. 2
( 29)


row $100,000 to purchase some equipment and yearling steers for his ranch. What information
does Sam need to help make the lending decision? What type of information should Bill col-
lect and analyze before even requesting the loan?

In an article in U.S. News & World Report, Dan McGraw described how two computer giants,
DELL and COMPAQ, were poised to do battle in the personal computer market. Compaq had
13.2% of the U.S. market share for personal computers to Dell s 8.8%. However, Dell s mar-
ket share had more than doubled in the last four years while Compaq s share had increased less
than 1%. What type of information, accounting or otherwise, do you think the management of
Compaq may have wanted and needed as they competed with Dell and the other PC compa-
Source: Dan McGraw, Shootout at PC Corral, U.S. News & World Report, June 23, 1997, pp. 37 38.

July 1, 1997, marked a historic date as Hong Kong reverted to political and economic control
by mainland China. The Stock Exchange of Hong Kong offers the opportunity to invest in both
local Hong Kong companies and in red-chip offerings, which are stocks of companies that are
listed in Hong Kong but controlled by mainland China interests. As an international investor,
what accounting information might be helpful as you consider investing in the Hong Kong stock
market? For which variables in this situation is accounting information unlikely to be very
f24 Accounting Information: Users And Uses
Part 1 EOC Financial Reporting and the Accounting Cycle


Assume that you are applying for a part-time job as an accounting clerk in a retail clothing es-
tablishment. During the interview, the store manager asks how you expect to contribute to
the business. How would you respond?

Describe how bookkeeping is applied in each of the following settings:

a. Your college English class.
b. The National Basketball Association.
c. A hospital emergency room.
d. Jury selection for a major murder trial.
e. Four college roommates on a weekend skiing trip.

You are the owner of Automated Systems, Inc., which sells APPLE computers and related
data processing equipment. You are currently trying to decide whether to continue selling the
Apple computer line or to distribute the Windows-based computers instead. What informa-
tion do you need to consider in order to determine how successful your business is or will be?
What information would help you decide whether to sell the Apple or the Windows-based
personal computer line? Use your imagination and general knowledge of business activity.

Why might each of the following individuals or groups be interested in a firm s financial
statements? (a) The current stockholders of the firm; (b) the creditors of the firm; (c) the
management of the firm; (d) the prospective stockholders of the firm; (e) the Internal Rev-
enue Service (IRS); (f) the SEC; (g) the firm s major labor union.

You work in a small convenience store. The store is very low-tech; you ring up the sales on
an old-style cash register that merely records the amount of the sale. The store owner uses this
cash register tape at the end of each day to verify that the correct amount of cash is in the
cash register drawer.
In addition to verifying the cash amount, how else could the information on the cash
register tape be used to evaluate the store s operation? What additional bookkeeping proce-
dures would be necessary to make these additional uses possible?

Assume your grandparents have just given you $20,000 on the condition that you invest the
money in the stock market. As you contemplate making your investment choices, what ac-
counting information do you want to help identify companies that will have high future rates
of return?

Assume you are a small business owner trying to increase your company s profits. How can
accounting information help you efficiently allocate your limited resources to maximize your
business profit?
24 f25
Accounting Information: Users And Uses EOC Chapter 1
Accounting Information: Users and Uses

This chapter discusses two areas of accounting: management and financial accounting. Con-
trast management and financial accounting with respect to the following:
Overall purpose
Type of financial reports used (i.e., external, internal, or both)
Users of the information
Also, in what ways are these two fields of accounting similar?

It is not often that the federal government has allowed the private sector to govern itself, but
that is exactly what has happened with the field of accounting. The SEC has delegated the re-
sponsibility of rule making to the FASB, a group of seven individuals who are hired full-time
to discuss issues, research areas of interest, and determine what GAAP is and will be. What
are the advantages of allowing the private sector to determine accounting standards? Identify
any advantages that the SEC might gain if it established the rules that govern the practice of

This past year you were married. This coming April you will be faced with preparing your
first tax return since mom and dad said you are now on your own. As you review the IRS
regulations, you notice several differences from what you learned in your accounting class. It
appears that businesses must keep two sets of books: one for the IRS and one in accordance
with GAAP. Why aren t GAAP and IRS rules the same?

In the United States, accounting for inventory is a difficult issue. Inventory is comprised of
those items either purchased or manufactured to be resold at a profit. Numerous methods are
available to account for inventory for financial reporting purposes. A very commonly used
method called LIFO (last-in, first-out) minimizes a company s tax obligation. In the
United Kingdom, however, LIFO is not permitted for tax purposes and thus is not used very
often for financial reporting. In Turkey, the use of LIFO is severely restricted, and in Russia,
LIFO is a foreign term. Only in Germany, where the tax laws have been modified to allow
the use of LIFO, is LIFO being adopted. Different accounting methods are available for nu-
merous other issues in accounting. Identify some major problems associated with comparing
the financial statements of companies from different countries.

The text has pointed out that ethics is an important topic, especially for CPAs. Derek Bok,
former law professor and president of Harvard University, has suggested that colleges and uni-
versities have a special opportunity and obligation to train students to be more thoughtful and
perceptive about moral and ethical issues. Other individuals have concluded that it is not pos-
sible to teach ethics. What do you think? Can ethics be taught? If you agree that colleges
and universities can teach ethics, how might the ethical dimensions of accounting be pre-
sented to students?

You are scheduled to graduate from college with a degree in accounting, and your mother
would like to know what you plan to do with the rest of your life. She assumes that your
only option is to be a bookkeeper like Bob Cratchit in the story A Christmas Carol. What can
you tell Mom regarding the options available to you with your degree in accounting?

One of your college friends recently graduated from school with a major in music (specifically
piano). He has told you that he is going to start his own piano instructional business. He
f26 Accounting Information: Users And Uses
Part 1 CEO Financial Reporting and the Accounting Cycle

plans to operate the business from home. You ask him how he is going to account for his
business, and his reply is, I graduated in music, not accounting. I am going to teach music,
not number crunching. I didn t need accounting in college and I don t need it now! Is your
friend right? What financial information might he find useful in operating his business?

As the business world continues to change the way in which business is conducted, accoun-
tants are faced with the challenge of accounting for these changes. Who, for example, could
have anticipated the risks associated with asbestos? Or the decline of communism? Or the in-
creasingly litigious environment in the United States? Each of these events, and many more,
has influenced business which has, in turn, influenced accounting. From your general un-
derstanding of accounting and the current business environment, what are some of the chal-
lenges you see facing the accounting profession?

competency enhancement opportunities

The Debate
Analyzing Real Company Information
Internet Search
International Case
Ethics Case
Writing Assignments

The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
skills, experience with electronic research, and teamwork through group and
business activities.

Analyzing 1-1 (Microsoft)
In the Appendix at the back of this text is MICROSOFT s complete annual re-
port for the year ended June 30, 1999. Review the annual report and identify
its major areas. How many pages of the report are devoted to a narrative of
the prior three years performance? How many pages focus on explaining tech-
nical accounting and business-related issues and procedures? In your opinion,
given your limited knowledge of accounting, what is the most interesting part
of the annual report? What is the least interesting?

Analyzing 1-2 (General Motors)
Below is a condensed listing of the assets and liabilities of GENERAL MOTORS
as of December 31, 1999. All amounts are in millions of U.S. dollars.

Assets Liabilities
Cash $ 21,250 Loans payable $187,059
Loans receivable 80,627 Pensions 3,339
Inventories 10,638 Other retiree benefits 34,166
Property & equipment 69,186 Other liabilities 28,708
Other assets 92,572
Total assets $274,273 Total liabilities $253,272
26 f27
Accounting Information: Users And Uses CEO Chapter 1
Accounting Information: Users and Uses

1. Among its assets, General Motors lists more than $80 billion in loans re-
ceivable. This represents loans that General Motors has made and expects
to collect in the future. This is exactly the kind of asset reported among the
assets of banks. Given what you know about General Motors business,
how do you think the company acquired these loans receivable?
2. The difference between the reported amount of General Motors assets and
liabilities is $21.001 billion ($274.273 $253.272). What does this differ-
ence represent?

Should the SEC choose the FASB or the IASC?
The SEC has received from Congress the legal authority to set accounting stan-
dards in the United States. Historically, the SEC has allowed the FASB to set
those standards. In addition, the SEC has refused to allow foreign companies
to seek investment funds in the United States unless they agree to provide U.S.
investors with financial statements prepared using FASB rules.
The number of foreign companies seeking to list their shares on U.S. stock
exchanges is increasing. Even more would likely sell stock to the American
public if the SEC were to agree to accept financial statements prepared ac-
cording to usually less stringent IASC standards.
Why do you think the SEC has so far insisted on financial statements pre-
pared using FASB rules? Do you agree with its policy? Explain.

Disagreement With the Boss
You recently graduated with your degree in accounting and have accepted an
entry-level accounting position with BigTec, Inc. One of your first responsibilities
is to review expense reports submitted by various executives. The expense re-
ports include such items as receipts for taking clients to dinner and hotel receipts
for business travel. In conducting this review, you note that your boss has sub-
mitted for reimbursement several items that are clearly outside the established
guidelines of the corporation. In questioning your boss about the items, he told
you to process the items and not worry about them. What would you do?

The Language of Business
Accounting is known as the language of business. Prepare a one- to two-
page paper explaining why all business students should have some account-
ing education. Also include a discussion of how accounting applies to at least
five different types of businesses, such as a grocery store, a university, or a
movie theater.
Visiting an Accounting Professional
Select a field of accounting you are interested in. Visit a professional who works
in that area and discuss the career opportunities available in that specific ac-
counting field. After the visit, prepare a one- to two-page paper summarizing
what you learned from your discussion with the accounting professional.

Insulate the FASB
As mentioned in the text, the FASB conducts public hearings concerning any
new accounting standards that it is considering. In addition, the FASB invites
f28 Accounting Information: Users And Uses
Part 1 CEO Financial Reporting and the Accounting Cycle

interested parties (businesses, trade groups, user groups, accounting profes-
sors) to send in written comments on proposed standards. This due process
system occasionally exposes the FASB to intense lobbying pressure for and
against proposed standards. For example, when the FASB was deliberating
over the proper accounting for option compensation (see the example in the
chapter), some companies, upset at the FASB s proposed approach, appealed
to Congress to pass a bill outlawing the FASB s standard. Can the FASB es-
tablish good accounting standards in such a heated, public environment?
Divide your group into two teams.
One team represents the Open Door Policy. Prepare a two-minute oral
argument supporting the continuation of the FASB s policy of adopting ac-
counting standards only after public debate.
The other team represents the Insulate the FASB Movement. Prepare a
two-minute oral argument outlining why it is impossible for the FASB to
design conceptually correct accounting standards while being bombarded
with the complaints and threats of self-interested companies and lobbyists.

The Financial Accounting Standards Board
The FASB s Web address is http://www.fasb.org. Sometimes Web addresses
change; so if this address is out of commission, access the Web site for this
textbook (http://albrecht.swcollege.com) for an updated link.
Once you have gained access to the site, answer the following questions.
1. What is the mission of the FASB?
2. How many FASB statements are there? When was the most recent state-
ment issued?
3. When was the first statement issued and what is it about? What other state-
ments are related to Statement No. 1?
4. In what ways are the following three types of FASB pronouncements dif-
ferent: (1) Statements of Financial Accounting Standards (SFAS), (2) Inter-
pretations of SFAS, and (3) Statements of Financial Accounting Concepts?
Statements: An


learning objectives After studying this chapter, you should be able to:

1 Understand the basic 3 Describe the purpose of an 5 Explain the fundamental
elements and formats of the audit report and the concepts and assumptions
three primary financial incentives the auditor has to that underlie financial
statements balance sheet, perform a good audit. accounting.
income statement, and
4 Use financial ratios to
statement of cash flows.
identify a company s
2 Recognize the need for strengths and weaknesses
financial statement notes and to forecast its future
and identify the types of performance.
information included in the
30 chapter f2
Financial Statements: An Overview

Under Peter Magowan s leadership,
In addition to founding the brokerage firm
Safeway eliminated 2,000 office and ware-
of MERRILL LYNCH, in 1926 Charles Mer-
house jobs and embarked upon an impres-
rill was instrumental in the consolidation of
sive program of new construction and re-
several grocery store chains in the western
modeling. During much of the early 1980s,
United States to form one big holding com-
Safeway spent more on capital expendi-
pany called SAFEWAY. In 1955, control of
tures than any other U.S. company, aver-
Safeway passed to Robert Magowan, Mer-
aging nearly $600 million per year. In No-
rill s son-in-law. Under Magowan s leader-
vember 1986, Safeway was acquired by
ship, Safeway expanded to become the
second largest supermarket chain in the
(KKR) for $5.3 billion in what was then the
United States. Shortly after Magowan re-
second-largest leveraged buyout (LBO) of
tired in 1971, Safeway passed THE GREAT
all time. In an LBO, a group of private in-
vestors, sometimes joined by company
(A&P) to become the largest supermarket
managers, supply only a small amount of
the money needed to buy an entire corpo-
During the 1970s, Safeway became
ration. The bulk of the purchase price is pro-
too cautious and conservative (in the view
vided by banks and other lenders, with the
of many). It was whispered that Safeway
assets of the acquired company serving as
would become the A&P of the West a
collateral for the loans. As an indication of
fallen giant no longer willing to make the
how leveraged the Safeway buyout was,
bold moves that had created its success
the KKR investors put only $130 million of
in the first place. In 1980, Robert
their own money into the $5.3 billion deal.
Magowan s 37-year-old son, Peter (who
So, how is Safeway doing today? In
had started out in Safeway as a teenager
the 1999 Fortune 500 survey, Safeway,
bagging groceries), became chairman of
with 1999 sales of $28.9 billion, ranks as
the board of directors. As he assumed
the third-largest food and drug chain in the
leadership of Safeway, Magowan faced a
United States, behind KROGER ($45.3 bil-
host of problems: an overall decrease in
lion in sales) and ALBERTSON S ($37.5 bil-
the size of the grocery market due to an
lion in sales).1 In fact, Safeway s 1999 sales
increased tendency by Americans to eat at
setting the stage
fast-food restaurants; union contracts that increased 18% to reach this peak. Sales
resulted in higher labor costs for Safeway volume isn t the only financial measure
than many of its competitors; high corpo- that can be used to evaluate a company,
rate overhead; and stores that were too however. For example, Safeway s net in-
small and too close together. As a result come in 1999 was $971 million, higher
of these problems, between 1976 and than the net income for both Kroger and
1980 Safeway lost market share in 9 of the Albertson s. Also, Safeway s cash income
14 major markets in which it operated. As ( cash from operations ) was $1,488.4 mil-
one executive put it, [Losing market lion. Further, Safeway earned 23.8 cents of
share] in the food business [is] a hell of profit for every dollar invested by its stock-
an indicator you re not giving the cus- holders a decent one-year return on in-
tomer what he wants. By 1981, Safe- vestment (a dollar invested in a certificate
way s financial performance had hit dis- of deposit during the same period would
appointing lows. have earned only about 4 cents).

To adequately answer the question of how Safeway is doing today, one must have a working knowl-
edge of financial statements. In this chapter, you will learn that the financial statements are summary
reports that show how a business is doing and where its successes and failures lie. The financial state-
ments covered in this chapter are the same as those used every day by millions of business owners, in-
vestors, and creditors to evaluate how well or poorly organizations are doing.
You will also be introduced to the use of financial ratios, which are the tools of financial state-
ment analysis. You will learn how to compute and interpret ratios such as return on equity, asset

1 In 1999, Albertson s merged with AMERICAN STORES to form what was, at the time, the largest supermar-
ket chain in the United States. Coincidentally, American Stores traces its roots back to the Skaggs family, whose
stores also formed the backbone of the original Safeway chain organized by Charles Merrill in 1926.
f32 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle

turnover, and price-earnings (PE) ratio. Hopefully, you will come away from this chapter convinced
that the purpose of accounting is not to fill out dull reports that are then filed away in dusty cabi-
nets, but rather to prepare summary financial performance measures to be used as the basis for thou-
sands of economic decisions every day.

Understand the basic
The job of a mortgage loan officer is to evaluate each mortgage applicant to determine the like-
elements and formats of
the three primary financial lihood that he or she will repay the mortgage loan. A key piece of evidence in each applicant s
statements balance sheet,
file is the financial information included as part of the loan application. A loan officer can use
income statement, and
this information to evaluate whether an applicant will generate enough income to make the
statement of cash flows.
monthly mortgage payments and continue to make the required payments on other obligations.
In fact, it is difficult to imagine how a mortgage loan officer could make an informed decision
without this financial information.
Gaining access to an applicant s financial information clearly helps the mortgage lender
make a better loan decision, but the applicant also benefits from making these financial disclo-
sures. If no financial disclosures were provided, lenders would be forced to make loan decisions
in the absence of reliable financial information about applicants. With greater uncertainty about
applicants ability to repay loans, a lender s risk would increase, causing the lender to raise the
interest rate charged on loans. Thus, disclosure of financial information allows a lender to make
better lending decisions and also allows an applicant to reduce the lender s uncertainty, leading
to a lower interest rate on the loan.
The financial statements prepared by companies yield the same benefits as do the finan-
cial disclosures provided by mortgage applicants. Financial statement information provides
potential lenders and investors with a reliable basis for evaluating the past performance and
future prospects of a company. Because financial statements are used by so many different
groups (investors, creditors, managers, etc.), they are sometimes called general-purpose finan-
cial statements. The three primary financial statements are the balance sheet, the income
primary financial state-
ments The balance sheet, statement, and the statement of cash flows. These statements provide answers to the follow-
income statement, and
ing questions:
statement of cash flows,
used by external groups to 1. What is the company s current financial status?
assess a company s eco-
2. What were the company s operating results for the period?
nomic standing.
3. How did the company obtain and use cash during the period?
The balance sheet (or statement of financial position) reports the resources of a company
balance sheet (statement of
financial position) The fi- (assets), the company s obligations (liabilities), and the difference between what is owned (as-
nancial statement that re- sets) and what is owed (liabilities), called owners equity. The income statement (or statement
ports a company s assets,
of earnings) reports the amount of net income earned by a company during a period, with an-
liabilities, and owners eq-
nual and quarterly income statements being the most common. (Net income is discussed later
uity at a particular date.
in the chapter.) The income statement represents the accountant s best effort at measuring the
income statement (state- economic performance of a company. The statement of cash flows reports the amount of cash
ment of earnings) The fi-
collected and paid out by a company in the following three types of activities: operating, in-
nancial statement that re-
vesting, and financing. As an illustration, the 1999 financial statements from MICROSOFT are
ports the amount of net
reproduced in Appendix A at the end of the book. The Microsoft statements are referred to
income earned by a com-
pany during a period. throughout this chapter and the rest of the book.
statement of cash flows
The Balance Sheet
The financial statement that
reports the amount of cash
In the movie The Princess Bride, the hero, Wesley, was mostly dead all day until being revived
collected and paid out by a
by a miracle pill. Wesley was immediately challenged to come up with a plan to stop the im-
company during a period of
time. minent marriage of his true love, Buttercup, to the evil Prince Humperdinck. In formulating
his plan, Wesley s first question to his conspirators was What are our liabilities? followed by
What are our assets? In essence, the recently revived hero was saying, Let me see a balance
sheet. Similarly, the first questions asked about any business by potential investors and credi-
32 f33
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview

tors are What are the resources of the business? and What are its existing obligations? The
assets Economic resources
that are owned or con- balance sheet answers these questions.
trolled by a company.
The three categories of the balance sheet assets, liabilities, and owners equity are each
explained below.
liabilities Obligations to pay
cash, transfer other assets,
or provide services to
Assets are economic resources that are owned or controlled2 by a company. Assets
someone else.
for a typical company include cash, accounts receivable (amounts owed to the company by cus-
tomers), inventory (goods held for sale), land, buildings, equipment, and even intangible
fyi items, such as copyrights and patents. To be summarized and aggregated on a balance
sheet, each asset must be assigned a dollar amount. A balance sheet wouldn t be very use-
The insurmountable difficulties
ful with the following asset listing: one bank account, two warehouses full of goods, three
in valuing some assets can
trucks, and four customers who owe us money. As emphasized throughout this text, the
cause important economic as-
monetary measurement and valuation of assets is an area in which accountants must ex-
sets to be excluded from a com-
ercise considerable professional judgment.
pany s balance sheet. For ex-
ample, how does one put a
Liabilities are obligations to pay cash, transfer other assets, or provide ser-
monetary value on the world-
vices to someone else. Your personal liabilities might include unpaid phone bills, the re-
wide reputation of Coca-Cola or
maining balance on an automobile loan, or an obligation to complete work for which you
on the genius and leadership
have already been paid. Some common liabilities of a company are accounts payable
of Bill Gates? These assets,
(amounts owed by the company to suppliers), notes payable (amounts owed to banks or
though incredibly valuable, are
others), and mortgages payable (amounts owed for purchased property, such as land or
not listed in the balance sheets
buildings). Like assets, liabilities must be measured in monetary amounts. And, as with
of THE COCA-COLA COMPANY assets, quantifying the amount of a liability can require extensive judgment. As one ex-
or of Microsoft. ample, consider the difficulties faced by a company to quantify its obligation to clean up
a particular toxic waste site when the cleanup will take years to complete; the exact extent
owners equity The owner- of the environmental damage at the site is still in dispute; and legal responsibility for the toxic
ship interest in the net as- mess is still debated in the courts. Properly valuing a company s liabilities is one of the biggest
sets of an entity; equals total
(if not the biggest) challenges that an accountant faces.
assets minus total liabilities.

net assets The owners eq-
The remaining claim against the assets of a business, after the liabili-
uity of a business; equal to
ties have been deducted, is owners equity. Thus, owners equity is a residual amount; it rep-
total assets minus total lia-
resents the net assets (total assets minus total liabilities) available after all obligations
have been satisfied. Obviously, if there are no liabilities (an unlikely situation, except at
fyi the start of a business), then the total assets are exactly equal to the owners claims against
those assets the owners equity.
Although the emphasis in this
In order to get a business started, investors transfer resources, usually cash, to the
book is on corporations, most
business in return for part ownership. Ownership of a company can be restricted to one
of the same principles also
person (a sole proprietorship), to a small group (a partnership), or to a diffuse group of
apply to proprietorships and
owners who often don t even know one another (a corporation). When owners initially
partnerships. Differences in ac-
invest money in a corporation, they receive evidence of their ownership in the form of
counting for proprietorships and
shares of stock, represented by stock certificates. These shares of stock may then be pri-
partnerships are explained in de-
vately traded among existing owners of the corporation, privately sold to new owners, or
tail in the expanded material in
traded publicly on an organized stock exchange such as the New York Stock Exchange
Chapter 11.
(NYSE) (where SAFEWAY s shares are traded) or the NASDAQ exchange (where Mi-
crosoft s shares are traded). The owners of a corporation are called stockholders or share-
holders, and the owners equity section of a corporate balance sheet is sometimes referred to as
stockholders (shareholders) stockholders equity.
The owners of a corpora-
Owners equity is increased when owners make additional investments in a business or when
the business generates profits that are retained in the business. Since business profits belong to
stockholders equity The the owners, retaining the profits in the business is equivalent to giving the profits to the own-
owners equity section of a
ers and then having them immediately reinvest that amount back into the business.
corporate balance sheet.

2 An example of an asset that a company technically does not own, but does economically control, is a build-
ing that the company uses under a long-term, noncancelable lease agreement.
f34 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle

business environment essay

Should I Incorporate? Pick up just directly from, those businesses. Legally, a propri-
about any business newspaper or mag- etorship is merely an extension of the owner. The
azine, look in the classified section, and owner is personally responsible for all the activi-
you are sure to see advertisements of- ties and obligations of the business.
2. Partnership. A partnership is a business associa-
fering to help you set up a corporation.
Incorporate in USA by Fax or tion of two or more individuals. As in a propri-
Phone!!! Incorporate: All 50 States etorship, the partners generally own and manage
and Offshore. Typical Incorporating the business and are personally responsible for all
Fees: Delaware, $199; Wyoming, $285; the obligations of the business. A partnership or-
the Bahamas, $500; Isle of Man, £250. ganization makes sense when the workload and fi-
With all this eagerness to incorporate, there must be nancial requirements associated with starting and
some advantages. To understand these advantages, operating a business are too much for one person.
3. Corporation. A corporation is a business that is char-
as well as the disadvantages, it is necessary to review
the three major types of business entities: proprietor- tered (incorporated) as a separate legal entity under
ships, partnerships, and corporations. the laws of a particular state or country. With a pro-
prietorship or a partnership, the owners are the busi-
1. Proprietorship. A proprietorship is a business ness. With a corporation, the operations and obli-
owned by one person. Almost always, the owner gations of the business are legally separated from
of the business also manages the operation. For the personal affairs of the owners. Typically, stock-
example, many owners of small businesses (espe- holders in a corporation can freely buy and sell their
cially those that provide personal services) manage interests, thus allowing the corporate ownership to
the day-to-day activities of, and receive the profits change without dissolving the business. The stock-

Owners equity is decreased when the owners take back part of their investment. If the
business is a corporation, distributions to the owners (stockholders) are called dividends.
Owners equity can also be decreased if operations generate a loss instead of a profit. In the
dividends Distributions to
extreme, very poor performance can result in the loss of all the assets originally invested by
the owners (stockholders)
of a corporation. the owners. For a corporation, the amount of accumulated earnings of the business that have
not been distributed to owners is called retained earnings. The portion of owners equity
retained earnings The
contributed by owners in exchange for shares of stock is called capital stock. The amount of
amount of accumulated
earnings of the business retained earnings plus the amount of capital stock equals the corporation s total owners
that have not been distrib-
uted to owners.

capital stock The portion of
The balance sheet presents information based on the basic ac-
a corporation s owners eq-
counting equation:
uity contributed by owners
in exchange for shares of
Assets Liabilities Owners Equity
In fact, the name balance sheet comes from the fact that a proper balance sheet must always bal-
accounting equation An al-
ance total assets must equal the total of liabilities and owners equity. The accounting equa-
gebraic equation that ex-
tion is not some miraculous coincidence; it is true by definition. Liabilities and owners equity
presses the relationship be-
tween assets (resources), are just the sources of funding used to buy the assets; that is, they are the claims (creditors claims
liabilities (obligations), and
and owners claims) against the assets. So, another way to view the accounting equation is that
owners equity (net assets,
the total amount of the assets is equal to the total amount of funding needed to buy the assets.
or the residual interest in a
The total resources, therefore, equal the claims against those resources. This is illustrated in Ex-
business after all liabilities
hibit 2-1.
have been met): Assets
Liabilities Owners The accounting equation is presented here merely to give you a glimpse of double-entry
accounting. Chapter 3 gives an in-depth discussion of the equation elements and the mechan-
ics of double-entry accounting.
34 f35
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview

holders elect a board of directors, which then hires Management of the business is separated from
executives to manage the corporation. The man- ownership. The owners must be cautious in mon-
agers, as employees of the corporation, may or may itoring the activities of their hired managers.
not be stockholders. Thus, in a corporation there is
As shown below, the majority of business activity in
a separation of ownership from management.
the United States is conducted by corporations, al-
The primary advantages of incorporation are: though the actual number of proprietorships is
Investment funds can be accumulated from many
different individuals, allowing for the development Type of Number of
Business Businesses Sales
of larger, more efficient companies.
Individual owners can buy and sell their ownership
Sole proprietorships 16.955 million $ 843 billion
shares without getting the permission of the other
Partnerships 1.654 million 1,042 billion
Corporations 4.631 million 14,890 billion
The liability of the owners is limited. If the business
does not flourish, the worst that can happen to the
owners is that they lose their investment; their Source: U.S. Bureau of the Census, Statistical Abstract of the United
States: 1999 (Washington, D.C., 1999). Data are based on IRS infor-
other personal assets are not at risk.
mation for 1996.
The primary disadvantages of incorporation are:

Corporate income is taxed twice: once when it is
earned by the corporation and again when it is paid
out to shareholders in the form of dividends.

Elements of the Accounting Equation
exhibit 2-1

Assets Liabilities Owners™ Equity

Sources of funding

Creditors™ Owners™
claims claims
against against
resources resources

Decreased by distributions Increased by investments
to owners (dividends) and by owners and profitable
unprofitable operations operations

double-entry accounting A A simple balance sheet, adapted from Microsoft s
system of recording trans- 1999 balance sheet reproduced in Appendix A at the end of the book, is shown in Exhibit 2-2.
actions in a way that main-
Note that a balance sheet is presented for a particular date because it reports a company s
tains the equality of the ac-
financial position at a point in time. The balance sheet in Exhibit 2-2 presents Microsoft s fi-
counting equation.
nancial position as of June 30, 1999.
f36 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle

Simplified Balance Sheet for Microsoft
exhibit 2-2

Microsoft Corporation
Balance Sheet
June 30, 1999
(amounts in millions)

Assets Liabilities
Cash and short-term Accounts payable $00,874
investments $17,236 Accrued compensation 396
Accounts receivable 2,245 Income taxes payable 1,607
Other current assets 752 Unearned revenue 4,239
Property, plant, and Other current liabilities 1,602
equipment 1,611 Long-term loans 0
Equity and other investments 14,372 Total liabilities $08,718
Other assets 940

Owners Equity
Capital stock $14,824
Retained earnings 13,614
Total liabilities and
Total assets $37,156 owners equity $37,156

As illustrated, the balance sheet is divided into the three major sections we have described:
assets, liabilities, and owners equity. The asset section identifies the types of assets owned by
Microsoft (cash, for example) and the monetary amounts associated with those assets. The lia-
bility section defines the extent and nature of Microsoft s debts (income taxes not yet paid, for
Remember that the balance sheet is not merely a report to be prepared and forgotten; it is
a summary of important information that is useful to investors and creditors. For example, if
you were a banker, would you give a loan to Microsoft based on the informa-
tion from the June 30, 1999, balance sheet? Of course you would, because you
Actually, the Microsoft
see that Microsoft already has enough cash on hand ($17 billion) to be able to
balance sheet is quite unusual. Very few
pay off all existing liabilities ($8.7 billion) almost two times over. Based on the
companies have the large amount of cash
balance sheet information, you can see that any loan to Microsoft could be eas-
($17 billion) and low amount of long-term ily repaid.
debt ($0) that Microsoft has. Is it good for a Owners equity completes the balance sheet. This section identifies the por-
tion of Microsoft s resources that were contributed by owners, either in ex-
company to have so much cash?
change for shares of stock or as undistributed earnings since Microsoft s in-
ception. Together with liabilities, owners equity indicates how a company is financed (whether
by borrowing or by owner contributions and operating profits). You can see that Microsoft has
been financed primarily through owner investment. Almost half of this owner investment ($13.6
billion) has been in the form of retained earnings.

Imagine that two people each
owe you $10,000. You ask to see the balance sheets of each. Borrower A has assets of $10,000
in the form of cash. Borrower B has assets of $10,000 in the form of undeveloped land. If you
need to collect the loan in the next two weeks, which of the two borrowers is more likely to be
able to pay you back? Borrower A is more likely to be able to repay you quickly because the as-
sets of A are more liquid, meaning that they are in the form of cash or can be easily converted
into cash. Assets such as undeveloped land are said to be illiquid in that it takes time and effort
to convert them into cash. This illustration shows that not all assets are the same. For some pur-
poses, it is very important to distinguish between current assets, which are generally more liq-
36 f37
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview

uid, and long-term assets. A balance sheet that distinguishes between current and long-
term assets is called a classified balance sheet.
Don t worry about fully under- To illustrate a classified balance sheet, we consider the balance sheet for Safeway, the
standing all the items in Safe- supermarket chain described in the opening scenario of this chapter. In Exhibit 2-3, Safe-
way s classified balance sheet, way s assets are classified as current, or short-term, and long-term.
Current assets include cash and other assets that are expected to be converted to cash
such as the Property under
within a year. Current assets generally are listed in decreasing order of liquidity; cash is
capital leases and the Cumu-
listed first, followed by the other current assets, such as accounts receivable. Long-term
lative translation adjustments.
assets, such as land, buildings, and equipment, are those that a company needs in order
If there was nothing else to
to operate its business over an extended period of time.
learn, this book would be much
Like assets, liabilities usually are classified as either current (obligations expected to
shorter and this accounting
be paid within a year) or long-term. Accounts payable, for example, usually would be paid
class would last only two weeks.
within 30 to 60 days, whereas a mortgage may remain on the books for 20 to 30 years
before it is fully paid.
Safeway s balance sheet in Exhibit 2-3 includes financial information for both the current
year and the preceding year. Most companies prepare such comparative financial statements
classified balance sheet A
balance sheet in which as- so that readers can identify any significant changes in particular items. For example, notice that
sets and liabilities are sub- Safeway s total assets increased by $3,510.7 million ($14,900.3 million $11,389.6 million)
divided into current and
from 1998 to 1999. Where did the money come from to finance this increase in assets? Most
long-term categories.
of it came from an increased amount of loans (liabilities increased by $2,507 million).
current assets Cash and
other assets that can be
Although the balance sheet is useful in showing
easily converted to cash
the financial status of a company, it does have some limitations. The primary limitation of the
within a year.
balance sheet is that it does not reflect the current value or worth of a company. Refer back to
liquidity The ability of a the balance sheet numbers for Microsoft in Exhibit 2-2. If the balance sheet were perfect, mean-
company to pay its debts in
ing that it included all economic assets reported at their current market values, then the amount
the short run.
of owners equity would be equal to the market value of the company. In the case of Microsoft,
the value of the company would be $28.438 billion, which is the amount of assets that would
long-term assets Assets
that a company needs in remain after all the liabilities were repaid. The actual market value of Microsoft on May 18,
order to operate its busi-
2000, however, was $348 billion. How could the balance sheet be so wrong?
ness over an extended pe-
The discrepancy between recorded balance sheet value and actual market value is the result
riod of time.
of the following two factors:
comparative financial state-
1. Accountants record many assets at their purchase cost, not at their current market value.
ments Financial statements
in which data for two or Market value is the price that would have to be paid to buy the same asset today. For ex-
more years are shown to- ample, if land was obtained ten years ago, it would still be reported on the balance sheet at
its original cost, even though its market value may have increased dramatically.
2. Not all economic assets are included in the balance sheet. For example, important economic
market value The value of
a company as measured by assets of Microsoft are its proven track record of successful products, the genius of Bill Gates,
the number of shares of and a strong, established position in the marketplace (ask NOVELL, WORDPERFECT, LO-
stock outstanding multi-
TUS, and NETSCAPE what it is like to compete against Microsoft). These intangible factors
plied by the current market
are all very valuable economic assets. In fact, they are by far the most valuable assets Microsoft
price of the stock; the cur-
has. Nevertheless, these important economic assets are outside the normal accounting process.
rent value of a business.

Because the balance sheet can underreport the value of some long-term assets, and not re-
port other important economic assets, the accounting book value of a company (measured by
book value The value of a
company as measured by the amount of owners equity) is usually less than the company s market value, measured by the
the amount of owners eq-
market price per share times the number of shares of stock. This is illustrated in Exhibit 2-4 us-
uity; that is, assets less lia-
ing data for the ten largest companies (in terms of market value) in the United States.
Despite its deficiencies, the balance sheet is a useful source of information regarding the fi-
nancial position of a business. A lender would never loan a company money without knowing
what assets the company has and what other loans the company is already obligated to repay.
An investor shouldn t pay money in exchange for ownership in a company without knowing
something about the company s existing resources and obligations. When a balance sheet is clas-
sified, and when comparative data are provided, the balance sheet provides an informative pic-
ture of a company s financial position.
f38 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle

Classified Balance Sheets for Safeway
exhibit 2-3

Safeway, Inc.
Comparative Balance Sheet
December 28, 1999 and December 30, 1998
(amounts in millions)

1999 1998

Current assets:
Cash $00,106.2 $00,045.7
Accounts receivable 292.9 200.1
Merchandise inventories 2,444.9 1,856.0
Prepaid expenses and other current assets 208.1 218.1
Total current assets $03,052.1 $02,319.9

Land $00,996.2 $00,794.1
Buildings 2,502.3 2,069.9
Leasehold improvements 1,784.3 1,498.3
Fixtures and equipment 3,852.4 3,282.6
Property under capital leases 591.4 379.2
Total property $09,726.6 $08,024.1
Less accumulated depreciation and amortization 3,281.9 2,841.5
Total property, net $06,444.7 $05,182.6

Other assets:
Goodwill $04,786.6 $03,348.0
Prepaid pension costs 405.6 369.6
Investments in unconsolidated affiliates 131.6 115.2
Other assets 79.7 54.3
Total assets $14,900.3 $11,389.6

Liabilities and Stockholders Equity
Current liabilities:
Accounts payable $01,878.4 $01,595.9
Accrued salaries and wages 387.7 348.9
Other current liabilities 1,316.5 948.8
Total current liabilities $03,582.6 $02,893.6

Long-term debt:
Notes and debentures $05,922.0 $04,242.6
Obligations under capital leases 435.4 408.0
Total long-term debt $06,357.4 $04,650.6
Deferred income taxes 379.1 216.9
Accrued claims and other liabilities 495.4 546.4
Total liabilities $10,814.5 $08,307.5

Stockholders equity:
Common stock: par value $0.01 per share $00,005.6 $00,005.5
Additional paid-in capital 1322.4 1,297.3
Unexercised warrants purchased (126.6) (126.0)
Cumulative translation adjustments (11.5) (19.7)
Retained earnings 2,895.9 1,925.0
Total stockholders equity $04,085.8 $03,082.1
Total liabilities and stockholders equity $14,900.3 $11,389.6
38 f39
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview

Book Value and Market Value for the Ten Largest U.S. Firms
exhibit 2-4

Market Value*†
Book Value*
Rank Company

1 Microsoft $28,438.0 $492,462
2 Cisco Systems 11,678.0 453,879
3 General Electric 42,557.0 417,175
4 Intel 32,535.0 391,817
5 ExxonMobil 63,466.0 268,598
6 AT&T 78,927.0 236,704
7 Oracle 3,695.3 217,258
8 Lucent Technologies 13,584.0 214,185
9 Wal-Mart Stores 25,848.0 212,666
10 International Business 20,511.0 193,810
Machines (IBM)

*Accounting book value and market value are in millions of dollars.
†On a previous page we noted that Microsoft™s market value was $348 billion on May 18,
2000. In this exhibit, Microsoft™s value is listed as $492 billion as of March 14, 2000. The reason
for the dramatic decrease in market value in two months is the government™s theatened breakup
of the company.

Source: Fortune 500 listing, 1999. Market values are as of March 14, 2000. Accounting
book values are for the end of the immediately preceding fiscal year. Accessible at http://www.fortune.com.

to summarize
The balance sheet provides a summary of the financial position of a company
at a particular date. It helps external users assess the financial relationship be-
tween assets (resources) and liabilities and owners equity (claims against those
resources). Assets and liabilities are usually classified as either current or long-
term and are presented in descending order of liquidity. For a corporation, own-
ers equity consists of directly invested funds as well as retained earnings. Clas-
sified and comparative balance sheets provide useful information for readers
of financial statements. Because not all economic assets are included on the
balance sheet, the book value as shown in the balance sheet is usually less
than the market value of the company.

The Income Statement
Almost every day, The Wall Street Journal includes a section called Digest of Earnings Reports
that contains the net income, or earnings, figures announced by companies the day before. The
stock prices of companies go up or down depending on whether their announced earnings meet
the expectations of investors. For example, on April 19, 1997, Microsoft stock shot up from
$98.125 to $107.625 per share in response to news of an 85% increase in Microsoft s net in-
come as compared to the previous year. This high level of interest centered on net income makes
it apparent that investors find this accounting number useful in evaluating the health and per-
formance of a business.
Net income is reported in the income statement. The income statement shows the results
of a company s operations for a period of time (a month, a quarter, or a year). The income state-
ment summarizes the revenues generated and the costs incurred (expenses) to generate those rev-
enues. The bottom line of an income statement is net income (or net loss), the difference be-
tween revenues and expenses. To help you understand an income statement, we must first define
its elements revenues, expenses, and net income (or net loss).
f40 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle

Revenue is the amount of assets created through business operations. Think of
revenue Increase in a com-
pany s resources from the revenue as another way for a company to acquire assets. In the same way that assets can be ac-
sale of goods or services. quired by borrowing or by owners investment, assets can also be acquired by providing a prod-
uct or service for which customers are willing to pay. Manufacturing and merchandising com-
panies receive revenues from the sale of merchandise. For example, Safeway s revenue is the cash
that customers pay in exchange for groceries. A service enterprise generates revenues from the
fees it charges for the services it performs. For example, a portion of the sales price of Microsoft
software is not payment for the software itself, but instead is an advance payment for the cus-
tomer support service that Microsoft promises. Companies might also earn revenues from other
activities, such as charging interest or collecting rent. When goods are sold or services performed,
the resulting revenue is in the form of cash or accounts receivable (a promise from the buyer to
pay for the goods or services by a specified date in the future). Revenues thus generally repre-
sent an increase in total assets. These new assets are not tied to any liability obligation; there-
fore, the assets belong to the owners and thus represent an increase in owners equity.

Expenses are the amount of assets consumed through business operations. Ex-
expenses Costs incurred in
the normal course of busi- penses are the costs incurred in normal business operations to generate revenues. Employee
ness to generate revenues.
salaries and utilities used during a period are two common examples of expenses. For Safeway,
the primary expense is the wholesale cost of the groceries that it sells to its customers at retail.
Just as revenues represent an increase in assets and equity, expenses generally represent a decrease
in assets and in equity.
In considering revenues and expenses, remember that not all inflows of assets are revenues;
nor are all outflows of assets considered to be expenses. For example, cash may be received by
borrowing from a bank, which is an increase in a liability, not a revenue. Similarly, cash may
be paid for supplies, which is an exchange of one asset for another asset, not an expense. The
details of properly identifying revenues and expenses will be discussed further in Chapter 3.
net income (net loss) An
overall measure of the per-
formance of a company; Net income, sometimes called earnings or profit, is an over-
equal to revenues minus
all measure of the performance of a company. Net income reflects the company s accomplish-
expenses for the period.
ments (revenues) in relation to its efforts (expenses) during a particular period of time. If rev-
enues exceed expenses, the result is called net income (revenues expenses net income). If
expenses exceed revenues, the difference is called net loss. Because net income results in an in-
crease in resources from operations, owners equity is also increased; a net loss decreases own-
ers equity. Exhibit 2-5 lists the ten U.S. companies with the highest net incomes in 1999.
net work
It is important to note the difference between revenues and net income. Both concepts rep-
At its Web site (http://
resent an increase in the net assets (assets liabilities) of a firm. However, revenues represent
www.fortune.com), Fortune
total resource increases; expenses are subtracted from revenues to derive net income or net loss.
magazine provides selected
Thus, whereas revenue is a gross concept, income (or loss) is a net concept.
stories from current issues
as well as summaries of its
famous lists: the Fortune
Comparative income statements, which
500 (largest companies in
the United States) and the have been modified to a multi-step format, for Safeway are presented in Exhibit 2-6. In con-
Global 500 (largest compa-
trast to the balance sheet, which is as of a particular date, the income statement refers to the
nies in the world).
year ended. Remember, the income statement covers a period of time; the balance sheet is a
1. Search the Fortune 500
report at a point in time. The multi-step format illustrated here highlights several profit mea-
Top Performers to find
out which U.S. company surements including gross profit, operating income, and net income.
has the most assets.
The income statement usually shows two main categories, revenues and expenses, although
2. Search the Global 500
several subcategories may also be presented (as illustrated). Revenues are listed first. Typical op-
Top Performers and
erating expenses for most businesses are employee salaries, utilities, and advertising. For Safe-
identify which company
employs more people
way, as with any retail firm, the largest expense is for cost of goods sold. The difference between
than any other company
sales and cost of goods sold represents the difference between the retail price Safeway receives
in the world.
from a grocery sale and the wholesale cost of the groceries that are sold. This difference (sales
cost of goods sold) is called gross profit or gross margin.
gross profit (gross margin)
Expenses are sometimes divided into operating and nonoperating categories. The primary
The excess of net sales rev-
nonoperating expenses are interest and income taxes. These expenses are called nonoperating be-
enue over the cost of
cause they have no connection with the specific nature of the operation of the business. For ex-
goods sold.
40 f41
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview

Top Ten U.S. Companies, Ranked by Net Income
exhibit 2-5

Company Name Net Income*

General Electric $10,717.0
Citigroup 9,867.0
SBC Communications 8,159.0
ExxonMobil 7,910.0
Bank of America Corporation 7,882.0
Microsoft 7,785.0
International Business Machines 7,712.0
E.I. du Pont de Nemours 7,690.0
Philip Morris 7,675.0
Intel 7,314.0

*Net income is in millions of dollars.

Source: Fortune 500 listing, 1999. Accessible at http://www.fortune.com.

ample, Safeway and Microsoft deal with interest and income taxes in a similar way, even though
the two companies operate in completely different industries.
gains (losses) Money made
Two other items that frequently appear in the income statement are gains and losses. Gains
or lost on activities outside
and losses refer to money made or lost on activities outside the normal business of a company.
the normal operation of a
For example, when Safeway receives cash for selling groceries, it is called revenue. But when

Adapted Comparative Income Statements for Safeway
exhibit 2-6

Safeway, Inc.
Comparative Income Statement
For the Years Ended December 28, 1999
and December 30, 1998
(in millions)

1999 1998

Sales $28,859.9 $24,484.2
Less: Cost of goods sold 20,349.2 17,359.7
Gross profit $08,510.7 $07,124.5
Less: Operating and administrative expense 6,411.4 5,466.5
Goodwill amortization 101.4 56.3
Operating income $01,997.9 $01,601.7
Add: Other income 38.3 30.2
Less: Interest expense 362.2 235.1
Less: Income tax expense 703.1 590.2
Net income $00,970.9 $00,806.6
Basic earnings per share $00,001.95 $1.67
f42 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle

Safeway makes money by selling an old delivery truck, the amount is called a gain, not revenue,
because Safeway is not in the business of selling trucks.
Recently, companies have been providing an additional measure of income comprehen-
sive income. The wealth of a company is affected in a variety of ways that have nothing to do
with the business operations of the company. For example, changes in exchange rates can cause
the U.S. dollar value of a company s foreign subsidiaries to increase or decrease. Comprehen-
comprehensive income A
measure of the overall sive income is the number used to reflect an overall measure of the change in a company s
change in a company s wealth during the period.
wealth during a period;
In addition to net income, comprehensive income includes items that, in general, arise from
consists of net income plus
changes in market conditions unrelated to the business operations of a company. These items
changes in wealth resulting
are excluded from net income because they are viewed as yielding little information about the
from changes in investment
values and exchange rates. economic performance of a company s business operations. Nevertheless, they do affect the value
of assets and liabilities reported in the balance sheet, so they are reported as part of compre-
hensive income.
The most common examples of items included in comprehensive income include changes
in foreign currency exchange rates, changes in the value of certain investment securities, and
changes in the value of certain derivative financial instruments. Each of these items is affected
by market conditions, affects a company s reported assets and liabilities, yet cannot be influ-
enced in any large degree by the company. Therefore, they are reported as part of a firm s com-
prehensive income. To summarize, net income is a measure of a company s performance dur-
ing the period; comprehensive income includes the net income performance measure plus other
wealth changes resulting from changes in investment values and exchange rates.
One final bit of information required on the income statements of corporations is earnings
earnings (loss) per share
(EPS) The amount of net in- (loss) per share (EPS). This EPS amount is computed by dividing the net income (earnings or
come (earnings) related to
loss) for the current period by the number of shares of stock outstanding during the period.
each share of stock; com-
Earnings per share information tells the owner of a single share of stock how much of the net
puted by dividing net in-
income for the year belongs to him or her.
come by the number of
Like the balance sheet, the income statement usually shows the comparative results for two
shares of stock outstanding
during the period. or more periods, allowing investors and creditors to evaluate how profitable an enterprise has
been during the current period as compared with earlier periods. For example, examination of
Safeway s comparative income statements in Exhibit 2-6 shows that net income in 1999 was
20% higher [($970.9 $806.6) $806.6] than in 1998. Further analysis of the income state-
ment is introduced later in this chapter and reinforced throughout the text. (For another illus-
tration of a comparative income statement, see the income statement for Microsoft in Appen-
dix A at the back of the book.)
statement of retained earn-
ings A report that shows
In addition to an income statement, cor-
the changes in retained
porations sometimes prepare a statement of retained earnings. This statement identifies changes
earnings during a period of
in retained earnings from one accounting period to the next. As illustrated in Exhibit 2-7, the

Illustrated Statement of Retained Earnings for Safeway
exhibit 2-7

Safeway, Inc.
Illustrated Statement of Retained Earnings
For the Year Ended December 28, 1999
(in millions)

Retained earnings, January 1, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,925.0
Add net income for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 970.9
Less dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0
Retained earnings, December 28, 1999. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,895.9
42 f43
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview

statement shows a beginning retained earnings balance, the net income for the period, a de-
duction for any dividends paid, and an ending retained earnings balance. For Safeway, which
paid no dividends during 1999, its retained earnings would simply increase by the amount of
reported net income.
Note how the accounting equation is affected by the elements reported in the statement of
retained earnings. Net income results in an increase in net assets and a corresponding increase
in Retained Earnings, which increases Owners Equity.
(+) Assets Liabilities Owners Equity (+)

Capital Stock Retained Earnings (+)

Dividends reduce net assets (e.g., cash) and similarly reduce Retained Earnings, which reduces
Owners Equity.
()) Assets Liabilities Owners Equity ())

Capital Stock Retained Earnings ())

Corporations sometimes present a statement of stockholders equity instead of a statement of
retained earnings. The statement of stockholders equity, illustrated for Microsoft in Appendix
A at the back of the book, is more detailed and includes changes in capital stock as well as
changes in retained earnings.

to summarize
The income statement provides a measure of the success of an enterprise over
a specified period of time. The income statement shows the major sources of
revenues generated and the expenses associated with those revenues. The dif-
ference between those revenues and expenses is net income or net loss. Gains
and losses refer to money made or lost on activities outside the normal activ-
ities of a business. The income statements of corporations must also include
earnings per share figures. Comprehensive income includes net income as well
as other wealth changes resulting from changes in investment values and ex-
change rates. Like balance sheets, income statements are usually prepared on
a comparative basis. A statement of retained earnings or statement of stock-
holders equity is often provided by corporations in their annual reports to

The Statement of Cash Flows
Net income is the single best measure of a company s economic performance. However, anyone
who has paid rent or college tuition knows that bills must be paid with cash, not with eco-
nomic performance. Accordingly, in addition to net income, investors and creditors also desire
to know how much actual cash a company s operations generate during a period and how that
cash is used. The statement of cash flows shows the cash inflows (receipts) and cash outflows
(payments) of an entity during a period of time. As shown in Exhibit 2-8, companies receive
cash primarily by selling goods or providing services, by selling other assets, by borrowing, and
by receiving cash from investments by owners. Companies use cash to pay current operating ex-
penses such as wages, utilities, and taxes; to purchase additional buildings, land, and otherwise
expand operations; to repay loans; and to pay their owners a return on the investments that have
been made.
In the statement of cash flows, individual cash flow items are classified according to three
main activities: operating, investing, and financing.
f44 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle

Cash Flows
exhibit 2-8

Operating activities: Investing activities: Financing activities:
Selling goods Selling buildings Borrowing money
Providing services Selling land Receiving investments
from owners

Inflows of Cash


Outflows of Cash

Operating activities: Investing activities: Financing activities:
Paying wages Purchasing buildings Repaying loans
G Paying utilities G Purchasing land G Distributions to
G Paying taxes owners

Operating activities are those activities that are part of the day-
operating activities Activi-
ties that are part of the day- to-day business of a company. Cash receipts from selling goods or from providing services are
to-day business of a com-
the major operating cash inflow. Major operating cash outflows include payments to purchase
inventory and to pay wages, taxes, interest, utilities, rent, and similar expenses.

The primary investing activities are the purchase and sale of land,
investing activities Activi-
ties associated with buying buildings, and equipment. You can think of investing activities as those activities associated with
and selling long-term as-
buying and selling long-term assets.

Financing activities are those activities whereby cash is obtained
financing activities Activi-
ties whereby cash is ob- from or repaid to owners and creditors. For example, cash received from owners investments,
tained from or repaid to
cash proceeds from a loan, or cash payments to repay loans would all be classified under fi-
owners and creditors.
nancing activities.
Conceptually, the statement of cash flows is the easiest to prepare of the three primary fi-
nancial statements. Imagine examining every check and deposit slip you have written in the past
year and sorting them into three piles operating, investing, and financing. You would have to
exercise some judgment in deciding which pile some items go into (for example, is the payment
of interest an operating or a financing activity?). But overall, the three-way categorization of cash
flows is not that difficult. In essence, this is all that is involved in the preparation of a statement
of cash flows. As you will see in Chapter 13, however, actual preparation of a statement of cash
flows can sometimes be challenging. The reason for this is that traditional accounting systems
are designed to streamline the computation of net income. So, instead of preparing the state-
ment of cash flows directly from the raw cash flow data, the process is as shown in Exhibit
2-9. The raw cash flow data are transformed into revenue and expense data using the account-
ing adjustments, assumptions, and estimates that you will learn about in this text. Then, to pre-
pare the statement of cash flows, all of those adjustments must be undone to get back to the
raw cash flow data. Challenging, but by the time we get to Chapter 13, you will be ready for it.
44 f45
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview

Cash Flow to Net Income to Cash Flow
exhibit 2-9

Raw Cash Flow Data

Accounting Adjustments

Net Income

Undo Accounting Adjustments


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