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P3-14 Preparing Financial Statements and Making Decisions
Objs. 2, 3, 4
The Desert Harbor Inn has been in business for more than 100 years but was recently reno-
vated. On January 1, 2004, the balance sheet of the company was as shown on the next page.
During 2004, the inn earned $165,000 from room rentals and another $35,000 from park-
ing, the gift shop, and other guest services. Of this amount, $187,000 was received in cash by
year end; $13,000 was still collectible from credit card companies and one very reliable cor-
porate account. Expenses incurred during the year included staff wages, $49,000; utilities,
$10,400; supplies used, $4,300; depreciation on furniture and fixtures, $1,500; depreciation on
the building, $3,500; interest on note payable, $4,700; cost of goods sold by gift shop, $11,000;
and other miscellaneous expenses of $3,300.
Except for depreciation, supplies consumed, and $890 of wages still owed to employees,
all expenses were paid for in cash. Other cash payments included $800 for purchase of sup-
plies and $35,000 paid on the principal of the note payable. Owners withdrew $45,000 from
the business for living expenses during the year.
F119
CHAPTER F3: Measuring Revenues and Expenses
118 Measuring Revenues and Expenses


Desert Harbor Inn
Balance Sheet
January 1, 2004

Assets Liabilities and Owners™ Equity

Cash $ 4,900 Notes payable $ 56,500
Supplies on hand 8,800 Investment by owners 60,000
Furniture and equipment 25,000 Retained earnings 19,200
Buildings 95,000
Accumulated depreciation (10,000)
Land 12,000
Total $135,700 Total $135,700



Required
A. Prepare year-end financial statements for the company for 2004. Include an income
statement, statement of cash flows, and a balance sheet.
B. From a financial perspective, does this company appear to be one that you would like
to own? Why or why not?

Identifying Problems in Financial Reporting
P3-15
Objs. 2, 3, 4 Alma Zorditch started an Internet company and has computed the first year™s profit as shown
below. She is distressed. She thought the business had been going fairly well but does not know
how she can live on the meager profit the company has earned. She is considering going out
of business. Alma doesn™t have any formal training in accounting but once took a 4-hour sem-
inar on the subject. That seminar impressed on her the importance of keeping detailed and
accurate records. All the numbers reported below are accurate, but there may be other prob-
lems that you can identify.


Zorditch.com
Profits I Made the First Year

Revenue:
Cash collected from customers $173,400
Accounts receivable at year end 18,200
Total revenue $191,600
Expenses:
Money I contributed to start the firm 15,000
Purchase of office furnishings & equipment 28,500
Purchase of office supplies 1,560
Rent on the office space 13,000
Loan from the bank 50,000
Wages paid to employees 36,200
Advertising and promotion 24,280
Miscellaneous 11,300
Total expenses 179,840
Profit $ 11,760



After talking with Alma, you discover the following additional information.
1. When purchased, the office furnishings and equipment have an expected useful life of 5
years. That estimate still appears reasonable.
2. All office supplies have been used up.
3. The rent amount includes $1,000 rent paid in advance for the first month of Year 2.
4. Half of the advertising and promotion amont is for a campaign that will begin 3
months from now. (Continued)
F120 SECTION F1: The Accounting Information System
119
Measuring Revenues and Expenses

Required
A. Study the information given and prepare a new income statement making all changes
you believe are appropriate.
B. Wherever your report differs from Alma™s, justify the change you have made.
C. Based on your revised income statement, what advice would you have for Alma? List
two or three specific suggestions.

Adjusting Entries and Closing Entries: Effects on Financial
P3-16
Statements
Objs. 4, 5
The Flash Pan Company manufactures cooking products. On August 1, 2004, the company
borrowed $125,000 from creditors. Semiannual interest payments of $7,500 are to be made to
creditors beginning January 31, 2005. On July 1, 2004, the company purchased a 1-year in-
surance policy for $10,000 and recorded it as prepaid insurance. On January 1, 2004, the com-
pany purchased equipment for $50,000. The equipment has an expected life of 4 years. On
October 1, 2004, the company rented some of its unused warehouse space to another com-
pany. The other company agreed to pay $15,000 for the space every 6 months beginning April
1, 2005. Balance sheet and income statement information reported by Flash for the fiscal year
ended December 31, 2004 included:

Assets $625,000
Liabilities 250,000
Owners™ equity 337,500
Revenues 150,000
Expenses 112,500
Net income 37,500

The balance sheet did not balance but it was distributed anyway. Later, it was discovered
that the company™s accounting staff had failed to record any adjusting entries at the end of
2001 for interest, insurance, depreciation, or rent. In addition, no closing entries had been
made.

Required
A. Record the adjusting entries that should have been made at year end 2004.
B. Explain why the balance sheet did not balance and whether this was caused by the fail-
ure to record adjusting entries or the failure to record closing entries.
C. Identify the corrected amounts for the balance sheet and income statement. Show your
work.

End-of-Period Adjustments and Closing
P3-17
Objs. 4, 5 At December 31, 2004, the accountant at Puget Sounds, a recording studio, has entered all the
firm™s transactions into the accounting system and is beginning the end-of-period process. He
asks your help in identifying the necessary adjusting entries. In the first column on page F121,
the accountant has listed the company™s account balances before considering adjustments. In
addition, he has provided other information that may cause you to recommend that certain
adjusting entries be made.
1. $4,350 of wages earned by employees during December have not been recorded or
paid.
2. The prepaid insurance is for a 3-year policy purchased on the first day of the year just
ending.
3. Unearned revenues are for contracts for the use of studio facilities. $12,000 of this
amount has been earned by December 31.
4. A count at year-end shows that $10,050 of supplies remain on hand.
5. The note payable was issued on October 1, 2004. Interest accumulates in the amount of
$3,000 per month. Interest has not yet been recorded for December.
6. Depreciation on equipment is $1,500 per month. Depreciation on buildings is $600
per month. No depreciation has yet been recorded for the quarter (3 months) just
ended.
F121
CHAPTER F3: Measuring Revenues and Expenses
120 Measuring Revenues and Expenses


Account Balance Account Balance
Before Adjustment Adjustments After Adjustment
Cash $ 52,500
Accounts receivable 35,250
Supplies 19,200
Prepaid insurance 4,050
Equipment 468,000
Accumulated depreciation”equipment (129,000)
Buildings 649,500
Accumulated depreciation”buildings (85,500)
Land 58,500
Total assets $1,072,500
Unearned revenues $ 36,000
Accounts payable 27,900
Interest payable 6,000
Wages payable 0 (1) 4,350 4,350
Notes payable 420,000
Common stock 300,000
Retained earnings (a) 224,100
Total liabilities & stockholders™ equity $1,014,000
Rent revenues $ 100,500
Wages expense (36,000) (1) 4,350 (40,350)
Supplies expense 0
Insurance expense 0
Interest expense (6,000)
Depreciation expense 0
Net income $ 58,500
(a) Net income has not been added for
the current year.



Required
A. Identify any adjustments you believe necessary and enter their effects in the adjust-
ments column of the table above. Code each adjustment with the number to which it
relates. The first item is completed for you as an example.
B. Record the proper ending amount for each account in the final column.
C. On the table you have completed, why doesn™t the total of all asset accounts equal the
total of all liability and equity accounts?
D. What additional step(s) needs to be performed before financial statements can be pre-
pared? Explain how this will solve the imbalance identified in part (C) above.
E. By what amount (and percentage) would net income have been misstated if no adjust-
ing entries had been recorded by this company?
F122 SECTION F1: The Accounting Information System
121
Measuring Revenues and Expenses

P3-18 Types and Treatment of Accounts
Obj. 5
Encanto Properties, Inc., uses the accounts listed below.
A. Prepaid Insurance J. Prepaid Advertising
B. Retained Earnings K. Notes Payable
C. Accumulated Depreciation L. Cost of Goods Sold
D. Wages Expense M. Machinery
E. Commissions Revenue N. Owners™ Capital
F. Interest Payable O. Accounts Receivable
G. Supplies P. Bonds Payable
H. Insurance Expense Q. Supplies Expense
I. Unearned Rent R. Depreciation Expense

Required (a) For each account above, indicate whether it is an asset, liability, owners™ eq-
uity, revenue, or expense account. (b) Indicate whether the account is closed at the end of the
fiscal year.

Ethical Issues in an Accounting System
P3-19
Obj. 6 Ethel Spikes works for Hard Rock Candy Company. She enters customer orders in the com-
pany™s accounting system. The orders are written on prepared forms by the company™s sales
representatives (reps). The company employs ten sales reps, who work different territories.
The reps are paid on a commission basis for sales made during the preceding month. Sales
reports prepared by the accounting department supervisor are used to determine the com-
missions. Sales reps drop off the forms with the accounting supervisor each week. The super-
visor then delivers the forms to Ethel. She enters the orders in a computer and prints out a
sales report and sales invoices for each customer. These are picked up by the supervisor, who
delivers them to payroll and to shipping. The result of entering the orders in the accounting
system is to increase accounts receivable and to increase sales revenue.
Ethel has discovered an interesting regularity in some of the orders. One of the sales reps
always reports abnormally high orders from a particular customer. A few days after the end
of each month, the rep submits a cancelation form for the customer to eliminate a large por-
tion of the customer™s order. The supervisor directs Ethel to record the cancelation by reduc-
ing accounts receivable for the customer and recording an increase in an operating expense
account. Ethel doesn™t know much about accounting. When she asked her supervisor about
this procedure, she was told that it was standard for this customer and not to worry about it.
Ethel smells a rat, however, and has considered discussing the matter with the vice pres-
ident for finance. But she is concerned she may simply be making waves that will alienate her
supervisor.

Required Ethel has sought your advice, as a friend, about this matter. What would you rec-
ommend to Ethel? What problems do you see in Hard Rock™s accounting system? How might
these problems be solved?

Describing Processes in an Accounting System
P3-20
Obj. 6 Flora Wiser is the daughter of the owner of Wiser Florist Company. She recently completed
college with a major in biology and has taken the job of assistant manager. Her primary du-
ties involve purchasing inventory from suppliers. Flora has little understanding of account-
ing, and you have been asked to help her become familiar with the company™s accounting
system and how the system processes information.

Required Write a memo to Flora describing the purpose of an accounting system. Describe
each of the basic processes that occur within financial accounting systems and how these
processes accomplish the purpose of the system.

Excel in Action
P3-21
The problem in Chapter F2 provided account balances for The Book Wermz on September
30, 2004, the end of the company™s fiscal year: Cash $4,238.72, Inventory of Books $235,892.35,
Supplies $2,343.28, Equipment $43,297.00, Notes Payable $123,452.88, Investment by Owners
F123
CHAPTER F3: Measuring Revenues and Expenses
122 Measuring Revenues and Expenses

$100,000, and Retained Earnings $62,318.47. Chapter F2 also listed summary transactions for
October 2004:

Cash sales $38,246.50
Cost of goods sold 27,318.93
SPREADSHEET
The Equipment account balance of $43,297.00 is net of accumulated depreciation of
$12,353.00. Therefore, the Equipment balance before considering the effect of depreciation is
$55,650.00.
Other transactions for the month ended October 31, 2004, include:

Cash paid for books purchased $18,243.27
Cash paid for supplies 1,750.92
Cost of supplies used in October 2,129.48
Employee wages earned and paid in October 3,620.83
Employee wages earned in October but unpaid 527.12
Cash paid for portion of Notes Payable 1,122.77
Cash paid for interest incurred on Notes Payable 823.02
Cash paid for October rent 1,534.86
Depreciation on equipment for October 721.62

In addition, The Book Wermz held classes on book binding for local civic organizations in
October. The organizations agreed to a $500 fee for these services but did not make the pay-
ment in October.

Required Add the transactions described above to those created in Chapter F2. Additional
rows should be added to the spreadsheet for the transactions. Additional columns also will be
needed for accounts not included in Chapter F2. The following accounts should be included
in the spreadsheet in the order indicated: Cash, Accounts Receivable, Supplies, Inventory,
Equipment, Accumulated Depreciation, Wages Payable, Notes Payable, Investment by Own-
ers, Retained Earnings, Sales, Service Revenues, Cost of Goods Sold, Supplies Expense, Wages
Expense, Rent Expense, Depreciation Expense, and Interest Expense. The beginning balance
of all new accounts except Accumulated Depreciation is $0. The beginning balance of the Ac-
cumulated Depreciation account is $12,353 (note this is a negative amount because it is a con-
tra account), and the beginning balance of the Equipment account should be changed to
$55,650 (to permit Accumulated Depreciation to be included as a separate account). Column
sums should be recalculated to determine totals at October 31. Make sure to close the revenue
and expense accounts to Retained Earnings. Use October 31 as the date for all transactions.
Update the balance sheet and income statement by including the effects of the transac-
tions recorded for October. Use cell references in the financial statements to identify amounts
for each account. Add captions to identify each statement. The statements should include the
name of the company on the top line. The next line should identify the financial statement as
a balance sheet or income statement. The third line should identify the date (October 31, 2004
for the balance sheet) or period (for October 2004 for the income statement). List total rev-
enues and total expenses as subtotals on the income statement. Use underlines to separate the
subtotals from other numbers. The Borders button can be used for this purpose.

Multiple-Choice Overview of the Chapter
P3-22
1. The primary difference between control accounts and subsidiary accounts is that
a. control accounts appear on the balance sheet but subsidiary accounts appear on the
income statement.
b. subsidiary accounts provide detailed information; control accounts provide sum-
mary information.
c. control account balances are reported on the financial statements but subsidiary ac-
counts appear only in the general ledger.
d. subsidiary accounts are necessary in a manual accounting system but not in a com-
puterized system.

2. At the beginning of the year, Lagos Importers had $750 of office supplies on hand.
During the year, an additional $3,250 of supplies were purchased and recorded in
(Continued)
F124 SECTION F1: The Accounting Information System
123
Measuring Revenues and Expenses

Office Supplies Inventory. At year end, $900 of supplies remained on hand. Just prior
to preparing the year-end adjusting entry, the balance in the Office Supplies Inven-
tory account was $1,200. Which of the following is a true statement about the neces-
sary adjusting entry?
a. An asset account must be decreased by $300.
b. An asset account must be decreased by $3,250.
c. An expense account must be increased by $1,200.
d. An expense account must be increased by $900.

3. The balance of the merchandise inventory account increased by $3,000 during Febru-
ary. Which of the following statements can be made as a result of this information?
a. Credit sales for the month were $3,000 greater than cash received from cus-
tomers.
b. Purchases of inventory for the month were $3,000 less than the cost of merchandise
sold for the month.
c. Purchases of inventory for the month were $3,000 greater than the cost of merchan-
dise sold for the month.
d. Merchandise purchased for the month totaled $3,000.

4. Which of the following accounts should always have a zero balance after all closing en-
tries are completed?
a. Interest Expense
b. Interest Payable
c. Prepaid Interest
d. Accounts Payable

5. Tempel Manufacturing uses accrual accounting. Each of the following events occurred
during the month of February. Which one of them should be recorded as a revenue or
expense for the month of February?
a. Sales of $30,000 were made on credit. They will be collected during March.
b. Collections of $10,000 were made from sales that occurred during January.
c. Materials costing $18,000 were purchased and paid for. It is expected that they will
be used during March.
d. A bill in the amount of $8,600 was received from a supplier for goods purchased
during January. It was paid immediately.

6. Zinsli Company uses the accrual basis of accounting. Each of the following events oc-
curred during July. Which one of them should be reported as an expense for July?
a. Office supplies costing $800 were used up. They had been purchased and paid for
during April.
b. A new delivery truck was purchased on the last day of July. It was not put into use
until August.
c. On the third day of the month, $8,000 was paid to employees for hours worked
during the month of June.
d. Near the end of the month, August™s rent of $1,500 was paid in advance.

7. The following information is available for two companies for the year 2004:

Handle-Bar Pencil-Thin
Mustache Co. Mustache Co.
Cash Operating Accrual Income
Statement Statement
For the Year 2001 For the Year 2004
Receipts/Revenues $50,000 $55,000
Payments/Expenses 38,000 31,000
Net Cash/Net Income $12,000 $24,000
F125
CHAPTER F3: Measuring Revenues and Expenses
124 Measuring Revenues and Expenses

Which of the following statements can be determined from the information provided?
a. Pencil-Thin collected more cash from customers during 2004 than did Handle-Bar.
b. Pencil-Thin was profitable during 2004, whereas Handle-Bar may have been profitable.
c. Pencil-Thin was twice as profitable as Handle-Bar.
d. Handle-Bar consumed more total resources during 2004 than did Pencil-Thin.

8. Are the following accounts a liability?
Depreciation expense Accounts receivable
a. Yes Yes
b. Yes No
c. No Yes
d. No No

9. Using accrual-basis measurement, expenses should be recognized when
a. a business owner recognizes that the firm is generating too much profit.
b. resources are used rather than when they are paid for.
c. cash is paid for resources.
d. sufficient revenue is earned to offset the expenses.

10. Match the account name to the financial statement on which it is reported.
Accumulated Depreciation
Depreciation Expense
a. Statement of stockholder™s equity Balance sheet
b. Balance sheet Balance sheet
c. Income statement Balance sheet
d. Balance sheet Income statement



CASES
Ethical Issues Involving Revenue Recognition
C3-1
Obj. 4 Flash Newton is national sales director at Bright & Shiny Toothpaste Company. The firm man-
ufactures and distributes a full line of premium-priced personal care products sold through a
carefully selected set of distributors nationwide. The popularity and profit margins of the
Bright & Shiny product line make distributorships very profitable and there is intense com-
petition when one becomes available.
Flash, and the regional sales directors working for him, are compensated by a base salary and
a significant bonus tied to percentage increases in yearly sales. Because of an impending reces-
sion, sales have been mostly flat during the first three quarters of the year. On October 3, Flash
convened a national sales meeting with representatives of all distributors. At that meeting, he pre-
sented the distributors with Bright & Shiny™s newest sales plan. All distributors would be required
to buy, during the 4th quarter, up to 2 years™ worth of inventory of the firm™s products. Further,
the prices charged on these special purchases would be 10% greater than usual. Any distributors
not agreeing to the proposal would automatically lose their distributorship. Because most dis-
tributors are not expected to have cash readily available to pay for these additional purchases un-
der the usual 30-day credit terms, Bright & Shiny will allow up to 12 months to pay.
The new policy has been a huge success and by year end, total orders and shipments to
distributors are up by 12% over the previous year. Bright & Shiny recorded all shipments as
revenue even though some distributors were told by lower-level managers that they could re-
turn unsold products. Because many distributors could not handle the large shipments in their
usual storage facilities, many orders have been shipped to third-party warehouses for storage
at Bright & Shiny™s expense. At Flash™s suggestion, and to obtain maximum benefit of this new
sales program, the company held the books open for a few days after December 31 to obtain
and ship additional orders.

Required Identify and explain any problems you see with the sales plan. If you were Bright
& Shiny™s CEO, which aspects of the sales plan would you have approved and which would
you have denied? Why?
F126 SECTION F1: The Accounting Information System
125
Measuring Revenues and Expenses

C3-2 Evaluating the Results of an Organization™s Transformation Process
Objs. 1, 5
SoftwareSolutions.com has been in business for several years and is publicly traded on a ma-
jor U.S. stock exchange. It is an Internet wholesaler of a variety of commercial software ap-
plications. On January 1, 2004, the company™s balance sheet appeared as follows (all amounts
are in thousands of dollars):



SoftwareSolutions.com
Balance Sheet
January 1, 2004

Assets Liabilities & Stockholders™ Equity
Cash $ 4,240 Wages payable $ 640
Accounts receivable 6,800 Capital stock (owner™s investment) 33,000
Inventory 15,200 Retained earnings 13,600
Buildings & equipment 16,780
Accumulated depreciation (4,780)
Land (for plant expansion) 9,000
Total assets $47,240 Total liabilities and stockholders™ equity $47,240




During the first quarter of the current year (January, February, March), the following events
occurred.
A. New office furniture costing $500 was purchased on the last day of March. This was to
be used in a new sales office that was scheduled to open April 1. The office furniture
was paid for in cash.
B. Wages and salaries totaling $3,200 were paid. Of this amount, 20% was to liquidate
wages payable that arose in the fourth quarter of the previous year. The company has a
policy of not making wage or salary advances to employees.
C. All accounts receivable outstanding at January 1 were collected.
D. The company™s advertising agency billed the firm $1,000 for a campaign that had run
during the current quarter. The company is planning to pay the bill during April.
E. Sales totaling $18,000 were made to customers. Of these sales, 60% was collected during
the first quarter, and the balance is expected to be collected during the next quarter.
The goods that were sold had cost the company $13,000 when they were purchased.
F. Dividends were declared and paid to stockholders in the amount of $1,500.
G. Inventory (software programs) costing $10,500 was purchased, of which 10% was paid
for by the end of the quarter.
H. A 3-year, $4,000, 12% loan was obtained from a local bank on the last day of the
quarter.
I. New shares of stock were sold by the company for $2,000 in cash.
J. A new 3-year lease agreement was signed and executed. The lease required that a $900
monthly rental be paid in advance for the first 2 quarters of the current year. (Total
paid is $5,400 = $900 — 6 months.)
K. The accountants calculated that depreciation totaling $350 should be recorded for the
quarter for the firm™s buildings and equipment.
L. The land that had been held for plant expansion was sold for $9,000.

Required Prepare any summary documents you believe might help management (or inter-
ested external parties) better understand the effectiveness or efficiency of the firm™s first quar-
ter transformation process. Did the company have a satisfactory first quarter?
F127
CHAPTER F3: Measuring Revenues and Expenses
126 Measuring Revenues and Expenses


COMPREHENSIVE REVIEW
Financial Statement Preparation and Closing Process
CR3-1
Summary account balances for Mom™s Cookie Company at the end of February are presented
below. The summary includes all transactions for February, not just those described in this
chapter. In particular, additional sales transactions have been included.



Mom™s Cookie Company
Account Balances
February 28, 2004

Account Balance
Assets:
Cash 7,740
Accounts Receivable 1,580
Merchandise Inventories 7,520
Supplies 60
Prepaid Rent 1,200
Equipment 31,000
Accumulated Depreciation (1,040)
Total Assets 48,060
Liabilities:
Accounts Payable 1,400
Unearned Revenue 3,000
Interest Payable 400
Notes Payable 30,000
Total Liabilities 34,800
Owners™ Equity:
Contribution by Owners 10,000
Retained Earnings 480
Sales Revenue 17,160
Cost of Goods Sold (11,440)
Wages Expense (1,000)
Rent Expense (600)
Depreciation Expense (520)
Supplies Expense (400)
Utilities Expense (220)
Interest Expense (200)
Total Owners™ Equity 13,260




Required Use the account balances to (a) prepare an income statement for February,
(b) close the revenue and expense accounts (show journal transactions and ledger accounts),
(c) prepare a post-closing summary of account balances, and (d) prepare a balance sheet.
F4 4
REPORTING EARNINGS
AND FINANCIAL
POSITION
How do we report earnings and financial position to
stockholders?

P revious chapters described business activities of Mom's Cookie Company and the
system the company used to account for those activities. As the business grew dur-
ing 2004, Maria and Stan needed additional financial resources to take advantage of op-
portunities to sell more of their product. In October, they decided to issue shares of stock
in their company to other individuals. Cash received from issuing the stock was used to ac-
quire additional equipment, particularly delivery vans, and to increase the amount of inventory
the company could purchase. Because the company has external investors (stockholders who are
not managers of the company), it must report its business activities in conformance with gener-
ally accepted accounting principles to ensure these stockholders are properly informed of the com-
pany's earnings and financial position.


FOOD FOR THOUGHT
Assume you own shares of stock in Mom's Cookie Company. What information about the company is
important to you? As the company prepares to report accounting information to you and its other owners
at the end of its 2004 fiscal year, what information must it include in its income statement and balance
sheet? What information do corporations report, especially about their earnings and stockholders' equity,
that other companies do not? Is there any information about the company that does not have to be
disclosed?

Maria and Stan have arranged to meet with their accountant, Ellen, to discuss these issues.


We have prepared monthly financial statements for our use in managing the company. I suspect that those
Maria:
statements are not adequate for reporting to our other stockholders.
That's correct. The statements you have been preparing are fine for internal use and contain correct
Ellen:
information. However, formal financial statements for external users need to follow a somewhat different
format than those you have been using.
Does this mean we have to redo our accounting system and learn a new way of accounting for our
Stan:
company?
No. Your accounting system is fine. You just need to modify the format of your statements to organize the
Ellen:
information a bit differently, and you need to include more information about earnings and stockholders'
equity than you have been reporting.
Will these changes be hard for us to make?
Maria:
No. You will need to understand how information is classified in formal financial statements and how
Ellen:
corporations report such matters as earnings per share and changes in stockholders' equity. Now that you
understand the basic content of financial statements and how business activities are reported in these
statements, you shouldn't have much trouble preparing statements for your stockholders.
F129
CHAPTER F4: Reporting Earnings and Financial Position
128 Reporting Earnings and Financial Position


OBJECTIVES

Once you have completed this chapter, you 3 Explain information presented on a
should be able to: company's balance sheet.
1 Identify the primary financial statements 4 Explain information presented on a
issued by businesses. company's statement of stockholders'
equity.
2 Explain information presented on a
company's income statement. 5 Identify some of the primary limitations of
financial statements.




THE PURPOSE FINANCIAL STATEMENTS
OF
Accounting information may serve general and specific purposes. Financial statements
OBJECTIVE 1
are the primary means organizations use to report general-purpose accounting infor-
Identify the primary mation to external decision makers. Most business organizations prepare three finan-
financial statements cial statements:
issued by businesses.
1. An income statement
2. A balance sheet
3. A statement of cash flows
Many corporations also prepare a statement of stockholders' equity because of the va-
riety and complexity of their ownership transactions. This chapter examines the pur-
pose and content of the income statement, the balance sheet, and the statement of
stockholders' equity. Chapter F5 examines the statement of cash flows. Information
contained in financial statements and in the notes accompanying the statements is the
primary focus of financial accounting. Specific-purpose accounting reports and other
information used by internal decision makers are subjects of managerial accounting.
The form and content of financial statements evolved throughout the twentieth
century and continue to change to meet user needs. Financial statements are used by
internal and external decision makers. The format and content of the statements used
by managers to make financing, investing, and operating decisions often follow those
of statements prepared for external users. Statements for internal use, however, may be
prepared in any form and with any content desired by management.
For many years the balance sheet was the primary financial statement reported to
external users. It was designed to meet the needs of creditors, who wanted information
about resources and claims to these resources. The income statement developed to meet
the needs of corporate investors, who wanted information about earnings. Earnings in-
formation is useful for evaluating management decisions that affect payments to stock-
holders and stock values. The statement of stockholders' equity describes transactions
affecting stock and the amount and use of retained earnings. The statement of cash
flows, which is a more recent addition to external reports, provides information that
enables creditors, investors, and other users to assess a company's ability to meet its
cash requirements.
Financial statements for general-purpose external reporting normally are prepared
according to generally accepted accounting principles (GAAP). As noted previously,
GAAP are accounting and reporting standards established by authoritative agencies and
monitored and enforced by the federal government. GAAP specify the format and con-
tent of the statements, though they permit managers to choose among alternative meth-
ods of reporting some transactions. The establishment and enforcement of accounting
standards are discussed in Chapter F6.
An income statement (sometimes called an earnings statement, a statement of oper-
ations, or a profit and loss (P&L) statement) reports a company's revenues and expenses
F130 SECTION F1: The Accounting Information System
129
Reporting Earnings and Financial Position

for a fiscal period. The income statement presents operating results on an accrual basis.
It measures the amount of goods and services provided to customers during a fiscal pe-
riod and resources consumed in providing those goods and services. Revenues and ex-
penses result from the sale and consumption of resources for a fiscal period. Therefore,
the income statement reports the results of operating activities for a particular period,
such as a month, quarter, or fiscal year.
A balance sheet reports the balances of the asset, liability, and owners' equity ac-
counts at a particular date. Other names for the balance sheet are statement of finan-
cial position and statement of financial condition. These names are good descriptions
of the statement because it reports the amount of resources available to an organiza-
tion at a particular date and the sources of financing used to acquire those resources.
In combination, the resources and financing are the financial position, or condition, of
the organization at the report date.
A statement of stockholders' equity reports changes in a corporation's owners' eq-
uity for a fiscal period. Owners of corporations are known as stockholders or share-
holders because they acquire ownership by purchasing shares of stock issued by the
corporation. Each share of stock represents an equal share of ownership in a corpora-
tion. The primary changes in stockholders' equity result from profits earned during a
period, from dividends paid to owners, and from the sale or repurchase of stock by a
corporation. Dividends are distributions of cash or stock by a corporation to its stock-
holders. The statement of stockholders' equity links the income statement to the bal-
ance sheet because it describes how much net income was reinvested as part of retained
earnings.



THE INCOME STATEMENT
The income statement reports the revenues, expenses, and net income for a fiscal pe-
OBJECTIVE 2
riod. Exhibit 1 provides the income statement of Mom's Cookie Company for the year
Explain information ended December 31, 2004. The income statement reports revenues and expenses that
presented on a company's are measured on an accrual basis. Revenues indicate the sales price of goods and ser-
income statement. vices sold during a fiscal period. They do not indicate how much cash was received
from the sales during that period. Expenses identify the cost of resources consumed in
producing and selling goods and services sold during a fiscal period. They do not iden-
tify how much cash was paid for resources during that period. Net income is not cash.
As a first step in understanding Exhibit 1, observe the general format of the statement.
Unlike the statements we described in Chapters 2 and 3 that simply listed revenues and



Exhibit 1
Mom's Cookie Company
A Corporate Income
Income Statement
Statement
For the Year Ended December 31, 2004

Sales revenue $ 686,400
Cost of goods sold (457,600)
Gross profit 228,800
Selling, general and administrative expenses (148,300)
Operating income 80,500
Interest expense (4,800)
Pretax income 75,700
Income taxes (22,710)
Net income $ 52,990
Earnings per share $ 13.25*
Average number of common shares 4,000
*rounded
F131
CHAPTER F4: Reporting Earnings and Financial Position
130 Reporting Earnings and Financial Position

expenses, the income statements prepared by most companies are divided into several
sections. The following paragraphs describe the sections commonly found on income
statements.


Gross Profit
The income statement reports gross profit, the difference between the selling price of
goods or services sold to customers during a period and the cost of the goods or ser-
vices sold. For a merchandising company, the cost of goods sold is the cost of the mer-
chandise inventory sold during a period. For a manufacturing company, cost of goods
sold includes the dollar amounts of materials, labor, and other resources that are con-
sumed directly in producing the goods sold during a period. These costs are product
costs. Product costs are recorded as an asset (Inventory) until goods are sold. Then the
costs are matched against the revenues generated from the sale by recording an expense
(Cost of Goods Sold) during the same fiscal period as the sale.
Cost of services sold, rather than cost of goods sold, is important for service com-
panies. The cost of services sold is the cost of material, labor, and other resources con-
sumed directly in producing services sold during a period. For example, in a hospital,
the cost of nursing is a cost of services. This cost cannot be held as inventory and, there-
fore, is expensed in the period in which the services are provided.
Gross profit is a measure of how much a company earned directly from the sale of
its products during a fiscal period. Every company would like to earn a large gross profit
by selling its products at a much higher price than their cost. Competition prevents
most companies from being able to do so. Companies must price their products at
amounts their customers are willing to pay, which is determined in part by prices of
other similar products that customers could buy from other companies. Mom's Cookie
Company cannot sell its cookies at a price that is much higher than that of other com-
panies that sell similar cookies. Therefore, Mom's Cookie Company has to purchase
the goods it sells at a cost that allows it to earn a reasonable gross profit. The amount
of gross profit a company can earn depends on the kinds of products it sells and the
markets in which it operates. Some markets are more competitive than others. For ex-
ample, many competing companies sell computers, but not many sell the operating sys-
tems for computers.


Operating Income
The second section of an income statement lists operating expenses other than cost of
goods sold or cost of services sold. Operating expenses are costs of resources consumed
as part of operating activities during a fiscal period and that are not directly associ-
ated with specific goods or services. Most operating expenses are period costs because
they are recognized in the fiscal period in which they occur. Operating expenses include
selling, general, and administrative expenses incurred during a period.
Corporations usually do not identify specific operating expenses in detail. Salaries
for managers and their support staffs who are not involved directly in producing goods
and the cost of resources used by managers are operating expenses. These expenses in-
clude depreciation, taxes, and insurance on office buildings and equipment, and the
costs of supplies and utilities consumed in operating these facilities. Operating expenses
also include marketing and product development costs. GAAP require most marketing
and selling costs and research and development costs incurred during a fiscal period to
be reported as operating expenses of the period in which they occur. Because identify-
ing how much of these costs is associated with benefits of future periods is difficult,
GAAP require that these amounts be expensed to avoid an overstatement of profits dur-
ing the current fiscal period.
The excess of gross profit over operating expenses is operating income. If oper-
ating expenses are greater than gross profit, a loss from operations results. Operating
income is a measure of how much a company earned from its basic business activities.
F132 SECTION F1: The Accounting Information System
131
Reporting Earnings and Financial Position

A company is in the business of acquiring and selling products. Cost of goods sold and
other operating expenses include the cost of acquiring and making its products avail-
able to customers. Sales revenues, sometimes referred to as operating revenues, are the
total prices of the goods sold during a fiscal period. Therefore, operating income is a
measure of how much a company made from selling its products, after considering nor-
mal and reoccurring expenses of doing business.


Other Revenues and Expenses
Revenues and expenses may occur that are not directly related to a company's primary
operating activities. These are considered non-operating items and are reported sepa-
rately on the income statement following operating income. The item listed in this cat-
egory most often is interest expense. Borrowing money is frequently necessary for an
organization's operations; however, except for financial institutions, it is not part of
most businesses' primary operating activities. Accordingly, other expenses and revenues
are reported on the income statement after operating income. This separate listing dis-
tinguishes them from revenues and expenses that result from a business's primary op-
erating activities.


Income Taxes
Most corporations pay income taxes on their earnings. The amount of income tax ex-
pense is determined by applying tax rates required by current tax laws and regulations
to the income earned by a company during a fiscal
period. Exhibit 1 reports that Mom's Cookie Com-
LEARNING NOTE
pany incurred income taxes of 30% on its pretax in-
Not all U.S. corporations pay income taxes on profits. Certain small
come ($22,710 $75,700 0.30).
corporations, known as Subchapter S corporations in the tax laws,
As noted in Chapter F1, direct taxation of income
are treated like partnerships for tax purposes. Each stockholder
is one of the disadvantages of corporations. Propri-
is taxed on his or her share of the corporation's profits.
etorships and partnerships do not pay income taxes
on their profits directly. Instead, those profits are
treated as personal income of the owners. Owners pay income tax on a proprietorship's
profits or on their share of the profits of a partnership as part of personal taxes.


Net Income
Net income, or net earnings, is the amount of profit earned by a company during a fis-
cal period. It represents an increase in owners' or stockholders' equity, and it can be ei-
ther distributed to owners or reinvested in the
LEARNING NOTE company. Distributions to owners, such as dividends,
are not an expense. They are a deduction from re-
It is important to note that cash dividends and cash withdrawals
tained earnings when a transfer is made to owners of
are paid out of cash. Therefore, a company must have sufficient
a portion of a company's earnings. Undistributed
cash available before it can pay dividends or before owners can
earnings are included in retained earnings on a com-
withdraw money. Remember that net income does not guarantee
pany's balance sheet.
that a company will have favorable cash flows during a period.


Earnings Per Share
GAAP require that corporate income statements prepared for distribution to stock-
holders and other external users present earnings per share as part of the statement.
Earnings per share is a measure of the earnings performance of each share of com-
mon stock during a fiscal period. Common stock is the stock that conveys primary
ownership rights in a corporation. We examine other types of stock in a later chap-
ter. In general, earnings per share is computed by dividing net income by the average
F133
CHAPTER F4: Reporting Earnings and Financial Position
132 Reporting Earnings and Financial Position

number of shares of common stock outstanding during a fiscal period. By multiplying
earnings per share times the number of shares they own, stockholders can identify the
amount of profit or loss associated with their individual investments.
The average number of common shares is based on the number of shares a com-
pany has outstanding, weighted by the portion of the fiscal period the stock is out-
standing. To illustrate, assume Mom's Cookie Company was formed on January 1, 2004,
as a corporation by issuing 1,000 shares of stock to Maria and Stan (500 shares each).
Then, on September 1, 2004, the company issued an additional 9,000 shares of stock
to other stockholders. Consequently, the company had 1,000 shares outstanding for 8
months (January through August) and 10,000 shares outstanding for 4 months (Sep-
tember through December).
The average number of shares outstanding was:

4,000 shares (1,000 shares 8/12) (10,000 shares 4/12)

Earnings per share for Mom's Cookie Company was computed as follows:
$52,990 net income
$13.25* earnings per share
4,000 average common shares
*rounded



Other Reporting Issues
Income statements of actual companies vary in format and terminology from that pre-
sented in Exhibit 1. Though it is not possible to present all the possibilities that you
may encounter in practice, certain issues are common for most corporate reports. These
are apparent from a review of an actual corporate income statement. Exhibit 2 provides
the income statement for Krispy Kreme Doughnuts, Inc., from its 2002 annual report.



Exhibit 2 Income Statement for Krispy Kreme


Krispy Kreme Doughnuts, Inc.
Consolidated Statements of Operations

(In thousands, except per share amounts)
Year ended Jan. 30, 2000 Jan. 28, 2001 Feb. 3, 2002
Total revenues $220,243 $300,715 $394,354
Operating expenses 190,003 250,690 316,946
General and administrative expenses 14,856 20,061 27,562
Depreciation and amortization expenses 4,546 6,457 7,959
Income from operations 10,838 23,507 41,887
Interest income 293 2,325 2,980
Interest expense (1,525) (607) (337)
Equity loss in joint ventures ” (706) (602)
Minority interest ” (716) (1,147)
Loss on sale of property and equipment ” (20) (235)
Income before income taxes 9,606 23,783 42,546
Provision for income taxes 3,650 9,058 16,168
Net income $ 5,956 $ 14,725 $ 26,378
Basic earnings per share $ 0.16 $ 0.30 $ 0.49
Diluted earnings per share $ 0.15 $ 0.27 $ 0.45
F134 SECTION F1: The Accounting Information System
133
Reporting Earnings and Financial Position

First note that the title of Krispy Kreme™s statement is labeled "consolidated statements
of operations." Most large corporations include a number of companies owned by the
corporation. The controlling corporation is referred to as the parent and the compa-
nies owned or controlled by the parent are its subsidiaries. Consolidated financial
statements include the activities of the parent and its subsidiaries as though they were
one company. Thus, Krispy Kreme™s income statement reports profits for the entire
corporation, including all subsidiaries it owns.
Most corporations, like Krispy Kreme, report income statements for three fiscal
years. Krispy Kreme™s fiscal year ends with the Sunday closest to the end of January.
Three years of data permit readers to evaluate how company performance has changed
in recent years. Also observe that amounts, except per share amounts, are in thousands
of dollars. Thus, revenues for 2002 were greater than $394 million. Total revenue is the
amount earned from selling goods and services.
The items presented in a company's income statement vary depending on the type
of company. Any items that are uncommon and that are important relative to the total
income of the company should be reported as a separate income statement item. For ex-
ample, Krispy Kreme reports store operating expenses and depreciation and amortiza-
tion as separate operating expenses. Amortization expense, like depreciation expense, is
the allocation of the cost of long-term intangible assets to the fiscal periods that ben-
efit from their use. We consider intangible assets later in this chapter and amortization
expense in Chapter F11. Krispy Kreme also lists "equity loss in joint ventures" as a sep-
arate item. This loss resulted from a cooperative effort between Krispy Kreme and other
companies and represents Krispy Kreme™s share of the loss from these ventures.
Krispy Kreme also reports "minority interest" as a separate item. Minority inter-
est on the income statement is that portion of the income of Krispy Kreme's subsidiaries
that cannot be claimed by Krispy Kreme. For example, if Krispy Kreme owns 90% of
a subsidiary and the subsidiary's net income is $1 million, Krispy Kreme's share of the
net income would be $900,000. The remaining $100,000 would be the minority inter-
est in the income. Because the reported revenues and expenses on the consolidated
statement include the subsidiary amounts in them, Krispy Kreme subtracts the minor-
ity interest on the income statement. This indicates Krispy Kreme does not have a claim
to that share of subsidiary income.
Items appearing after income from operations represent revenues and expenses that
are not part of a company's primary operating activities. Interest, joint venture income
or loss, minority interest, and gain or loss on sale of property and equipment are non-
operating revenues and expenses because they are not part of a company's primary op-
erating activities. Many companies report "net interest" by combining interest revenue
and interest expense into one item.
For some corporations, earnings per share is complicated because the company
has issued financial instruments, such as long-term liabilities, that can be exchanged
for shares of common stock or that might result in the issuance of additional shares
if certain conditions are met. If issued, the additional shares of common stock would
reduce earnings per share. These companies, like Krispy Kreme, report two sets of
earnings per share numbers, basic and diluted earn-
LEARNING NOTE ings per share. Basic earnings per share (as de-
scribed above) is calculated without considering the
You should become familiar with the variety of terms that are
effect of the additional shares that could be issued.
used by companies in their financial statements. "Net earnings"
Diluted earnings per share is adjusted for the effects
is often substituted for "net income" for example. Real compa-
of additional shares that could be issued. Diluted
nies do not follow textbook formats in presenting their statements.
earnings per share is never greater than basic earn-
As you increase your understanding of the basic content of these
ings per share. It is a more conservative measure of
statements, you will be able to determine the meaning of terms
earnings per share during a period than is basic
used by most companies.
earnings per share.
F135
CHAPTER F4: Reporting Earnings and Financial Position
134 Reporting Earnings and Financial Position



1 SELF-STUDY PROBLEM An income statement for IBM Corporation for a recent fiscal year
is provided below.


IBM Corporation
Income Statement

(Dollars in millions except per share amounts)
FOR THE YEAR ENDED DECEMBER 31: 2001
REVENUE:
Global Services $34,956
Hardware 33,392
Software 12,939
Global Financing 3,426
Enterprise Investments/Other 1,153
TOTAL REVENUE 85,866
COST OF SALES AND SERVICES:
Global Services 25,355
Hardware 24,137
Software 2,265
Global Financing 1,693
Enterprise Investments/Other 634
TOTAL COST OF SALES AND SERVICES 54,084
GROSS PROFIT 31,782
OTHER EXPENSE AND INCOME:
Selling, general and administrative 17,197
Research, development and engineering 5,290
Intellectual property and custom development income (1,535)
Other (income) and expense (361)
Interest expense 238
TOTAL OTHER EXPENSE AND INCOME 20,829
INCOME BEFORE INCOME TAXES 10,953
Provision for income taxes 3,230
NET INCOME $ 7,723
EARNINGS PER SHARE OF COMMON STOCK:
ASSUMING DILUTION $4.35
BASIC $4.45



Required Use this statement to answer the following questions:

1. How much revenue did IBM earn from selling computers?
2. How much revenue did IBM earn from other operating activities?
3. How much gross profit did IBM earn?
4. How much expense did IBM incur for non-operating activities?
5. Approximately how many shares of stock did IBM have outstanding?
6. What were IBM's total product costs?
7. How much net income did IBM earn?
8. How much cash did IBM receive from its operating activities during the year?
The solution to Self-Study Problem 1 appears at the end of the chapter.
F136 SECTION F1: The Accounting Information System
135
Reporting Earnings and Financial Position


THE BALANCE SHEET
A balance sheet reports the asset, liability, and owners' equity account balances for a
OBJECTIVE 3
company at the end of a fiscal period. Exhibit 3 provides a balance sheet for Mom's
Explain information Cookie Company for the year ended December 31, 2004.
presented on a company's Recall that the total amount of assets reported on the balance sheet at the end of
balance sheet. a fiscal period must be equal to the total amount of liabilities and owners' equity. This
relationship, assets liabilities owners' equity, is the fundamental balance sheet
equation.
Exhibit 3 provides a classified balance sheet in which assets and liabilities are sep-
arated by type. The primary sections of the balance sheet are described in the follow-
ing paragraphs.

LEARNING NOTE
Current Assets
An organization's operating cycle is the period from the time
GAAP require companies to report their current as-
cash is used to acquire or produce goods until these goods are
sets separately from their long-term assets. Current
sold and cash is received. The operating cycles of most organi-
assets are cash or other resources that management
zations are less than 12 months. A fiscal year is the primary re-
expects to convert to cash or consume during the
porting period for these companies. Occasionally, a company's
next fiscal year. Some current assets are liquid assets.
operating cycle is longer than 12 months. In such cases, which
are rare, current assets are defined as those that a company ex- Liquid assets are resources that can be converted to
pects to convert to cash or consume during the next operating cash in a relatively short period. Cash equivalents
cycle. include securities that are easily converted to cash and
that have a short maturity, usually less than three




Exhibit 3
Mom's Cookie Company
A Corporate Balance
Balance Sheet
Sheet
At December 31, 2004

Assets
Current assets:
Cash $ 10,680
Accounts receivable 8,570
Merchandise inventory 23,600
Supplies 690
Prepaid rent 2,000
Total current assets 45,540
Property and equipment, at cost 215,660
Accumulated depreciation (25,500)
Total assets $235,700
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 9,610
Unearned revenue 4,250
Interest payable 650
Notes payable, current portion 5,000
Total current liabilities 19,510
Notes payable, long-term 73,200
Total liabilities 92,710
Stockholders' equity:
Common stock, 10,000 shares issued 100,000
Retained earnings 42,990
Total stockholders' equity 142,990
Total liabilities and stockholders' equity $235,700
F137
CHAPTER F4: Reporting Earnings and Financial Position
136 Reporting Earnings and Financial Position

months. In addition to cash and equivalents, current assets include (1) accounts re-
ceivable for which a company expects to receive cash during the next fiscal year, (2) in-
ventory a company expects to sell during the next fiscal year, and (3) resources a
company expects to consume during the next fiscal year, such as supplies and prepaid
insurance, generally referred to as prepaid expenses.


Property and Equipment
Property and equipment, often called fixed assets or plant assets, are long-term, tan-
gible assets that are used in a company's operations. (Long-term intangible assets are
those that provide benefits to the company for more than one fiscal period.) Unlike
inventory, these assets are not intended for resale. U.S. GAAP require fixed assets, other
than land, to be depreciated over their estimated useful lives. Depreciation allocates the
cost of these assets to the fiscal periods that benefit from their use as a means of match-
ing expenses with revenues. The net value of fixed assets is the cost of the assets minus
accumulated depreciation.
Land is not depreciated because it is not used up. Natural resources, such as petro-
leum, minerals, or timber, are accounted for separately from land and other property as-
sets. The costs of these assets are allocated to expense over the periods that are expected
to benefit from the use of the assets. The process of allocating the cost of natural re-
sources to expenses is known as depletion. We examine depletion in Chapter F11.


Liabilities
GAAP require companies to report their current liabilities separately from their long-
term liabilities. Current liabilities are those obligations that management expects to
fulfill during the next fiscal year. Long-term liabilities are those obligations not clas-
sified as current liabilities.
Current liabilities include amounts owed by a company that will be paid during
the coming fiscal year. Accounts, wages, interest, and income taxes payable all fit in this
category. Unearned revenues that will be earned during the coming fiscal year also are
classified as current assets.
The portion of long-term debt that will become due and be paid during the next year
is a current liability. Exhibit 3 identifies this amount as "Notes payable, current portion."
For example, assume Mom's Cookie Co. issued $80,000 in long-term notes payable dur-
ing 2004. The notes are to be repaid in annual installments of $5,000. Therefore, $5,000
of the notes would be reported as a current liability on a balance sheet prepared at De-
cember 31, 2004. The unpaid balance would be reported as a long-term liability. From
Exhibit 3 you can determine that $1,800 ($80,000 borrowed less $5,000 current portion
and $73,200 long-term portion) of the notes was repaid in 2004, the year of issue.
The difference between current assets and current liabilities is known as work-
ing capital. Because current assets include those assets that are likely to produce cash
inflows for a company and current liabilities include those liabilities that are likely to
produce cash outflows, working capital is a measure of a company's liquidity. A com-
pany with a large amount of working capital should have little difficulty meeting its
short-term obligations. Mom's Cookie Company reports $26,030 ($45,540 of current
assets $19,510 of current liabilities) of working capital in 2004.
Working capital often is reported as a ratio. The ratio of current assets to current
liabilities is the working capital ratio or current ratio. Mom's Cookie Company's cur-
rent ratio for 2004 is 2.33 ($45,540 $19,510).


Stockholders' Equity
Stockholders™ equity includes (1) amounts paid by owners to a corporation for the pur-
chase of shares of stock and (2) retained earnings, profits reinvested in the corporation.
F138 SECTION F1: The Accounting Information System
137
Reporting Earnings and Financial Position

Common stock, as noted earlier, conveys basic ownership rights in a corporation. We
examine other types of stock in Chapter F9.


OTHER BALANCE SHEET CONTENT
Like the income statement, the balance sheet may appear in a variety of formats. Com-
panies may use reporting rules that differ from those previously described. Some types
of companies”many utilities, for example”report fixed assets prior to current assets
and report stockholders' equity prior to liabilities. Companies in the United States of-
ten use formats that differ from those used in other countries. The items included on
a balance sheet depend on the activities of a company.
Exhibit 4 provides the balance sheet from Krispy Kreme™s 2002 annual report. Krispy
Kreme™s balance sheet is comparative because it contains information for more than
one year. Also, it is consolidated because it includes all the companies owned by the
parent corporation.

Other Current Assets
In addition to current assets we considered earlier, Krispy Kreme reports short-term in-
vestments and deferred income taxes. Short-term investments are stocks or debt of other
companies owned by Krispy Kreme that it expects to sell in the near future. Deferred
income taxes listed as current assets are prepaid taxes. These are taxes that the company
has paid but that are associated with income tax expense of the coming fiscal period.
The deferred taxes will be written off to income tax expense in a future period.
Krispy Kreme reports its accounts receivable net of allowances. The allowances are
estimated uncollectible accounts. (These are sometimes referred to as allowance for
doubtful accounts or allowance for bad debts.) When companies sell goods on credit,
thus creating accounts receivable, it is likely that some customers will be unable to pay
for their purchases. Companies are required by GAAP to estimate the amount of un-
collectible receivables each fiscal period and to subtract that amount from their gross
accounts receivable. The amount reported on the balance sheet for accounts receivable
is the gross amount (total accounts receivable) minus the expected uncollectible amount
(allowance). The net amount is the amount the company expects to collect from cus-
tomers. We examine receivables in more detail in Chapter F13.

Other Long-Term Assets
In addition to property and equipment, long-term assets may include non-current re-
ceivables; fixed assets held for sale; prepaid expenses not expected to be consumed in
the next fiscal year; long-term legal rights such as patents, trademarks, and copyrights;
and long-term investments. These types of assets may be listed on the balance sheet un-
der separate headings if they constitute a significant portion of a company's assets. Oth-
erwise, they often are listed simply as Other Assets.
Accounts and notes receivable that a company does not expect to collect during
the next fiscal year are not included among current assets. These items are reported as
long-term assets. Fixed assets that a company is not using currently but is holding for
future use, disposal, or sale also are included in this category. For example, land held
for a future factory site would be listed here.
Long-term legal rights resulting from the ownership of patents, copyrights, trade-
marks, and similar items are known as intangible assets, in contrast to tangible assets
such as property and equipment. Goodwill is a special type of intangible asset that can
occur when one company acquires another company. Goodwill is the excess of the
price paid for a company over the fair market value of the net assets (assets less lia-
bilities) of the acquired company.
Long-term investments occur when a company lends money to or purchases stock
issued by other organizations and does not intend to sell those investments in the
F139
CHAPTER F4: Reporting Earnings and Financial Position
138 Reporting Earnings and Financial Position

Exhibit 4 Balance Sheet for Krispy Kreme


Krispy Kreme Doughnuts, Inc.
Consolidated Balance Sheets

(In thousands)
Jan. 28, 2001 Feb. 3, 2002
ASSETS
Current Assets:
Cash and cash equivalents $ 7,026 $ 21,904
Short-term investments 18,103 15,292
Accounts receivable, less allowance for doubtful accounts of
$1,302 (2001) and $1,182 (2002) 19,855 26,894
Inventories 12,031 16,159
Prepaid expenses and other current assets 6,787 16,913
Deferred income taxes 3,809 4,607
Total current assets 67,611 101,769
Property and equipment, net 78,340 112,577
Long-term investments 17,877 12,700
Investment in joint ventures 2,827 3,400
Intangible assets ” 16,621
Other assets 4,838 8,309
Total assets $171,493 $255,376

LIABILITIES AND SHAREHOLDERS™ EQUITY
Current Liabilities:
Accounts payable $ 8,211 $ 12,095
Book overdraft 5,147 9,107
Accrued expenses 21,243 26,729
Revolving line of credit 3,526 3,871
Current maturities of long-term debt ” 731
Income taxes payable 41 ”
Total current liabilities 38,168 52,533
Deferred income taxes 579 3,930
Long-term debt, net of current portion ” 3,912
Other long-term obligations 5,950 4,843
Total long-term liabilities 6,529 12,685
Minority interest 1,117 2,491
SHAREHOLDERS™ EQUITY:
Common stock, no par value, 100,000 shares authorized;
issued and outstanding ” 51,832 (2001) and 54,271 (2002) 85,060 121,052
Accumulated other comprehensive income and other items (1,928) (2,310)
Retained earnings 42,547 68,925
Total shareholders™ equity 125,679 187,667
Total liabilities and shareholders™ equity $171,493 $255,376




coming fiscal year. Companies often invest in other companies to share in their earn-
ings or to obtain access to resources, management skills, technology, and markets avail-
able to other companies. If management expects to hold these investments beyond the
next fiscal year, they are classified as long-term investments. We examine accounting
for each of these assets in later chapters.
Joint ventures reported on the balance sheet is the amount Krispy Kreme has in-
vested in these ventures. Joint ventures involve cooperative efforts among two or more
companies, with each company providing some of the financing for the venture, and
each company sharing in the profits or losses from these ventures.
F140 SECTION F1: The Accounting Information System
139
Reporting Earnings and Financial Position

Other Current Liabilities
The current liabilities listed on Krispy Kreme™s balance sheet are similar to those we
have discussed for Mom's Cookie Company. The titles used for these liabilities are dif-
ferent, however. Accrued expenses is simply another name for liabilities such as wages
payable and rent payable. One of the challenges of reading financial statements is be-
coming familiar with the wide variety of labels companies use.
The current liability, book overdraft, is a bit unusual. It suggests the company has
overdrawn its checking accounts. In actuality it reflects the fact that Krispy Kreme has
many bank accounts it uses to pay for business activities in various locations. It moves
money from its primary bank accounts to these other accounts daily, as needed to meet
operating expenses. At times, checks are written on these local accounts before cash is
transferred to the accounts. These amounts are reported in the book overdraft category
and indicate timing differences between when checks were written and cash was trans-
ferred. The category does not indicate a financial problem for the company. A careful
review of notes to the financial statements sometimes is important to understand the
items reported by a company in those statements.


Other Long-Term Liabilities
In addition to long-term debt, Krispy Kreme reports deferred taxes and minority in-
terest. When deferred taxes are reported as a long-term liability, they represent income
tax expenses that have not been paid and will not be paid during the coming year. De-
ferred taxes occur because of timing differences between when corporations recognize
revenues and expenses for tax purposes and when those revenues and expenses are rec-
ognized for financial reporting purposes. If pretax income on a company's income state-
ment exceeds its taxable income for tax purposes, a portion of the income tax expense
a company recognizes will not be paid until some future fiscal period.
Minority interest, also known as noncontrolling interest (or NCI), represents the
portion of a corporation's subsidiaries not owned by the parent corporation. Krispy
Kreme reports $2,491,000 of minority interest on its 2002 balance sheet. This is the
value of that portion of the subsidiaries not owned by Krispy Kreme. Note that the bal-
ance sheet amount refers to the book value of the subsidiary (assets less liabilities) owned
rather than to the portion of income associated with noncontrolling owners that is re-
ported on the income statement. Valuation of noncontrolling interest is a topic cov-
ered in advanced financial accounting texts.


Stockholders' Equity and Comprehensive Income
Like Mom's Cookie Company, Krispy Kreme reports common stock and retained earn-
ings. The number of shares of common stock authorized is the maximum number of
shares the company could issue under its current charter. The number of shares issued
(54,271,000 for 2002) is the total number of shares that the company has sold to stock-
holders.
In addition to net income reported on the income statement, companies must re-
port other comprehensive income. Comprehensive income is the change in a com-
pany's owners' equity during a period that is the result of all non-owner transactions
and activities. Comprehensive income includes profits resulting from normal operat-
ing activities. It includes any event that changes owners' equity except those arising from
dealings with the company's own stockholders. Accordingly, it excludes events such as
selling stock or paying dividends. Comprehensive income also includes some activities
that are not reported on the income statement.
Three items that are not included in net income are included as part of other
comprehensive income. These are (a) gains or losses from holding certain marketable
securities, (b) certain gains or losses from foreign currency effects on foreign sub-
F141
CHAPTER F4: Reporting Earnings and Financial Position
140 Reporting Earnings and Financial Position

sidiaries, and (c) certain changes in the minimum liability for employee pensions.
These items are reported as part of other comprehensive income that is included in
stockholders' equity. Gains and losses from holding marketable securities are dis-
cussed in Chapter F11.
Foreign currency transactions occur when a corporation operates in other coun-
tries or owns subsidiaries outside of the U.S. These international activities involve cur-
rencies other than U.S. dollars. To prepare financial statements that are stated in U.S.
dollars, those activities have to be translated from foreign currency amounts using ex-
change rates that are appropriate for the transaction. In some cases, U.S. currency must
INTERNATIONAL
be exchanged for foreign currency or vice versa. Gains or losses can occur from changes
in exchange rates. Gains or losses associated with foreign currency translations and ex-
changes are reported as part of other comprehensive income.
Changes in employee pension liabilities occur when estimates change about the
amount a company can earn on assets it has invested to cover these liabilities or when
other estimates change that affect the amount employees will receive in pension pay-
ments. These changes result in gains or losses that are reported as part of other com-
prehensive income.
Keep in mind that financial statements of actual companies can be complex be-
cause of the many types of business activities in which companies are involved. Un-
derstanding basic concepts of assets, liabilities, and owners' equity will help you interpret
this information.




2 SELF-STUDY PROBLEM Listed below are account balances, cash receipts and payments,
and other data for Lewy Pasture, Inc., a company that distributes
pharmaceutical supplies, for the fiscal year ended October 31, 2004.


Accounts payable $ 22,000
Accounts receivable 11,000
Accumulated depreciation 164,000
Buildings 412,000
Cash 16,000
Common stock 300,000
Cost of goods sold 146,000
Dividends (declared and paid) 17,000
Equipment 245,000
General and administrative expenses 96,000
Goodwill 13,000
Income tax expense 14,000
Income tax payable 6,000
Interest expense 25,000
Interest payable 14,000
Land 35,000
Long-term investments 35,000
Merchandise inventory 62,000
Notes payable, current portion 10,000
Notes payable, long-term 278,000
Prepaid insurance 7,000
Retained earnings, October 31, 2003 25,000
Sales revenue 357,000
Selling expenses 47,000
Supplies 13,000
Wages payable 18,000
F142 SECTION F1: The Accounting Information System
141
Reporting Earnings and Financial Position

The average number of shares of common stock outstanding during the year was 10,000.

Required From the data presented on the previous page, determine the amount of
each of the following items for Lewy Pasture's financial statements:
1. Gross profit
2. Income from operations
3. Net income
4. Earnings per share
5. Current assets
6. Land, buildings, and equipment
7. Other assets
8. Total assets
9. Current liabilities
10. Total liabilities
11. Retained earnings, October 31, 2004
12. Total stockholders' equity
13. Total liabilities and stockholders' equity
The solution to Self-Study Problem 2 appears at the end of the chapter.



THE STATEMENT STOCKHOLDERS' EQUITY
OF
The statement of stockholders' equity provides information about changes in owners' eq-
OBJECTIVE 4
uity for a corporation during a fiscal period. Exhibit 5 provides an example of this state-
Explain information ment for Krispy Kreme. Though Krispy Kreme, like other corporations, presents three years
presented on a company's of data for this statement in its annual report, only one year is included in Exhibit 5.
statement of stockholders' Exhibit 5 reports the number of shares of stock issued by Krispy Kreme at the be-
equity. ginning and end of the 2002 fiscal year, and describes changes in the amount associ-
ated with stock options, sale of stock, and other activities. The dollar amount of stock
issued increased during 2002, as well. The amount of common stock issued at the end
of the 2002 fiscal year ($121,052,000) is equal to the amount reported for common
stock on the balance sheet in Exhibit 4.
A primary reason for the increase in common stock was related to stock options.
Corporations often use stock option plans to provide an opportunity for employees to
receive shares of stock for achieving corporate goals. To provide stock to employees and
for other purposes, corporations repurchase shares from stockholders.
Retained earnings increased by the amount of net income earned in 2002. Retained
earnings would decrease by the amount of dividends paid or promised (declared) dur-
ing the fiscal year. However, Krispy Kreme did not pay any dividends during its 2002
fiscal year. Dividends are not reported on the income statement because they are not
expenses. They are a distribution of net income to owners. Dividends are a reduction
in retained earnings and are reported on the statement of stockholders' equity.
Accumulated other comprehensive income increases (or decreases) by the amount
of other comprehensive income reported during a fiscal period. Krispy Kreme reported
a holding loss of $111,000 and foreign currency translation losses of $42,000 during
2002. Remember that these losses are not reported on the income statement in the cal-
culation of net income. The holding loss reported by Krispy Kreme is unrealized be-
cause the securities that created the holding loss have not been sold. Their market value
decreased during the period, and the amount of the decrease is reported as a holding
loss. When Krispy Kreme actually sells the securities, any gain or loss from the sale will
be reported on the income statement. Krispy Kreme™s other comprehensive income de-
creased during 2002 and the balance of its accumulated other comprehensive income
is negative (a loss). The balance considers the effects of previous years' gains and losses.
These gains and losses are added together from year to year to obtain the total reported
on the statement of stockholders' equity. The ending balance also is reported on the
balance sheet as part of stockholders' equity, see Exhibit 4.
F143
CHAPTER F4: Reporting Earnings and Financial Position
142 Reporting Earnings and Financial Position

Exhibit 5 Changes in Corporate Equity


Krispy Kreme Doughnuts, Inc.
Consolidated Statement Of Shareholders™ Equity

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