevenueas what the company has earnedduring the
period, even if it is not equal to the amount of cash actually collected. Accountants measure expensesas the costs incurred to generatethose revenues,even if they are not the
same as the amounts actually paid in cash. Becausethis way of measuring revenuesand
expensesmay not have an exact correspondence
to the amount of cashcollectedand disbursed,the statementof cashflows is necessaryto get a completepicture of the business
transactionsfor the period.
The statementof cash flows is divided into three sections:
I
I
I

cash from operating activities

cash from investing activities
cash from financing activities

These representthe three generaltypes of businessactivities.Exhibit 1.12 shows some

common transactionsand how they fit into theseclassifications.Rememberthat the transactions must be cash transactionsto be shown on the statementof cash flows.
Cashinflows and outflows from operatingactivities pertain to the generaloperatingactivities of the business.For Tom's Wear, purchasingT-shirts is an operating activity. Look
at the other cash flows from operationson the statementof cash flows in Exhibit 1.13.
Cash inflows and outflows from investing activities are the cash flows related to the
purchaseand saleof assetsthat a firm usesfor more than a year.IfTom decidedto purchase
a piece of equipment to silk-screenhis own shirts, that purchasewould be an investing activity-not an operating activity-because Tom's Wear is not in the businessof buying and
selling equipment.The purchaseand sale of assetsthat last longer than a year-often called
long-term assets-are investing activities.
Financing activities are related to a company's sourcesof capital. The two sourcesof
capital, usually in the form of cash,for financing a businessare contributions from owners
and loans from creditors. Any cash inflows related to these transactionsare classified as
cash inflows from financing activities. Financing outflows include repayment of the principal of loans and distributions to owners.Tom's repaymentof the $500 loan is an example
of a financins cash outflow.

The statement of cashflows

showsall the cashcollected
and all the cashdisbursed
during the period.Eachcash
amount is classifiedas one of
three types:
1. Cashfrom operating
activities-cash
transactions
that relateto
the everyday,routine
transactionsneededto run
a business
2. Cashfrom investing
activities-transactions
involvingthe saleand
purchaseof long-term
assetsusedin the business
3, Cashfrom financing
activities-tra nsactions
relatedto how a business
is financed.Examoles:
contributionsf rom owners
and amountsborrowed as
long-termloans.

22

W HAT' S lT ALL AB O U T ?
CHAPTER1 . BUSI NESS:

EXHtBtT1.12

Finaneing

Types of Cash Flows

All transactionscan be classified
as one of thesethree types.
When the transactionsare cash,
they appearon the statementof
cashflows.

Cash inflows.,

Cash outflows..

From customerswho From sale of

purchaseproducts. property and
equipment.
FYominterest or
dividend income
earnedfrom bank
deposits.
To suppliersfor the
purchaseof
inventory.
To employeesin the
form of salaries.

FYomissuing
Iong-termdebt.
From issuing stock.

To purchase plant
and equipment.

To repay long-term
debt principal.

To purchase
investmentsin
other firms.

To pay dividends
to owners.

E XH |BtT1.13
Tom's Wear,Inc.
Statement of Cash Flows
For the Month Ended January 31, 2006

Statementof Cash
Flowsfor Tom'sWear
The statementof cash flows
shows all of the cash inflows and
outflows during the period. At
the end of the statement,the
beginning cash balance is added
to the changein cash to give the
endins cash balance.

Cash from operating activities:

Cash collected from customers . . . .
Cash paid to vendors
Cash paid for advertising
Cash paid for interest

$ 900
(400)
(50)
(5)

Cash from investing activities:

tom'swGal

Cash from financing activities:

Contributions from owners
Cash from loan
Cash to repay loan
Cash paid for dividends
Increase in cash
Add beginning cash balance
Ending cash balance

..... $ 445

$5,000
500
(500)
(100)

4,900
$5,345
0
$5,345

You should begin to seethe relationship between the four financial statements.Study
Exhibit 1.14, where all of the statementsfor Tom's Wear for January are shown with arrows indicating the relationships between the statements.All four financial statements
will be discussedin detail in the chaptersto follow. By the time you are finished,you will
be able to read and understandwhat is on most financial statements.You will also be able
to analyzebusinesstransactions and understandhow they affect the financial statements
of a business.

EXHIBIT1.14
Summary of Tom'sWear's FinancialStatements and Their Relationships
This shows how the four financial statements are related.

t0m'$weal
Tom's Wear,Inc.
Income Statement
For the Month Ended January 3I,2006

Revenue
Sa les .

......

Statement of Cnangesrn unarenoloers r.jqurty

For the Month Ended January 31, 2006

Expenses
Cost of goods sold
Advertising expense
Interest expense

900

Contributed capital
Beghningbalance
Contributions during the month

...........
.

$
b,000

(360)
(50)
(5)

Net income

Tom's Wear,Inc.
Statement of Cash Flows
For the Month Ended January 31, 2006

Cash ftom operating activities:

Cashcollectedfromcustomers . g 900
Cash paid to vendors
(400)
Cashpaid foradvertising . ... ..
(b0)
Cash paid for interest
(b)

Tom's Wear,Inc.
Balance Sheet
At January 31, 2006

$ M5

Cash from investing activities:

Liabilities

Cash from financing activities:

Contributionsfromowners .... $ b,000
Cash from loan . .
b00
Cash to repay loan
(b00)
Ca sh pa idfo rdividends . . . . . . .
( 100)
Increase in cash
Add begirming cash balance
E nding ca sh ba lan ce

Liabilities
Note payable

& Shareholder's Equity

Shareholder's Equity

4,900
$5,345
0
. . . . . $b , B 4 b

23

24

CHAPTER1 . BU5lNE55:W HAT' 5 lT ALL AB O U T ?

Your Turn l -7
'fk;i+pir
lft;;*.g:*

1. Referto Exhibit 1.14.How is the income statement relatedto the balance sheet?In other words, how does the amount of net income affect the balancesheet?
2. Why is it necessaryto have both an income statement and a statement of cash flows? Look at the statementsfor Tom'sWear and explain why they are different.

Flow of Informationand the FinancialStatements

A company records and uses a large amount of information about its transactions.The
amount of data and the way the information is collected and storedvary widely from company to company.The information contained in the four financial statementsis a specific,
well-defined part of the information available from a company's overall information system. The purpose of these four financial statementsis to provide the financial information
neededto representand evaluatethe transactionsof the business.Investors,regulators,vendors, customers,and creditorsrely on financial accountinginformation for decisionmaking.

L.O.5
ldentify the elementsof a
re al f ir m ' sf inanci a l
statements.

A single-stepincome
statementgroupsall revenues
together and showsall
expensesdeductedfrom total

A multistep income statement

startswith salesand subtracts
costof goodssoldto get a
subtotalcalledgrossprofit on
sales,alsoknown as gross
margin.Then,other operating
revenuesare added and other
operatingexpensesare
deducted.A subtotalfor
operating incomeis shown
before deductionsrelated to
nonoperatingitemsand taxes
are deducted.Then,income
taxesare subtracted,leaving
net income.

Statements
Financial
RealCompany
All publicly traded corporations-ones that sell their stock in the public stock exchanges
such asthe NewYork Stock Exchange(NYSE)-must preparethe four basic financial statements every year. Even though these statementsare much more complicated than those of
Tom's Wear,you will seeall of the basic financial statementelementsthat were on the statements for Tom's Wear.
The SEC requires thesecompaniesto regularly supply information about what is happening in their frrms. Check out the SEC's Web site at www.sec.gov.Explore the links to
seeif you can find some recent corporatefilings. One of the most important filings a company must make is the 10-K, an important report that companiesfile with the SEC. It prooverviewof the registrant'sbusiness.An importantpart of a 10-K is
vides a comprehensive
a company's audited financial statements,without the company's sales pitch and story
found in its glossyannualreport.The 10-K reportincludesinformationyou simply will not
find in most annualreports,suchas insiderstockholdingsandbriefbiographiesofthe managementteam. The report must be filed within 90 days after the end of the company's fiscal year.
Look at Dell Inc.'s, formerly called the Dell Computer Corporation, comparativebalance sheets(seeExhibit 1.15).Notice the similaritiesbetweenthe real world of Dell and
the fictitious world of Tom's Wear-the balance sheetsfor both actually balance. Both
companieslist assetsfirst, then liabilities and stockholders'equity.Both companieshave
used dollars to measuretheir balance sheet items. There are differences between the balance sheetsof the real-world example and our not-so-rea1-worldexample, which we will
discussin later chapters.
Dell's income statement(consolidatedstatementsof income in Exhibit I .16) doesnot
look exactly tike the Tom's Wear income statement(Exhibit 1.9). First, Dell provides three
years of comparativeincome statements.Both Dell and Tom's Wear have revenuesand expenses,but the two companieshave presentedthe data in a different order.Tom's Wear lists
revenuefirst and then groups all the expensestogether.This is called a single-step income
statement. Dell lists its largest revenuefirst and then subtractsthe largest expenserelated
to the revenue,cost of revenue-also known as cost of goods sold, which gives a subtotal
called gross margin. This is called a multistep income statement. If we were to recast
Tom's income statementinto a multistep income statement,we would subtractthe cost of
goods sold of $360 from the salesrevenueof $900 to get a subtotal of $540 for Tom's gross
margin. Although Dell and Tom's Wear have arrangedtheir revenuesand expensesdifferently, net income for each company is still the difference between all revenuesand all expenses.That is what net income always is, no matter how the revenuesand expensesare
grouped on the statement.

CHAPTER
1 . R E A LC O M P A N YF I N A N C | A LS T A T E M E N T S

EXHtBtT1.15

ME

ComparativeBalanceSheetsfor Dell
This is Dell's balance sheet,taken from its annual reoorl.

Dell,Inc.
Consolidated Statements of Financial Position
(in millions)

Statement of Financial

February3,
2006

Current assets:
Cashandcashequivalents .....
Short-term investments
Accounts receivable, net
Financing receivables, net . . .
Inventories
Other .
Total current assets
Property, plant, and equipment, net
Investments
Long-term financing receivables, net
Other non-current assets
Total assets
Liabilities *a StoJf,ota"o'
Equity are shown togethef, -

Liabilities

$ 7,042
2,016
4,099
.i.,et0d
D/O

2,620
17,706
2,005
2,691
325
382
$ 23,109

January28,
2005
4. A nA.

5,060
3,563
985
459
2,083
16,g97
1,691
4,294
199
134
$ 23,215.-i Noticethat

and Stockholders' Equity

Current liabilities:
Accounts payable
$ 9,840
Accrued and other
6,087
Total current liabilities
15,927
Long-term debt . .
504
Other non-current liabilities
2,549
Totalliabilities ....
18,980
Commitments and contingent liabilities (Note 8)
Stockholders' equity:
Preferred stock a.ndcapital in excess of $.01 par value; shares issued
and outstanding: none
Common stock and capital in excess of $.01 par value; shares
authorized: 7,000;shares issued 2,818 and2,769, respectively . .
9,540
Tleasury stock, at cost; 488 and 284 shares, respectively
(18,007)

Retainedearnings
other comprehensive
ro..'' . . : : : . : : : : : : : . : . : : . : : : . . .
Other .
Totalstockholders'equity
Totalliabilitiesand stockholders'equity

r2,746
(103)
(47)
4,129
$ 23,109

$ 8,895
5,24L
L4,136
505
2,099
L6,730

8,195
(10,758)
9,174
(82)
(44)
485

The accompanying notes are an integral part ofthese consolidated financial statements

A company's set of financial statementsinclude the four basic statements-balance

sheet,income statement,statementof changesin shareholders'equity, and the statementof
cashflows-as well as an important sectioncalled Notes to the Financial Statements.These
notes, sometimesreferred to as footnotes, are an integral part of the set of financial statements. The notes describethe company's major accountingpolicies and provide other disclosures required by the accounting standardsand the SEC. Accompanying every public
company's annual financial statementsis an audit opinion. Exhibit 1.17 shows the audit
opinion from the most recent financial statementsof Dell Corporation. Read it and think
about whether or not it makesyou feel confident in the reliability of the financial statements.

25

EXHIBTT1.16
Dell,Inc.
Consolidated Statements of Income

Dell'slncome
Statements

(in millions,exceptper shareamounts)

This shows the income

statementsfor Dell for three
consecutiveyears.

ruu

Fiscal Year Ended

Net revenue
Cos t of r ev enue . . . .
Gross margin
Operating expenses:
Selling, general, and administrative
Research,development,andengineering ..........
Total operating expenses
Operating income
Investment and other income, net
Income before income taxes
Income tax provision
Net income

February 3,
2006

January28,
2005

January30,
2004

$ 55,908
45,958
9,950

$ 49,205
40,190
9,015

$ 4r,444
33,892
7,552

5,140
463
5,603
4,347
227

4,298
463
4,761

3,544
464
4,008
3,544
180
3,724
1,079
$ 2,645

4 674

1,002
fi 3,572

EXHIB|T1.17
Report of the IndependentAuditor
to haveanaudit.Ontypartoftheauditreportis shownhere
is required
Everypubliccompany
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of DeII Inc.
ed nnancial statements
We have completed integrated audits of the 2006 and 2005do#b.
of DeIl Inc. (the "Company") and of its intemal control over financial reporting as of February
3, 2006 and an audit of its 2004 consolidated financial statements in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Our opinions
based on our audits, are presented below
Consolidated Financial Statements and Financial Statement Schedule
In our opinion, the consolidated furancial statements listed in the accompanying index
preserrt fairly, in all material respects, the financial position of DeIl Inc. and its subsidiaries at
February 3, 2006 and January 28,2005, and the results of their operations and their cash flows
for each of the three years in the period ended February 3, 2006 in conformity with
accognting principles generally accepted in the United States of America. In addition, in our
opinion, the financial statement schedule listed in the accompanying index presents fairly, in
all material respects, the information set forth therein when read in co4iunction with the
related financial statements. These financial statements and financial statement schedule are
the responsibility of the Company's management. Our responsibility is to express an opinion
on these financial statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit of financial statements includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial statements,
assessingthe accognting principles used and significant estimates made by management, and
eyaluating thg. orrerall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Austin, Texas
March 15, 2006

26

4 2.f\4

191
4,445
r,402
$ 3,043

CHAPTER
1 o BUSINESS
R I S K ,C O N T R O LA
, ND ETHtCS

Business
Risk,Control,andEthics
Starting a businessis more than having a good idea about what it should be and obtaining
the financing to get it going. Both are a good beginning, but they must be followed with
sound businessplanning for acquiring goods and servicesand selling the company's products or services.Paft of that planning is identifying the risks involved. Before we discuss
the details of the businessactivities in the chaptersto follow, we considerthe risks of being
in businessand how we can minimize the negativeconsequencesof those risks.
A risk may be generally defined as anything that exposesus to potential injury or loss.
In business,risks can turn into significantlosses,scandals,or total companyfailure. There
are hundredsofrisks that any businessfaces.Someexamplesare

27

$,.{}. f:
D escri be
the ri sks
associ ated
w i th bei ng in
busi ness
and the part that
ethi cspl aysi n busi ness.

A risk is a danger-something
that exposesa business
to a
potential injury or loss.

M the risk of product failure that might result in the death of consumers
ffi the risk that someonewill steal assetsfrom the company
ffi the risk that poor-quality inventory will be purchasedand sold
What lossescould result? For a serious product failure, such as the Firestone tires on
the Ford Explorers in the early 2000s, the financial lossesto the businesscould amount to
millions of dollars in lawsuit settlements.For employeetheft, the potential lossesrange
from significantfinanciallossesto the loss of a companysecretthat could causea business
to fail. Poor-qualityinventorycould result in the loss of customersand reputation.
Risks relateto all aspectsofthe business,including:
ffi general strategicrisks-for example, should we market our cigarettesto teenagers?
ffi operating risks-for example, should we operatewithout a backup power supply?
M financial risks-for example,should we borrow the money from the bank or get it from
our shareholders?
W informationrisks-for example,shouldwe use a manualaccountingsystem?
The potentiallossesfrom taking on businessrisks may be the loss of reputation,loss
of customers,lossof neededinformation,or lossof assets.All the lossestranslateinto monetary lossesthat can put the company at risk for total failure.
It is difficult to think of businessrisk without consideringthe relationshipof risks to
ethics.When the risks of businessresultin lossesor legal exposure,a firm's managerswant
to minimize the damageto the firm. In such cases,the ethical standardsof the firm and its
managersbecomeparamount.A managermust always put good ethical behavior above
putting a good face on the firm's financial position or performance.Failure to do this hasresultedin huge lossesfor employeesand investors.Enron,WorldCom, and HealthSouthare
just a few examplesto consider.Seehow many of the facesyou recognizein Exhibit 1. 18.

ffiffis#ndffis$
ffiil$KA,vffi ffitr#ddffis
Vinson,picturedhere,joined the accountingdepartmentof
,,fn ,1,996..Betty
lohg-distancecompanythat would later become WorldCom. In
,.al,.sma,ll
,2003fVinsonfaced 15 yearsin federal prisonfor her part in WorldCom's
,r.$11[1111on
f,raud:Aske-dby her bossesto make false accountingentries,
, Vinsonbalked*and then caved.At the end of 18 months,she had helped
fa,liify,,e-t,,lgast
$3.7 billion in profits.When Vinson and some colleagues
'"threatenedto quit, CFOScottSullivantold them to "Think of [the company]

We haveplanesin the air.Let'sget the planeslanded.

,1as1a1,.aircraf!,tarrier.

2a

W HAT' S lT ALL ABOU T ?

CHAPTER1 . BUSI NESS:

EXH|BIT1.18
Examplesof BusinessFailures,2001-2005

Company

What Happened

The Outcome of the Thials

Enron,
an energy
company

Filed for bankruptcy protection

in December 2001.At the time,
Enron was the seventh-largest
company in the United States
based on revenue.

Guilty:
Andrew Fastow, the former CFO, was
sentenced to 10 years in prison in 2004 after
pleading guilty to securities and wire fraud.
Kenneth Lay (pictured here), former CEO,
and Jeff Skilling, former CEO and President,
were both found guilty of fraud and
conspiracy charges in May 2006.Lay died
in July 2006before sentencing. In October 2006,Skilling was
sentenced to 24 years in prison.

Adelphia,
a cable
company

Filed for bankruptcy protection

in June 2002.At the time,
Adelphia was the sixthJargest
cable company in the United
States.John Rigas, founder and
CEO, charged with conspiracy,
bank fraud, and securities fraud
in JuIy 2004.

Guilty:
John Rigas, founder, and Timothy Rigas, the
former CFO, were found guilty in JuIy 2004 of
taking more than $2 billion from the company
for their own personal use and lying to the
public about Adelphia's financial condition.
John Rigas was sentenced to 15 years and
Timothy Rigas was sentenced to 20 years
ln Dnson.

Arthur Andersen,
an accounting
firm

One of the flve largest

accounting firms in the world,
Andersen surrendered its state
Iicenses in August 2002to
practice before the SEC.
Andersen served as the auditors
of Enron and WorldOom.

Guilty Verdict Overturned:

Andersen was initially found guilty in 2004 of
obstructing justice in the Enron case. This
marked the end of one of the flve largest
accounting flrms in the world, which had been
founded in 1914and employed nearly 28,000
people at the time of its demise. In 2005,the
Supreme Court overturned Andersen's
conviction. Although the ruling came too late to save Andersen, it
restored some respect for the accounting flrm that was once
considered the best in the world.

WorldOom, a
telecommunications
company

Filed for bankruptcy protection

Jttly 2002 after disclosing it
overstated profits by $3.8 billion.

Guilty:
CEO Bernard Ebbers (left), a former millonan
who became the CEO of WorldOom, was
convicted in March 2005 on all nine counts for
his role in an $11 billion accounting scandalthe largest in U.S. history. Ebbers was
sentenced to 25 yearc in prison in July 2005.

Tlco, a developer of
electronics, flre and
security products,
healthcare products,
and plastic and
engineering products

Executives Dermis Kozlowski

and Mark Swartz indicted in
September 2002 for allegedly
stealing more than $600million
from the firm.

Guilty:
Kozlowski and Swartz were convicted in
June 2005, and each was sentenced to
25 years in prison.

Computer Associates,
a computer company

Former chief executive Sa4iay

Kumar indicted in April 2004 for
fraudulent accounting of over
$2 billion and obstruction of
justice.

Guilty:
Kumar pleaded guilW to the charges in May
2006 and was sentenced to 12 years in prison
in November 2006.

C H A P TE1R. C H A P TESRU MMA R Y

P R OB LE MS 29
Why do people take risks? Every risk brings a potential reward. The reward is why we
are in business.An entrepreneurlike Tom has put his money and his reputation at risk to
start a business.Why? For the potential of developing a successfulbusiness.To deal with
the risks and increasethe chancesto reap the rewards, a firm must establishand maintain
control over its operations, assets,and information system. A control is an activity performed to minimize or eliminate a risk. As we study the businessprocessesthat Tom will
be engagedin during his frrst year in business,we will look at how he can control the risk
involved in each process.

ChapterSummary
Points
' A businessis startedwhen investorsare willing to risk their money to start a businessto provide something of value for customersand to make a profrt. The investors may
be owners or creditors.
' Investors,vendors,customers,and governmentalagenciesrequire financial information
aboutbusinesses.There arefour basicfinancial statementsthat provide the information:
the income statement,the balance sheet, the statementof changes in shareholders'
equity, and the statementof cashflows.
The
financial statementsare basedon a set ofguidelines called generally acceptedac'
counting principles (GAAP). The SEC and the FASB are currently the important players in the rule-setting game.
' The accountingequation,assets: liabilities * shareholder'sequity, is the basis ofthe
balance sheet.It is a snapshotof the businessat a specif,rcpoint in time.
' The income statementshows all revenuesand expensesfor a period of time, resulting
in net income.
The
statementof changesin shareholders'(owners')equity showsthe changesin share'
holders' equity-both contributedcapital and retainedearnings-for a period of time.
' The statementof cash flows presentsall the cash inflows and outflows for a period of
time. It accountsfor the difference between the balancesin cash on the balancesheets
at the end of two consecutiveaccounting periods.
Notes
to the financial statementsare an important part of the financial information pro'
vided with a firm's four financial statements,

ChapterSummary
Problems
Supposethe following transactionsoccurred during Lexar Computer Inc.'s first month of
business.
1. Two friends together contributed $50,000 from their savingsto start Lexar Computer
Inc. In return, the corporation issued 100 sharesof common stock to each of them.
2. The company paid $20,000 cash for parts for new computers that it planned to make
during the next few months.
3. The company rented office spacefor the month for $350 cash.
4. The company hired and paid employeesfor work done during the month for a total of

$1,s00.
5. The company sold computersfor $40,000 cash.(Thesecomputerswere made from the
parts the company purchasedin item 2.)
6. The company paid $400 in dividends to its shareholders.
7. Onthelastdayofthemonth,thecompanypurchased$12,000worthofofficefurniture
and equipment on credit. (Lexar signed a 60-day note-i.e., borrowed the moneyfrom the furniture company.)

CHAPTER1 . BU5lNE55:W HAT' 5 lT ALL ABOU T ?

lnstructions
a. For each transaction,tell whether the related accounting information will be shown on
the income statement.the balance sheet,or both.
b. For each transaction,tell whether it is an operating, investing, or financing activity.
c. For each transaction,identify an assetor a liability that is affected by the transaction,
and tell whether it is an increaseor a decreaseto the assetor liability you named.

Solution
Which financial
statementsare
affected?

Transaction

Which
activity?

Which assetor
liability is
affected?

B al ancesheet
1. Two friendstogether
contributed $50,000cash
to start LexarComputerInc.
In re tu rn ,th e corporati on
issued100 sharesof common
stockto eachof them.

Fi nanci ng

Asset:Cashincreased

2 . T h e c o m p a n yp ai d $20,000
cashfor partsfor new
c o m p u te rsth a t i t pl anned
to ma k e d u ri n g the next
few months.

B al ancesheet

Operati ng

Assets:
Inventoryi ncreased;
Cashdecreased

3, The companyrented office

spacefor the month for
$ 3 5 0c a s h .

B al ancesheetand
incomestatement

Operati ng

Asset:Cashdecreased

4 . T h e c o m p a n yh i red and
p a i d e m p l o y e e sfor w ork
d o n e d u ri n g th e month for
a to ta l o f $ 1 ,5 00.
5 . T h e c o mp a n ysol d
computersfor $40,ooocash.
(Thesecomputerswere made
fro m th e p a rtsthe company
p u rc h a s e di n i t em 2.)

B al ancesheetand
incomestatement

Operati ng

Asset:Cashdecreased

B al ancesheetand
incomestatement

Operati ng

Asset:Cashi ncreased

Fi nanci
ng

Asset:Cashdecreased

Investing

Asset:
E qui pment increased;
Li abi l i ty:Not es
payablei ncreased

B al ancesheet
6 . T h e c o mp a n yp ai d $+ OOi n
d i v i d e n d sto i ts sharehol ders.
B al ancesheet
7 . T h e c o mp a n ypurchased
$12,000worth of office
fu rn i tu re a n d equi pment
o n c re d i t.(L e xarsi gneda
60-daynote with the
fu rn i tu re c o mpany.)

KeyTermsfor Chapter1
Assets(p. la)
Balancesheet(p. 14)
Books(p. 18)
Capital(p.2)
Cash from financing
activities(p.2I)
Cash from investing
activities(p. 21)
Cash from
operating
activities(p.2I)

Certified public accountant

(CPA)(p. 13)
Comparativebalance
sheets(p. 16)
Contributed capital (p. 9)
Corporation (p. 7)
Dividends (p. 9)
Expenses(p. 10)
Financial Accounting
StandardsBoard
(FASB)(p.12)

Financialservices
company(p.4)
Fiscalyear (p. 15)
For-profit frrm (p. 3)
Generally accepted
accountingprinciples
(GAAP) (p.12)
Income statement(p. 18)
Interest(p. 10)
Internal RevenueService
(IRS) (p. 13)

C H A P TE1R. A N S W E RTO
S Y OU RTU R NQU E S TTONS 31
Liabilities (p.U)
Manufacturing
company(p. 4)
Merchandising
company(p. 4)
Multistep income
statement(p.24)
Net income (p. 19)
Not-for-profit firm (p. 3)
Notes to the financial
statements(p. 14)
(p.6)
Partnership
Principal (p 10)

Public Company
Accounting Oversight
Board (PCAOB) (p. 12)
Retainedearnings(p. 20)
Revenue(p. 10)
Risk (p. 27)
Securitiesand Exchange
Commission
(SEC) (p. 7)
Service company (p. 3)
Shareholder(stockholder)
(p.'7)
Shareholders'equity(p. la)

Sharesof common
stock (p. 7)
Single-stepincome
statement(p.2a)
Soleproprietorship(p. 5)
Statementof cash
flows (p. 21)
Statementof changes
in shareholder's
equity (p. 20)
Stock exchange(stock
market)(p.7)

Answersto YOUR
TURNQuestions
YourTurn1-I
1. The main purpose of a businessis to make a profit, increasing the value of the company for the owners.
2. The four generaltypes ofbusinessesare:
a. Service company: provides a service-it does somethingfor its customersrather
than selling them a tangible product.
b. Merchandising company: buys goods, adds value to them, and then sells them
with the addedvalue.
c. Manufacturing company: makesproducts and sells them to other companiesand
sometimesto the final consumers.
d. Financialservicescompany:providesservicesrelatedto money-insurance,
banking,etc.

YourTurn 1-2
1. The three generalforms of businessownershipare: 1- sole proprietorships(single
owner); 2- partnerships(multiple owners); 3- corporations (potential for widespread
ownership often with separationof ownership and management).
2. Some advantagesand disadvantagesof eachbusinessform are:

Advantages:

SoleProprietorship Partnership

Corporation

Owner control
Taxesflow to
proprietor'sincome

Limitedliabilityfor owners
Often easierto
raisecapital
For owners,they may
diversifytheir i nvestments
acrossmany different
companies,often for a very
smallinvestment
Often, managementand
ownersare separate,
creatinga conflict of
interests
Corporationpaystaxes
and then ownerspay
taxesagain on the
dividendsthey receive
(unlessthe tax law makes
dividendsexemptfrom tax)

Disadvantages: Owner is liablefor all

business
decisions

Often difficult to
raisecapital

Ownerscontrol
Taxesflow to
partners'income

Partnersare liable
for all business
decisions
Often difficult to
raisecapital

W HAT' 5 lT ALL AB O U T ?
CHAPTER1 . BUSI NESS:

YourTurn 1-3
1. The two sourcesof financing for a businessare investmentsby owners (contributed
capital) and loans from outsiders(liabilities).
2. Interestis the cost of using someoneelse'smoney.

YourTurn 1-4
1. Revenuesare the amountsa company earnsfrom providing goodsor servicesto its customers. Expensesare the costs to earn those revenues.
2. The four statementsare: income statement,balance sheet, statement of changes in
owner's equity, and statementof cash flows.
YourTurn 1-5
1. The two parts of shareholders'equity are contributed capital and retained earnings
(earnedcapital).
2. A fiscal year is a year in the life of a businessfor financial reporting purposes.It may
begin at any time and ends a year later.

YourTurn 1-6
1. Grossprofit is equalto salesminus cost of goodssold.It is also called grossmargin.
2. The time period capturedby the income statementis an accountingperiod, often a fiscal year.The statementcovers a period of time. On the other hand, the balance sheet
describesthe financial position of a company at a given point in time.

YourTurn1-7
l. The income statementgives the revenuesand expensesfor the period. The net amount,
net income, is added to retained earnings. So the income statementnumber becomes
part of the retained earningstotal on the year-endbalancesheet.
2. The income statementshowsall revenuesand expensesfor a period of time-all the revenuesthat havebeenearnedand expensesincurredto earnthoserevenues.The statement
of cashflows simply lists the cashinflows and outflows during the period. The income
statementand the statementof cash flows for Tom's Wear are different becauseTom's
Wear paid cashfor someinventory that was not sold, so the cost of that inventory is not
included in the income statement'scost of goods sold. AIso, any transactionswith owners (contributionsand dividends)are not included on the income statement.

Questions
What is the purposeof a business?
Is the goal of all organizationsto make a profit?
Name the three types of activities that make up most businesstransactions.
What are the possibleownershipstructuresfor a business?
What are the advantagesof the corporateform of ownership?
What are the disadvantagesof the corporateform of ownership?
Who are some of the people in need of businessinformation and for what purposes?
What is the relationship between the information availableto a businessand the information provided in financial statements?
9. What are the basic financial statements?Describe the information that each provides.
10. What makesthe income statementdifferent from the statementof cash flows?
1.
2.
3.
4.
5.
6.
7.
8.

Multiple-Choice Questions
1. What type of activities relate to what the firm is in businessto do?
a. Investingactivities
b. Operatingactivities
c. Financingactivities
d. Protectionactivities
2. Which financial statementis similar to the accounting equation?
a. The income statement
b. The balance sheet
c. The statementof changesin shareholders'equity
d. The statementof cash flows

C H A P TE1Ro S H OR T
E X E R C IS ES
3. The PetsPlus SuperstoreInc. acquires50 doggie bedsfrom a supplier for $500 in cash.
What is the give portion of this transaction?
a. PetsPlus giving the doggie beds to customersin return for cash
b. The supplier giving the doggie beds to Pets Plus
c. PetsPlus giving $500 in cash to the supplier
d. The supplier giving $500 to Pets Plus
4. The two parts of shareholders'equity are
a. Assets and liabilities
b. Net income and common stock
c. Contributed capital and retained earnings
d. Revenuesand expenses
5. Which financial statementis a snapshotof the financial position of a company at a specific point in time?
a. Income statement
b. Balancesheet
c. Statementof changesin shareholders'equity
d. Statementof cash flows
6. Online PharmacyCompany borrowed $5,000 cashfrom the National Bank. As a result
of this transaction,
a. Assetswould decreaseby $5,000
b. Liabilities would increaseby $5,000
c. Equity would increaseby $5,000
d. Revenuewould increaseby $5,000
7. Accounting information is
a. Useful in profitable businessesonly
b. Consideredthe most important part of a company's information systemby all
managers
c. An integralpart of business
d. Used only by CPAs
8. During its first year of business,West Company earnedservice revenuesof $2,000. If
the company collected $700 related to those sales,how much revenuewould be shown
on West's income statementfor the year?
a. $2,000
b. $700
c . $1, 300
d. Cannot be determinedwith the given information
9. Interestis the cost of
a. Purchasinginventory
b. Making a sale
c. Being in business
d. Using someoneelse'smoney
10. The balancesheetof United Studiosat December31 showedassetsof $30,000and
shareholders'equity of $20,000.What were the liabilities at December 3 1?
a. $30,000
b. $10,000
c. $20,000

d. s50.000
ShortExercises
SE1-1. Classifu businesstransactions. For each of the .following cash transactions,
identifu whether it is better described as an operating,financing, or investingactivity.
(LO 2\
a. An entrepreneurcontributeshis own money to start a new business.
b. The businessbuys a building.
c. The businesspurchasesinventory.
d. The businesssells inventory to customers.
e. The businessrepaysa loan.

34

W HAT' S lT ALL ABO U T ?

CHAPTER1 . BUSI NESS:

SE1-2. Identify balance sheet items. Classify the items listed (1 to 6) under the balance
sheetheadingsof: (LO 4)
a. Assets
b. Liabilities
equity
c. Shareholders'
1.
Cash
2.
Contributions from owners
Equipment
3.
Notes payable
4.
earnings
5. -Retained
Accounts receivable
6.
SE1-3. Calculateowner's equity.Donkey Doughnut Company shows$125,000worth of
assets on its December 31,, 2009, balance sheet. If the company's total liabilities are
$35,750,what is the amountof owners'equity?(LO 4)
SE1-4. Calculate inventory. Given the following items and amounts on Wedding Supplies
Inc.'s December31,2010, balancesheet,how much inventorydid WeddingSupplieshave
on hand on December31,2010? (LO 4)
Cash
Inventory
Equipment
Liabilities
Owner's equity

$150
???
$400
$400
$700

SE1-5. Calculate liability. Given the following items on Tiffany Restoration Company's
June 30, 2}}9,balance sheet, how much did the company owe its creditors on June 30,
2009? (LO 4)
Cash
Inventory
Equipment
Other assets
Total

$ 1,725
205
10,636
8.135
$20,701

Liabilities
Contributed capital
Retainedearnings

???
$8,600
7 ,450

SE1-6. Income statement analysis. For each of the following, calculate the missing
amount:(LO 4)

a. Revenues
$350;NetIncome=
$560;Expenses
:
b. NetIncome$500;Expenses
$475;Revenues
c. Expenses
$940;NetIncome=
$600;Revenues

d. Revenues$1,240;Net Income $670; Expenses=

:
$2,500;Revenues
e. NetIncome$6,450;Expenses

SE1-7.Calculateowners'equity.Jenna&YvonneEnterpriseshas$40,000in cash,$20,000
in inventory,$17,000balancedue to creditors,and $18,000balancedue from customers.
What is the amount of owners' equity? (LO 4)
SE1-8.Calculateowner'sequity.GiventheamountsforthebalancesheetonJune30,20ll,
how much owner's equity did College Bookstore have on June 30, 20ll? (LO 4)
Cash
Inventory
Other assets
Accountspayable
Notes payable
Salariespayable
Owner's equity

$300
$450
$350
$ ZS
$ 50
$125
????

CHAPTER
1 . E X E R C I S ES

SE1-9. Calculate retained earnings. After one year of business,Holt's Computer Repair
Inc. had $6,000in assets,$3,500in liabilities,and $1,000in contributedcapital.What is the
amountofretained earningsat the end ofthe corporation'sfirst year ofbusiness?(LO 4)
SEl-10. Calculateretainedearnlngs.Joe'sRepairShophad a retainedearningsbalanceof
$1,000 on December 31, 2008. For year 2009, saleswere $12,000 and expenseswere
$8,500.Cash dividendsof $2,000 were distributedon December31, 2009. What was the
amount of retained earnings on December 3l, 2009? (LO 4)
SEl-11. Identify and classifi financial statement items. Shelby Pet Boutiques Inc. sells
products for the pamperedpet. These items were shown on Shelby's financial statements
presentedin the company's 2008 annual report. For each item, give the type of financial
statementitem (asset,liability, shareholder'sequity, revenue, expense)and the financial
statementon which it appears.(LO 4)
a. Interest expense
b. Accountspayable
c. Equipment
d. Common stock
e. Salesrevenue
SE1-L2.Identfy businessrisks. Give threerisks of being in businessand what you might
do to minimize thoserisks. (LO 6)

Exercises-Set
A
El-lA, Businessexchanges.Identfu the transactionsfrom thefollowing story.For each,identify the give and get portion. Who would be interestedin this infotmation? (LO 1,3)
LatashaJonesdecidedto go into businessfor herself.As a talentedWeb designer,shedecided
to open a small consulting firm with $5,000 of her own money,for which shereceivedcommon stock. Latashaborrowed $500 from her best friend to help get the businessstarted,and
in exchangeshe gaveher friend an I-owe-you (IOU). The companybought a state-of-the-art
desktopcomputer,completewith the accessoriesand softwareneededto get the businessoff
the ground, at a total cost of $6,000.The businessrequired a separatephone line, which cost
$450. Then, the company put an advertisementin the local newspaper,at a cost of $45 per
month for weekly ads.The companywas ready to go. All of the paymentswere cash.
El-2A. Analyzebusinesstransactionsusingthe accountingequation.JamieBailey opened
a hair salon and spa named "Brazwells at Bradford Inc." The following transactionsoccurredduring its first month ofbusiness.Enter eachtransactionbelow into the accounting
equation and identify an increaseor decreaseto assets,liabilities, shareholder'sequity, revenues,or expenses.(LO 4)
1. Jamiecontributed$8,000of personalsavingsin exchangefor stock,and the salonborrowed $6,000 from the bank to start the busrness.
2. The salon bought $5,000 of inventory from a manufacturerin the Caribbean.
3. Brazwellsboughttwo salonchairsequippedwith hair dryersat a cost of $2,500each.
4. The salon paid rent expenseof $375 the first month.
5. Brazwells earnedservice revenueof $4,000 and sold the entire $5,000 of inventory it
had purchasedto customersfor $7,500cash.
All the transactionswere for cash.Use the followins format:
Shareholder'sequity
Total
assets

Total
liabilities

Contributed +
capital

Retained
eafnlngs

Transaction1:
E1-3A. Classfu businesstransactions.For each of the transactionsin El-zA, tell whether
the transactionwas an operating, investing, or financing activity. (LO 2)

35

i , rr,.,

36

W HAT' S lT ALL ABO U T ?

CHAPTER1 . BUSI NESS:

E1.-AA.Analyze the balance sheet.Use the balancesheetfor Rainy Day Umbrellas & RaincoatsInc. at June 30,2009, to answerthe following questions:(LO 3, 4)
BalanceSheet
RainyDay Umbrellas& RaincoatsInc.
At June 30, 2009

Assets

Liabilitiesand Shareholders'Equity

Cash

$ +,SOO
350

Accountspayable
Notespayable(equipment)

Short-terminvestments
Accountsreceivable

385

Inventory

250

Contributedcaoital

P re p a i di n s u ra n ce

200

Retainedearnings

Pre p a i dre n t
Eq u i p m e n t(n e t)

$ 2,soo
10,250

3,450
2,485

s00
12,500
$18,68s

$18,68s

a. List the assetsthe companyhad on June30, 2009.Who has claim to theseassets?

b. List the liabilities the companyhad on June30, 2009.
c. Who are the potential usersof this financial information?
E1-5A. Analyze businesstransactionsusing the accountingequation.Enter eachtransaction
below into the accountingequation.Then, calculatethe (1) amount of assetsowned by Jasmine's SushiBar Inc. at the end of its first month of business,nd(2) the amountof net income
for the month. All thesetransactionstook place during the fust 30 daysof business.(LO 4)
a. Jasminestartedthe sushibar by contributing$12,000in exchangefor common
stock,and the businessbonowed $10,000from the bank.
b. Jasmine'sSushiBar purchased$2,000worth of sushiand other items (its
inventory) for cash.
c. The sushibar hired a sushiexpertto help train Jasmineand help run the new
company.For this service,Jasmine'spaid $50 eachday.
d. The bar was popular and Jasmine'ssold three-fourths of its inventory for total
cashrevenuesof $6,000.
e. Jasmine'spaid rent expenseof $345 the first month.
f. Jasmine'srepaid $500 of the bank loan along with $20 of interestfor the first month.
E1-6A. Classifi businesstransactions.Classifyeachof the transactionsin El-5A as an operating, investing, or financing activity. (LO 2)
E1-7A. Businesstransactionsfficts on shareholders'equity.For eachof the transactions
Consider
or hasno effecton shareholders'equity.
given,tell whetherit increases,decreases,
both shareholders'equity components-contributed capital and retained earnings.(LO 4)
a. Two friends get together,each contributing $6,500 to start the Sweet Tooth
Candy Corporation, in exchangefor common stock.
b. SweetTooth purchasesequipmentfor $3,500cash.
c. Sweet Tooth purchases$4,500 worth of inventory for cash.
d. Sweet Tooth pays expensesof $ 1,500 for electricity and phone for the month.
e. SweetTooth makescashsalesto customersof $5,725during the month.
f. Sweet Tooth pays employees$175 for hours worked during the month.
g. Sweet Tooth declaresand distributes $250 dividends to each of its owners at the
end of the month.
E1-8A. Classfu cashflows.Classifyeachtransactionas an operating,investing,or financing activity. Assume all transactionsare for cash. (LO 2, 4)
a. Jackie Benefreld makes a contribution of $95,000 to start the Horse Trails &
Stablesfrom her personalfunds.
b. The company purchasesthree horsesand some equipment for $25,000 in cash.

CHAPTE1
R . EXERCISES

c. The company purchases$5,000 worth of adverlising with the local newspaper.

d. The company pays rent of $ 15,000for barn and pasturespaceas well as use of
50 acresofland for riding trails.
e. The company hires severalpeople to clean stablesat a cost of $600 for the month.
f. The first customerspay Horse Trails & Stables$4,225 for 6 months' worth of
riding lessons.
E1-94. Analyze businesstransactions using the accounting equation. Enter each transaction into the accounting equation and identify its increaseor decreaseto assets,liabilities,
shareholder'sequity, revenues,or expensesof Green Trees & Lawn Corp. (LO 4)
a. GreenTrees& Lawn earnedand collectedthe cashfor $15,000in servicerevenues.
b. The businesspaid $2,000cashfor supplies.
c. GreenTrees& Lawn paid $1,500of a $4,000note payableto creditors.
d. The companypaid $1,100for rent expense.
e. The company'sowner provided $7,500in additionalfinancingin exchangefor
common stock.
f. The businesspaid $2,100in dividends.
g. Green Trees & Lawn loaned $2,225 cash to anothercompany.
Use the following format:
Shareholder'sequity
Total

ASSETS

Total
liabilities

Contributed +
capital

Retained
earnlngs

Transactiona:
E1-10A. Changesin net income.For eachof the following transactions,determineif there
is an increase,decrease,or no changeon net income for Fun Movie ProductionsInc. (LO 4)
a. Fun Movie earned$10,000in monthly sales.
b. The firm recorded a decreasein inventory of $6,000 due to the monthly sales.
c. The companypaid currentmonth'srent of $1,500.
d. The company paid employees$2,500 for work done in the curuentmonth.
e. The companypurchasedland for $7,500.
f. Fun Movie invested$4,000in anothercompany'sstock.
g. The firm paid $1,000in cashdividends.
E1-11A. Relationshipbetweenincome statementand balance sheet.FiIl in the amounts
for X, Y, and Z in the table shown below. (The company started businesson January 1,

200e.)(Lo 4)
D e c .3 1
2009

D ec.31
2010

Assets
Liabilities

$1,ooo

$2,soo
$1,ooo

Contributedcapital
R e ta i n e de a rn i n g s

$ :OO
Y

Revenue

$300

z
$2,soo

Expenses

$ tO O

$1 , s 0 0

$ 300

El-124. Revenuesand the statementof cashflows. Joan starteda catering businesson

the first day ofJuly. She catered 10 partiesin July and earned$300 for eachparty. Most
of her customerspaid her at the time sheprovided her services,but one customer,George
Smith, askedJoanto sendhim a bill and he would then sendher a check. She sentGeorge
an invoice but had not receivedhis payment by the end of July. When Joan preparesher
first monthly income statement,how much will the statementshow for revenuefor the
month? How much will be shown on the statementof cashflows as cash collected from
customersfor the first month? (LO 4)

37

38

CHAPTER1 . BUSI NESS:

W H, AT' SlT ALL ABO U T ?

E1-13A. Expensesand the statementof cashflows. Naida decided to open a candle shop.
During her first month of business,she purchasedcandlesfrom the supplier for a total of
$500 and paid in cash.She sold half of thosecandlesduring the month. On the income statement for the month, what amount would appearfor the cost of goods sold expense?On the
statementof cash flows, what amount would appearas the cashpaid to suppliers?Classify
each ofthese activities as operating, hnancing, or investing. (LO 4)
E1-14A. Retained earnings and cash. The Flower Shop Inc. startedbusinesson January I,
2009, with $5,000 cash contribution from its owners in exchangefor common stock. The
company used $3,000 of the cash for equipment for the new shop and $1,500 for flowers
for its inventory. During the month, the company earned $3,000 revenue fiom the sale of
the entire inventory. On January 3 1, the owners then spent $2,500 for more flowers for the
inventory. What is the retained earningsbalance on January 31? How much cash does the
company have on hand on January 31? Explain what retained earnings are and why this
amount is not cash. Use the accounting equation to help enswer the questions.(LO 4)
E1-15A. Classifucashflows. For E1- 14,A',what amountswould The Flower Shop show
on its statementof cashflows for the month of January2006? Classify each as an operating, investing, or financing cash flow. (LO 2, 4)

Exercises-Set
B
E1-18. Businessexchanges.Identify the transactionsfrom the following story. For each,
identify the give and get portion. Who would be interestedin this information? (LO I, 3)
Bonnie Lawhon decidedto start a businessfor herself breedingAKC miniature dachshunds.
As a talented breeder who gave puppies to her friends and family, she decided to open a
small kennel with $6,500 of her own money. She receivedcommon stock in exchange.The
businesshad concretepoured and fencesinstalled to give the dogs and puppies shelter at a
cost of $3,250,paid in cash.Then,Bonnie'sbusinesshired a consultantto designand maintain a Web page for the company at a cost of $200 for the original design and $25 a month
maintenance.She paid for the design and one month's maintenancefee. The businessrequired a separatemobile phoneto be purchasedat a cost of $169 cash.Then, the business
put an advertisementin the local newspaper,at a cost of $20 per month for weekly ads.The
businesspaid cashfor one month's advertising.The businesswas ready to go.
El-28. Analyze business transactions using the accounting equation. Chris Evans
openeda fishing supply storenamedEvansBait & TackleInc. The following transactions
occurredduring its first month. Enter each transactioninto the accountingequation and
identify an increaseor decreaseto assets,liabilities, shareholder'sequity,revenues,or expenses.(LO 4)
1. Chris Evansused$115,000of personalsavingsin exchangefor commonstock,andthe
businessborrowed $20,000 from the bank to start the business.
2. The businesspurchaseda small building for $55,000.
3. The businessordered$6,500worth ofinventory.
4. The businesspaid operating expensesof $3 15 the first month.
5. EvansBait & TackleInc. sold $2,500of inventoryto customersfor $5,215.
Al1 the transactionswere for cash.Use the followins format:
Shareholder'sequity
Total
assets

Total
liabilities

Contributed +
capital

Retained
earnings

Transaction1:
E1-38. Classify businesstransactions.For each of the transactionsin EI-28, tell whether
the transactionwas an operating, investing, or financing activity. (LO 2)
E1-48. Analyze the balance sheet.Use the balance sheetfor Pet Specialty Supplies Inc. at
December31,2009, to answerthe following questions.(LO 3,4)

C H A P T E R l. E X E R C I S ES 3 9

BalanceSheet
Pet SpecialtySuppliesInc.
At December31,2009

Assets
Cash
Short-terminvestments

Liabilitiesand Shareholder'sEquity
$ 3,000
30

Accountspayable
Notespayable(van)

$ 1,SOO
12,500

Accountsreceivable

465

l n vent or y

725

P a i d-i ncapi tal

2,000

Pre paidins ur anc e

500

R e ta i nedearni ngs

4,020

Prepaidrent

300

Mo b ile gr oom ingv a n (n e t)

1 5 ,0 0 0

$2o,o2o

$2o,o2o

a. List the assetsthe companyhad on December3I,2009. Who has claim to these

assets?
b. List the liabilities the companyhad on December3I,2009.
c. Who are the potential users of this financial information?
E1-5B. Analyzebusinesstransactionsusing the accountingequation.Enter eachtransaction into the accountingequation.Then,calculatethe (1) amountof assetsownedby Barry's
Barrels of Ice Cream Inc. at the end of its first month of businessand (2\ the amount of net
income for the month.All transactionstook placeduring the first month; Barry's was open
for 25 days.(LO 4)
a, Barry startedthe businessby contributing$8,500in exchangefor common stock,
and the firm borrowed $2,500 from the bank.
b. Barry's Barrelsoflce Creampurchasedan ice creamdeliverytruck for $3,500
cash.
c. The businesspurchased$1,500 worth of ice cream and other items (its
inventory) for cash.
d. Bany hired a delivery driver to work 2 days a week for a total of 8 days the first
month to help deliver ice cream for the new company.For this service, Barry's
paid $25 eachday worked.
e. The ice creamdelivery servicewas popularand Barry's sold two-thirdsof its
inventory for total cashrevenuesof $4,500.
f. Barry's paid operatingexpensesof $115 the first month.
g. Barry's repaid$100 of the bank loan along with $5 of interestfor the first
month.
E1-68. Classifybusinesstransactions.For eachof the transactionsin E1-5B, tell whether
the transactionwas an operating, investing, or financing activity. (LO 2)
E1-78. Businesstransactionseffectson shareholders' equity. For each of the transactions given next, tell whetherit (1) increases,(2) decreases,or (3) has no effect on shareholders' equity. Consider both shareholders'equity components-contributed capital
and retainedearnings.(LO 4)
a. Two friends get together,each contributing$23,25} to start the SpotlessCleaning
Corporation in exchangefor common stock.
b. SpotlessCleaningpurchasesa companyvan for $30,000cash.
c. SpotlessCleaning purchases$2,250 worth of inventory for cash.
d. SpotlessCleaningpays expensesof $2,150 for gas and auto insurance.
e. SpotlessCleaning earnsservicerevenuefrom customersof $8,150 during the
month and receivedpayment in cash.
f. SpotlessCleaning pays employees$465 for hours worked during the month.
g. SpotlessCleaningdeclaresand distributes$360 dividendsto eachofits owners
at the end of the month.

40

W HAT' S lT ALL ABOU T ?

CHAPTER1 . BUSI NESS:

E1-88. Classfu cashflows. Classify each cash transactionfor the statementof cash flows
as an operating, investing, or financing activity. (LO 2,4)
a. William makes a contribution of $75,000 from his personal funds to start the
Cookie Dough & More Ice Cream Co. and received common stock in exchange.
b. The company purchasesa building and some equipment for $45,000 in cash.
c. The company purchases$5,500 worth of advertising time on a local television
station for cash.
d. The company pays electricity and insuranceexpensesof $1,500 for the month.
e. The companyhires severalpeopleto help make ice creamat a cost of $350 for the
month and pays them in cash.
f. The National Bank pays $2,500 for ice cream and catering servicesfor its grand
opening.
El-98. Analyze businesstransactionsusing the accounting equation.Enter eachtransaction
into the accountingequation and identify an increaseor decreaseto assets,liabilities, shareholders' equity, revenues,or expensesof CapturedMemories PhotographyInc. (LO 4)
a. CapturedMemoriesearned$16,150in salesrevenues.
b. The firm paid $1,500cashfor supplies.
c. CapturedMemoriespaid $1,000of a $3,000note payableto creditors.
d. The companypaid $1,750for operatingexpenses.
e. The company'sowner provided$6,500in additionalfinancingin exchangefor
common stock.
f. The firm paid $1,020in dividends'
g. CapturedMemoriesloaned$1,000cashto anothercompany.
Use the following format:
Shareholder'sequity
Total
assets

Total
liabilities

Contributed+
capital

Retained
earnings

Transactiona:
E1-10B. Changesin net income.For eachof the following transactions,determineif there
is an increase,decrease,or no changeon net income for WisteriaLane ProductionsInc.
(LO 4)
a. WisteriaLane earned$12,000in monthly sales.
b. The firm recordeda decreasein inventoryof $7,500due to the monthly sales.
c. Supplieswere purchasedfor $50, and all ofthem were used.
d. The companypaid employees$1,715for currentwork done.
e. The companypurchasedland for $26,500.
f. Wisteria Lane paid rent of $2,500 for the current month.
g. The firm paid $1,000in cashdividends.
E1-11B. Relationshipbetweenincomestatementand balancesheet.FllTin the amountsfor
X, X and Z in the table.The companystartedbusinesson July l, 2008. (LO 4)

June30
2009

June30
2010

Assets
Liabilities

$z,ooo

$q,zso

Contributedcapital

$ 500

$ 700

R etai nedearni ngs

YZ
$ aoo
$ zso

$7,200
$6,700

Revenue
Expenses

92,500

El-128. Revenuesand the statementof cash.flows.LyndaWatson starteda consulting business on the first day of April. She provided consulting servicesfor 30 hours in April and

CHAPTER
1 o PROBLEMS

earned$ 140 per hour. Most of her clients paid her at the time sheprovided her services,but
one customer,Ray Linch, askedLynda to sendhim a bill for the 5 hours sheworked for him
and he would then sendher a check. She sent Ray an invoice but had not receivedhis payment by the end of April. When Lynda preparesher first monthly income statement,how
much will the statementshow for revenuefor the month? How much will be shown on the
statementof cash flows for the month as cash collected from customers?(LO 4)
El-I38. Expensesandthe statementof cashflows.Naida owns a candleshop.During herthird
month of business,shepaid $50 to principal and $5 to intereston a loan from the bank. On the
income statementfor the month, what amountwould appearas an expense?On the statement
of cash flows, what amount would appearas the loan payment to principal? Would each of
theseactivitiesbe classifiedas operating,financing, or investing?(LO 4)
E1-148. Retainedearningsand cash. Cookies & PastriesInc. startedbusinesson July 1,
2010, with $16,000 cash contribution from its owners in exchangefor common stock. The
companyused$7,500ofthe cashfor equipmentfor the new shopand $3.500for cookiesand
pastriesfor its inventory. During the month, the company earned$7,000 cashrevenuefrom
the sale of the entire inventory. On July 31, the owners spent $5,000 for more cookies and
pastriesfor the inventory.What is the retainedearningsbalanceon July 31? How much cash
doesthe companyhaveon hand on July 3 1?Explain what retainedearningsare and why this
amount is not cash. Use the accounting equation to help answer the questions.(LO 4)
E1-158. Classify cashflows. For El-14B, what amountswould Cookies & PastriesInc.
show on its statementof cash flows for the month of July 2010? Classify each as an operating, investing,or financingactivity.(LO 2,4)

Problems-SetA
PI-IA, Analyzeincomestatementand balancesheet.A setof.financialstatements.for
Seminole Companyfollows. (LO 4)
SeminoleCompany
lncome Statement
For the year ended 12131107
Sales
Costof goods sold
Grossprofit on sales
Administrativeexpenses
Op e ra ti n gi n c o m e
Interestexpense
In c o meta x e x p e n s e

$600,000
?
37s,000
54,000
?
6,000
94,500

Net income
SeminoleCompany
BalanceSheet
At 12t31tO7
Cash
Accountsreceivable
Inventory
E quipm ent

$U
13,024

Accountspayable
Notespayable

$ 13,3s0
9,830

Contributedcapital

605,000
?
?

43,271
972,684

R e tai nedearni ngs

Total

$1,129,780

Total

Required
Fill in the missing amounts (indicated with question marks).

41

42

CHAPTER1 . BUSI NESS:

W HAT' S lT ALL ABO U T ?

P1-2A. Analyze businesstransactions using the accounting equation. The following transactionsapply to Jenna& Frith's Maid Serviceduring April 2008. (LO 3,4)
1. Jennastartedthe businessby depositing$5,000in a businesscheckingaccounton April 1
in exchangefor common stock.
2. The company provided servicesto clients and received $4,215 in cash.
3. The companyborrowed$1,200from the bank for the businessby signing a note.
4. The companypaid $1,125ofoperating expenses.
5. The companypurchaseda new computer for $3,000 cashto use to keep track of its customers, starting next month.
6. The companydistributed$1,050to the owner.

Required
a.
b.
c.
d.
e.

Enter the transactionsinto the accounting equation.

What are the total assetsof the company at the end of April 2008?
Preparea statementof cash flows for April 2008.
What was net income for April 2008?
Who might find the information on Jenna& Frith's Maid Service financial
statementsuseful?

P1-3A. Analyzebusinesstransactionsand the ffict on thefinancial statements.The following

businesstransactionsoccurredduring Gator'sAntiquesInc.'sfust month of business.(LO 2,4)
1. Philip Gatorbeganhis antiquebusinessby depositing$15,000into the businesschecking account.He receivedcommon stock in exchange.
2. Gator'sAntiquesprovided servicesto customersfor $25,000.
3. The companypaid travel expensesin the amountof $700.
4. Gator'sAntiquesborrowed$1,000from the bank for operatingcapital.
5. The company purchased$150 worth of office supplies(for future use) from Office
Market for cash.
6. During the month, Gator'spaid $3,500for operatingexpenses.
7. The companypaid monthly rent on the retail spacein the amountof $500.
8. The companypaid the staff $ I ,200.
9. The company paid a dividend of $ I 00 to the owner, Philip Gator.
10. On the last day of the month, Gator'spurchasedequipmentcosting$7,500by signing
a note payable with the bank.

Required
For eachtransaction(items 1-10), do the following:
a. Identify whether it is an operating, investing, or financing transaction.
b. Determine whether there is an increase,decrease,or no effect on the total assets
of the business.
c. Determine whether there is an increase,decrease,or no effect on net income.
d. Indicate on which financial statementeach amount would appear:the income
statement(IS), the balancesheet(BS), the statementof changesin shareholder's
equity (OE), or the statementof cash flows (CF). (Some will be shown on more
than one statement.)
P1-4A. Analyze businesstransactionsand the ffict on the financial statements.Usitg
transactions1-10 in Pl-3A, answerthe following questions:(LO 4)
Required
a. What is the cashbalance at the end of Gator's first month of business?
b. Does Gator's Antiques have any liabilities at the end of the first month of
business?If so, how much?
c. Which assetswill appearon the balance sheetat the end of Gator's first month of
business?
d. Did Gator's Antiques generatenet income or net loss for its first month of
business?How much?

CHAPTER
1 . PROBLEMS

P1-54. Analyze effect of transactionson accounting equation.What will be the effects (increase,decrease,or no effect) on total assets,total liabilities, and total stockholder'sequity
in each of the following situations?When shareholder'sequity changes,note whether it is
contributed capital or retained earnings that changes.Identify whether each transactionis
an operating,investing,or financingtransaction.(LO 2,4)
Shareholder'sequitv
Total
assets

Total
liabilities

Contributed +
capital

Retained
earnlngs

1. Receivedcash
and issued
sharesof
common stock
) Purchased
equipment with
cash
3. Receivedcash
from customers
for services
rendered
4. Borrowed
money from
the bank
Receiveda
utility bill and
paid cash fbr it
P1-6A. Analyzebusinesstransactionsand prepare thefinancial statements.
The following
cashtransactionstook place during April 2009, the first month of businessfor Fast Food
SuppliesInc. (LO 4)
l. Kristin Adams starteda business,FastFood SuppliesInc. by contributing$6,000.She
receivedcommon stock in exchange.
2. The company earnedand received cash of $900 in revenue.
3. The companypaid expensesof $650 in cash.
4. Companypaid dividendsof $25.
5. On April 30, the companyborrowed $3,000from the local bank by signing a 3-yearnote.

Required
a. Show how each transactionaffects the accounting equation.
b. Preparethe four basic financial statementsfor the month of April. (Balance Sheet
at April 30,2009)
P1-7A. Retainedearningsportion of the statementof changesin shareholder'sequity.The
following information is for Pete'sPet Shop. (LO 4)
1.. Retainedearningson January1,2010, were $100,000.
2. In January,revenueswere 950,000and expenseswere $60,000.
3. In February,revenueswere $70,000 and expenseswere $65,000.
4. In March, revenueswere $90,000and expenseswere $55,000.
5. The only dividendspaid were in March for $3,000.
Required
Preparethe retainedearningsportion of the statementof changesin shareholder'sequity for
the threemonthsendedMarch 31. 2010. for Pete'sPet Shoo.
l-&t-l--

Problems-Set B
Pl-1B. Analyze income statementand balance sheet.A set of Jinancial statementsfor
Shelby'sMusic Inc. follows. (LO 4)

1;W
r.;@
Excel

TeEplate

43

'

, ' ; l' : ' '

I 'I : : : : .:

44

W HAT' s I T ALL ABO U T ?

CHAPTER1 ' BUSI NESS:

Shelby'sMusic Inc.
lncomeStatement
For the year ended June 30, 2008
S al es

375,000

Costof goodssold
Grossprofit on sales

525,000
x

Administrativeexpenses

419,000

Operati ngi ncome

Interestexpense
lncometaxes

142,450

Net income

264,550

Shelby'sMusic Inc.
BalanceSheet
At June 30, 2008
Cash
Accountsreceivable
Inventory
Eq u i p m e n t

$ 158,592
18,621

Accountspayable
Notespayable

895,895

C ontri butedcapi tal

R etai nedearni ngs

Total

$ 14,070
12,520

Total

x
425,00 0

$1,231,000

Required
Fill in the missingamounts.
Pl-28. Analyze businesstransactions using the accounting equation. The following transactionsapply to Xavier Bostic'sAuto Detail Serviceduring November2008. (LO 3, 4)
L. Xavier startedthe businessby depositing$3,350 in a businesschecking accounton
November 1 in exchangefor common stock.
2, The companypurchaseda vacuumcleanerfor $1,145cash.
3. The companyborrowed$1,575from the bank for the businessby signing a note.
4. The companyprovided servicesto clientsand received$5,705in cash.
5. The companypaid $535 of operatingexpenses.
6. The company made a distribution of $200 to the owner.

Required
a.
b.
c.
d.
e.

Enter the transactionsinto the accounting equation.

What are the total assetsof the company at the end of November 2008?
Preparea statementof cashflows for November 2008.
What was net income for November 2008?
Who might find the information on Xavier Bostic's Auto Detail Service financial
statementsuseful?

P1-3B. Analyze businesstransactions and the effect on the financial statements.The following businesstransactionsoccunedduring Dolphin's DinghiesInc.'shrst month of busin e s s (L
. O 2 ,4 )
L. Douglas Dolphin beganhis dinghy businessby depositing$40,000into the business
checking account in exchangefor common stock.
2. The company paid travel expensesin the amount of $250.
3. Dolphin's Dinghies borrowed $5,000 from the bank for operating capital.
4. The company purchased$350 worth of office supplies (for future use) from Office
Supermarketfor cash.
5. During the month, Dolphin's repairedcustomers'dinghiesfor $8,900cash.
6. The company paid the monthly rent on the retail spacein the amount of $1,200.

C H A P T E R l. P R O B L E M S

7. The company paid the staff $3,000.

8. Other operating expensesfor the month were $1,500, which were paid in cash.
9. On the last day of the month, the company purchasedequipment costing $17,000 by
signing a note payable with the bank
10. The companypaid a dividend of $175 to the owner,DouglasDolphin.

Required
For each transaction (items 1-10), do the following:
a. Identify whether it is an operating, investing, or financing transaction.
b. Determine whether there is an increase.decrease.or no effect on the total assets
of the business.
c. Determine whether there is an increase.decrease.or no effect on net income.
d. Indicate on which financial statementeach amount would appear:the income
statement(IS), the balance sheet(BS), the statementof changesin stockholder's
equity (SE), or the statementof cashflows (CF). (Somewill be shownon more
than one stat"ement.)
P1-48. Analyze businesstransactionsand the ffict on the financial statements.Using
transactions1-10 in Pl-38, answer.thefollowing questions.(LO 4)

Required
a. What is the cashbalanceat the end of Dolphin's first month of business?
b. Does Dolphin's Dinghieshave any liabilities?If so, how much?
c. Which assetswill appearon the balancesheetat the end of Dolphin's first month
of business?
d. Did Dolphin's Dinghiesgeneratenet income or net loss for its first month of
business?How much?

--

Pl-58. Analyze ffict of transactionson accounting equation.What will be the effects (increase,decrease,or no effect)on total assets,total liabilities,and total shareholder'sequity
in eachof the following situations?When shareholder'sequity changes,note whetherit is
contributed capital or retained earnings that changes.Identify whether each transactionis
an operating,investing,or financingtransaction.(LO 2,4)
Shareholder'secuitv
Total
assets

Total
liabilities

Contributed +
capital

Retained
earnings

1. Purchasedland
with cash
2. Performed
servicesand
received cash
from customers
3. Receivedcash
from the issue
of sharesof
common stock
4. Paid cash
for inventory
5. Sold inventory
for cash
P1-6B. Analyze businesstransactionsand prepare thefinancial statements.The following
cash transactionstook place during January 2001, the first month of businessfor Auto Detail Unlimited, a corporation. (LO 4)
1. Dustin SoperstartedAuto Detail Unlimited by contributing $24,000 cashand received
common stock in exchange.
2. The company earnedand received $3,100 cash in service revenue.

45

46

CHAPTER1 . BUSI NESS:

W HAT, SI T ALL ABOU T ?

3.
4.
5.
6.

The companypaid employees$985 cash.

Miscellaneous expensespaid amountedto $650 cash.
The companypaid cashdividendsof $500.
On January3 1, the company borrowed $8,000 from the local bank, to be repaid at the
end of December 200'7.

Required
a. Show how each transactionaffects the accounting equation.
b. Preparethe four basic financial statementsfor the month of January.(Balance
sheetat January3l,2007 .)
P1-78. Retainedearningsportion oJ the statementof changesin shareholder's equity. The
following information is for Pete'sPet Shop. (LO 4)
1.
2.
3.
4.
5.

Retainedearningson April 1, 2008 were $127,000.

In April, revenueswere $85,000and expenseswere $72,000.
In May, revenueswere $16,582and expenseswere $37,000.
In June,revenueswere $82,000and expenseswere $18,582.
The companypaid dividendsin April of $8,000and in Juneof $19,500.

Required
Preparethe retainedearningsportion ofthe statementofchanges in shareholder'sequity for
the quarter(3 months)endedJune30, 2008, for Pete'sPet Shop.

Analysis
Financial
Statement
FSA 1-1. Use Apple ComputerInc.'sbalancesheetsgiven hereto answerthe questions.(LO 5)

AppleComputerInc.
Condensed
Balance
Sheets
(in millions)
Assets:
Cashand cashequivalents
Short-termi nvestments
Accountsreceivable(net)
lnventories
Other currentassets
Total current assets
Property,plant, and equipment(net)
Goodwill
Other assets
Total assets

Ar9/24/Os
$ 3,4e1
4,770
895
165
979

10,300
817
69
365
$ 11,551

el25/04
$ 2,969
2,495
774
101
716
7,055
707
80
208

$ 8,0s0

Liobiliriesond Shoreholders' Equity:

Accountspayable
Accruedexpenses
Totalcurrent liabilities
Other noncurrentliabilities
Tot al liabilit ies
Commonstock
Retainedearnings
Other equity accounts
Totalshareholders'
equity
equity
Total liabilitiesand shareholders'

$ 1,779
1,705
3,484
601
4,085

$ t, qst
1,200
2,651
323

3,521
4,005
(60)
7,466

2 ,5 1 4
2,670
(108)
5,076

) r r,))l

2,974

$ 8,0s0

CHAPTER
1 . F I N A N C I A LS T A T E M E N T
ANALYSIS

Required
a. What date marks the end of Apple's most recent fiscal year?
b. Did Apple earn a net income or net loss during the year? How can you tell?
c. Did the owners of Apple make any capital contributions during the year (or did
Apple get some new owners)?
d. Did Apple buy or sell any property, plant, or equipment during the year? How
can you tell?
e. On the last day of the fiscal year, did Apple have any debts?If so, what was the
total amount?
FSA 1-2. The statementof cashflows for Apple Computer Inc. for the year endedSeptember 24,2005, is shownbelow.Use it to answerthe following questions.(LO 5)
Apple ComputerInc.
Adapted Statement of CashFlows
For the year ended September 24,2005
(in million s)
Cashand cashequivalents,beginningof the year
OperatingActivities:
Net income(loss)
Adjustmentsto reconcilenet incometo cashgeneratedby operatingactivities:
Cashgeneratedby operatingactivities
InvestingActivities:
Purchaseof short-term i nvestments
Proceeds
from maturitiesof short-terminvestments
Proceedsfrom salesof short-term investments
Purchase
of property,plant, and equipment
Other
Cashgeneratedby (usedfor) investingactivities
FinancingActivities;
Proceeds
from issuance
of common stock
Cashgeneratedby (usedfor) financingactivities
Increase(decrease)
in cashand cashequivalents
Cashand cashequivalents,end of the year

$2,969

1,335
1,200

2,53s
(11,470)
8,609
s86
(260)
(21)
(2,ss6)
543

543
522
$3,491

Required
a. Did Apple purchaseany property, plant, or equipment during the year?
b. If you were to examineApple's balancesheetat September24,2005, what
amount would be shown for cash and cash equivalents?
c. Was cash generatedfrom operationsor used by operations?By what amount?
d. Did Apple receive any new contributions from owners during the year? How can
you tell?
e. What was the primary sourceof cash for Apple for the year ended September24,
2005?What doesthis say to you aboutApple's operationsfor this year?
FSA 1-3. Use the annual report from Office Depot found on this book's website to answer
(LO 2,3,5)
thesequestions.

Required
a. What type of businessis Office Depot and how is it organized?
b. Supposeyou inherited $10,000 when your great-unclepassedaway and you want
to invest in a promising company.Would you invest in Office Depot? What
information in the annual report would be useful in your decision?Be specific. Is
there any information that is not provided in the annual report that you would
want to have before making your decision?
c. What is your opinion of the information in the annual reporl? For example, do
you think it is accurate?Useful? Interesting?Informative? Why or why not?

47

48

CHAPTER1 . BUSI NESS:

W HAT' S lT ALL ABOU T ?

CriticalThinkingProblems
Risksand Controls
Being in businessis risky. Imagine that you are starting a business.What type of business
would you start?What are the most significant risks you face with your business?What controls would you put into effect to minimize those risks?
Group Problem
Look at the four basic financial statementsfor Staples,found in the book's appendix.Find
the total assets,liabilities, and shareholders'equity for the two most recent years. As a
group, discussthe changein the company'sfinancial position without looking at the income
statement.Jot down your opinions. Then, study the income statementfor the most recent
year. Do the results suppoft your opinions about the balancesheetchanges?What information do these statementsprovide for your analysis?What additional information would be
useful? After answering thesequestionsas a group, look at the notes to the financial statements. Do the notes help answer any of your questions?
Make a list of 10 questionsyou have about the financial statements.Try to answerthem
and discusswhy you would like answersto thesequestions.Savethe list so you can check
to seehow many of the questionsyou are able to answer at the end of the course.

Ethics
Does your school have an honor code?If it does,it very likely addressesthe issueof cheating on assignmentsor exams. Have you ever cheated on an exam? Have you ever "borrowed" a friend's assignmentand used it to help you complete yours? Have you ever been
a witness to a violation of the honor code by your peers?Compare Target's code of ethics
(called Business Conduct Guide and found at www.targetcorp.com,/targetcorp3roup/
investor-relations/investor-relations,jhtml)to your school's honor code. How are they similar in purpose and scope?How are they different? If you compareyour behavior to that of
some of the executivesof Enron, WorldCom, or Tyco, how do you stack up?

lnternetExercise:
DisneyCorporation
The Walt Disney Company is a diversified worldwide entertainmentcompany with interests in ABC TV ESPN, film production, theme parks, publishing, a cruise line, Infoseek,
and the NHL Mighty Ducks. By using the Disney Web site, you can explore vacation options and get Disney's latest financial information.
Pleasego to the Disney Web site athttp:llcorporate.disney.go.com/investors/
IE1-1. What is the Walt Disney Company's key objective?
Go to Financial Information and click on the most recent annual report.
a. What are the key businessesof the Walt Disney Company?Identify whether you
think the primary businessactivity is manufacturing,merchandising.or service
for eachkey businesssegment.
b. Use the Site Map to find Financial Highlights. Identify the amount of total
revenuesand operating income for the most recent year. On which financial
statementwill you find these amountsreported?Is the Walt Disney Company a
proprietorship, a partnership,or a corporation?How can you tell?
c. Use the Site Map to frnd Financial Review. What key businesssegmentearnsthe
greatestproportion ofrevenues? Identify the proportion ofrevenues earnedby
eachkey businesssegment,listing them in the order of greatestproportion to
least proportion. Does this order surpriseyou? Explain why or why not?
Pleasenote: Internet Web sites are constantly being updated.Therefore, if the information
is not found where indicated,pleaseexplore the annualreport further to find the information.