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Statement of Cash Flows



Exhibit 2-10 contains the statement of cash flows for the BOSTON CELTICS for
fyi
the year ended June 30, 19963. As sports fans know, the Boston Celtics is the NBA team
Notice that the Boston Celtics
with the most championships in history. What is not widely known is that ownership
has chosen June 30 as the end shares in the Boston Celtics could once be purchased by the general public and were traded
of its fiscal year. About two- on the New York Stock Exchange. Because the Celtics was a publicly traded company, it
was required to make its financial statements publicly available, thus providing the infor-
thirds of large U.S. companies
mation for Exhibit 2-10. As with balance sheets and income statements, companies usu-
choose December 31. The
ally provide comparative statements of cash flows. However, we have elected not to show
Boston Celtics uses June 30 be-
comparative statements of cash flows in order to keep the Celtics illustration simple. (The
cause that coincides with a nat-
Microsoft financial statements in Appendix A provide comparative statements of cash
ural lull in its business (the
flows.)
playoffs are over and the next
One interesting item to note in the Celtics cash flow statement is the $5.2 million
regular season is months
payment for deferred compensation. This represents players salaries that were earned (and
away). Safeway chooses the
reported as expenses) in prior years but not paid until 1996. Also notice the large amount
last Saturday of the year to
of activity in buying and selling investment securities $171 million in securities pur-
make sure that each fiscal year
chased and $157 million sold. And you thought that the Celtics only played basketball.
contains a whole number of
weeks.

to summarize
The statement of cash flows is one of the three primary financial statements.
It shows the significant cash inflows (receipts) and cash outflows (payments)
of a company for a period of time. These cash flows are classified according
to operating, investing, and financing activities. The statement of cash flows is
discussed and illustrated in Chapter 13.



How the Financial Statements Tie Together
Although we have introduced the primary financial statements as if they were independent of one
another, they are interrelated and tie together. In accounting language, they articulate. Articu-
articulation The interrela-
tionships among the finan- lation refers to the relationship between an operating statement (the income statement or the
cial statements.
statement of cash flows) and comparative balance sheets, whereby an item on the operating state-
ment helps explain the change in an item on the balance sheet from one period to the next.

3 Beginning in 1997, the Celtics were no longer publicly traded.
45
f46 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle



Statement of Cash Flows for the Boston Celtics
exhibit 2-10


BOSTON CELTICS LIMITED PARTNERSHIP
Statement of Cash Flows
For the Year Ended June 30, 1996

CASH FLOWS FROM OPERATING ACTIVITIES

Receipts:
Basketball regular season receipts:
Ticket sales $31,323,249)
Television and radio broadcast rights fees 19,908,800)
Other (principally promotional advertising) 8,424,038)
Basketball playoff receipts 360,895)
60,016,982)

Outflows:
Basketball regular season expenditures:
Team expenses 26,066,875)
Game expenses 2,481,007)
Basketball playoff expenses 0)
General and administrative expenses 13,996,805)
Selling and promotional expenses 1,333,238)
43,877,925)
16,139,057)
Interest income 9,553,938)
Interest expense (4,624,043)
Ticket refunds paid (504)
Proceeds from league expansion 4,490,673)
Payment of income taxes (4,973,883)
Payment of deferred compensation (5,226,095)
Other operating cash outflows (2,931,742)
NET CASH FLOWS FROM OPERATING ACTIVITIES 12,427,401)

CASH FLOWS FROM INVESTING ACTIVITIES

Purchases of investment securities (171,422,268)
Proceeds from sales of investment securities 156,655,561)
Net cash proceeds from the sale of Boston Celtics
Broadcasting Limited Partnership 77,597,929)
Capital expenditures (796,424)
Other investing receipts 293,503)
NET CASH FLOWS FROM INVESTING ACTIVITIES 62,328,301)


CASH FLOWS (USED BY) FINANCING ACTIVITIES

Repayment of bank borrowings (80,000,000)
Repurchase of Boston Celtics Limited Partnership
shares from owners (1,941,450)
Cash distributions to owners (26,395,139)
NET CASH FLOWS (USED BY) FINANCING ACTIVITIES (108,336,589)
NET (DECREASE) IN CASH (33,580,887)
Cash at beginning of period 39,563,015)
CASH AT END OF PERIOD $0,5,982,128)
46 f47
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview


Exhibit 2-11 shows how the financial statements tie together. Note that the beginning
amount of cash from the 1998 balance sheet is added to the net increase or decrease in cash
(from the statement of cash flows) to derive the cash balance as reported on the 1999 balance
sheet. Similarly, the retained earnings balance as reported on the 1999 balance sheet comes from
the beginning retained earnings balance (1998 balance sheet) plus net income for the period
(from the income statement) less dividends paid. As you study financial statements, these rela-
tionships will become clearer and you will understand the concept of articulation better.


2 NOTES TO THE FINANCIAL STATEMENTS
Recognize the need for
The three primary financial statements contain a lot of information. Still, three summary re-
financial statement notes
and identify the types of ports cannot possibly tell financial statement users everything they want to know about a com-
information included in the
pany. Additional information is given in the notes to the financial statements. In fact, in a
notes.
typical annual report, the notes go on for 15 pages or more, whereas the primary financial state-
notes to the financial state- ments fill only 3 pages. The notes tell about the assumptions and methods used in preparing
ments Explanatory informa- the financial statements and also give more detail about specific items.
tion considered an integral
The financial statement notes are of the following four general types:
part of the financial state-
ments.
1. Summary of significant accounting policies.
2. Additional information about the summary totals found in the financial statements.
3. Disclosure of important information that is not recognized in the financial statements.
4. Supplementary information required by the Financial Accounting Standards Board (FASB)
or the Securities and Exchange Commission (SEC).

Summary of Significant Accounting Policies
As mentioned earlier, accounting involves making assumptions, estimates, and judgments. In
addition, in some settings, there is more than one acceptable method of accounting for certain


How the Financial Statements Tie Together
exhibit 2-11


Statement of Cash Flows, 12/28/99
Operating activities. . . . . . . . . . . $ 1,488.4
Investing activities. . . . . . . . . . . (2,064.3)
Financing activites. . . . . . . . . . . 636.4
Net increase in cash. . . . . . . . . . $ 60.5
Beginning cash. . . . . . . . . . . . . . 45.7
Ending cash. . . . . . . . . . . . . . . . . $ 106.2
Balance Sheet, 12/30/98
(in millions)
Balance Sheet, 12/28/99
$ 45.7 Cash. . . . . . . . . . . . $ 106.2
Cash. . . . . . . . . . .
11,343.9 All other assets. . . 14,794.1
All other assets. . . Income Statement, 12/28/99
$28,898.2
Revenues. . . . . . . . . . . . . . . . . . .
$ 8,307.5 $10,814.5
Liabilities. . . . . . . Liabilities. . . . . . . .
27,927.3
Expenses. . . . . . . . . . . . . . . . . . .
1,157.1 1,189.9
Capital stock. . . . . Capital stock. . . . . .
$ 970.9
Net income. . . . . . . . . . . . . . . . . .
1,925.0 Retained earnings 2,895.9
Retained earnings




Statement of
Retained Earnings, 12/28/99
$1,925.0
Retained earnings, 12/30/98. . . . .
970.9
Net income. . . . . . . . . . . . . . . . . . .
0
Dividends. . . . . . . . . . . . . . . . . . . .
$2,895.9
Retained earnings, 12/28/99. . . . .
47
f48 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle



business environment essay

How to Get Your Own Copy of Mi- Become an investor in Microsoft by buying shares
crosoft s Financial Statements The com- of stock in the company. As a Microsoft investor,
plete Microsoft annual report containing you are entitled to receive a copy of the annual re-
the 1999 financial statements is repro- port each year. In fact, according to U.S. govern-
duced at the end of this text. Is this se- ment regulations, Microsoft is required to send a
cret information, available only to own- copy of the annual report to all of its investors
ers of this book? No. Anyone can get a within three months of the end of Microsoft s fis-
copy of the most recent annual report cal year on June 30.
of Microsoft or any other public corpo- Call, write, fax, or e-mail Microsoft s Investor Rela-
ration in the United States. Any of the tions department. The phone numbers and ad-
following methods will work: dresses are given in the Microsoft annual report re-




items. For example, there are a variety of acceptable ways of estimating how much a build-
fyi
ing depreciates (wears out) in a year. In order for financial statement users to be able to
In its 1920 annual report, IBM properly interpret the three primary financial statements, they must know what proce-
included zero pages of notes dures were used in preparing those statements. This information about accounting poli-
(and the dollar amounts were cies and practices is given in the financial statement notes.
carried out to the penny). In
Additional Information about Summary Totals
1966, there were four pages of
notes (and dollar amounts were
For a large company, such as MICROSOFT or SAFEWAY, one summary number in the
rounded to the nearest dollar). financial statements represents literally thousands of individual items. For example, the
In 1996, IBM s annual report in- $5.922 billion in long-term notes and debentures included in Safeway s 1999 balance sheet
cluded 26 pages of notes (and (see Exhibit 2-3) represents loans of U.S. dollars, loans of Canadian dollars, mortgages,
senior secured debentures, senior subordinated debentures, an unsecured bank credit agree-
dollar amounts were rounded
ment, and more. The balance sheet includes only one number, with the details in the
to the nearest million).
notes.

Disclosure of Information Not Recognized
One way to report financial information is to boil down all the estimates and judgments into
one number and then report that one number in the financial statements. This is called recog-
nition. The key assumptions and estimates are then described in a note to the financial state-
ments. Another approach is to skip the financial statements and just rely on the note to convey
the information to users. This is called disclosure. Disclosure is the accepted way to convey in-
formation to users when the information is too uncertain to be recognized. For example, in July
1988, Safeway suffered a fire in one of its warehouses in Richmond, California. As of February
10, 2000, there were still 2,600 unsettled lawsuits against Safeway stemming from the fire. It is
impossible to summarize the complexity of the potential outcome of these lawsuits in one fi-
nancial statement number; so, Safeway describes the situation, in some detail, in the notes to
the financial statements.

Supplementary Information
The FASB and SEC both require supplementary information that must be reported in the
financial statement notes. For example, the FASB requires the disclosure of quarterly finan-
cial information and of business segment information. A sample of this type of disclosure
can be seen in Microsoft s annual report in Appendix A. In the notes to its financial state-
ments, Microsoft reports that 30% of its 1999 net income was generated outside of the
United States.
48 f49
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview




produced at the back of this book. For promotional Download a copy of the annual report (and lots of
purposes, companies are happy to mail their an- other information) from the U.S. government
nual report to anyone who asks. archives at sec.gov/edgarhp.htm. These government
Download a copy of the annual report from Mi- filings are pure text documents (no pictures) and are
crosoft s Web site at microsoft.com. On the Web made available through the EDGAR (Electronic Data
sites of most companies (Microsoft included), the Gathering, Analysis, and Retrieval) system.
annual report is not easy to find. You have to skirt
Now that you know how to get your own copy of the
past games, promotional material, and lots of non-
Microsoft annual report, make sure you study the rest
financial information, but the annual report is usu-
of this book to learn how to use the report.
ally there somewhere.




to summarize
The notes to the financial statements contain additional information not in-
cluded in the financial statements themselves. The notes explain the company s
accounting assumptions and practices, provide details of financial statement
summary numbers and additional disclosure about complex events, and re-
port supplementary information required by the SEC or the FASB.




3 THE EXTERNAL AUDIT
Describe the purpose of an
Refer back to the opening scenario for this chapter. Following the November 1986 leveraged
audit report and the
incentives the auditor has buyout by KOHLBERG, KRAVIS, ROBERTS & CO. (KKR), SAFEWAY decided to again
to perform a good audit.
issue shares to the public. In April 1990, Safeway issued shares at a price of $11.25 per share.
The $11.25 price implied that the market value of KKR s initial investment had risen from $130
million to $731 million. The $11.25 price was determined by investment bankers and poten-
tial investors after examining the financial statements of Safeway. Now, consider the following
questions:
Who controlled the preparation of the Safeway financial statements used by investors in ar-
riving at the $11.25 price? The owners and managers of Safeway, led by KKR.
Did KKR have any incentive to bias the reported financial statement numbers? Absolutely.
The better the numbers, the higher the stock offering price and the more money raised by
KKR.
Since KKR had control of the preparation of the financial statements and stood to benefit
substantially if those statements looked overly favorable, how could the financial statements
be trusted? Good question.
audit report A report issued
by an independent CPA that
This situation illustrates a general truth: the owners and managers of a company have an in-
expresses an opinion about
centive to report the most favorable results possible. Poor reported financial performance can make
whether the financial state-
ments fairly present a com- it harder to get loans, can lower the amount that managers receive as salary bonuses, and can lower
pany s financial position, the stock price when shares are issued to the public. With these incentives to stretch the truth, the
operating results, and cash
financial statements would not be reliable unless they were reviewed by an external party.
flows in accordance with
To provide this external review, a company s financial statements are often audited by an
generally accepted account-
independent certified public accountant (CPA). A CPA firm issues an audit report that ex-
ing principles.
49
f50 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle


presses an opinion about whether the statements fairly present a company s financial po-
fyi
sition, operating results, and cash flows in accordance with generally accepted accounting
Notice that MICROSOFT s audit principles. Note that the financial statements are the responsibility of a company s man-
report is dated July 19, 1999. agement and not of the CPA. Although not all company records have to be audited, au-
This means that it took less dits are needed for many purposes. For example, a banker may not make a loan without
first receiving audited financial statements from a prospective borrower. As another ex-
than three weeks (from the end
ample, most securities cannot be sold to the general public until they are registered with
of the fiscal year on June 30)
the SEC. Audited financial statements are required for this registration process.
for the completion of the audit.
Though an audit report does not guarantee accuracy, it does provide added assurance
Obviously, much audit work
that the financial statements are not misleading since they have been examined by an in-
was conducted during the year
dependent professional. However, the CPA cannot examine every transaction upon which
to make this happen.
the summary figures in the financial statements are based. The accuracy of the statements
must remain the responsibility of the company s management. An example of a typical
audit report is found in Appendix A in Microsoft s 1999 annual report. Microsoft s financial
statements were audited by DELOITTE & TOUCHE LLP, one of the large international au-
dit firms.
One final question: Who hires and pays Deloitte & Touche to do the audit of Microsoft s
financial statements? Microsoft does. At first glance, this situation appears to be similar to al-
lowing students in an accounting class to choose and pay the graders of the examinations. How-
ever, two economic factors combine to allow us to trust the quality of the audit, even though
the auditor was hired by the company being audited:
Reputation. Deloitte & Touche, as one of the large accounting firms, has a reputation for
doing high-quality audits (as do almost all independent auditors in the United States). It
would be very reluctant to risk this reputation by signi ng off on a questionable set of fi-
nancial statements.
Lawsuits. Auditors are sued all the time, even when they conduct a perfect audit. Investors
who lose money claim that they lost the money by relying on bogus financial statements
that were certified by an external auditor. If even honest auditors get sued, then an auditor
who intentionally approves a false set of financial statements is at great risk of losing a big
lawsuit.




to summarize
An audit report is issued by an independent CPA firm attesting to the confor-
mity of a set of financial statements with generally accepted accounting prin-
ciples. CPA firms have an economic incentive to perform credible audits in or-
der to preserve their reputations and to avoid lawsuits.




4 FINANCIAL STATEMENT ANALYSIS
Use financial ratios to
Financial statements are prepared so that they can be used. One important use is in analyzing
identify a company s
a company s economic health. Financial statement analysis involves the examination of both
strengths and weaknesses
and to forecast its future the relationships among financial statement numbers and the trends in those numbers over time.
performance.
One purpose of financial statement analysis is to use the past performance of a company to pre-
dict how it will do in the future. Another purpose of financial statement analysis is to evaluate
financial statement analysis the performance of a company with an eye toward identifying problem areas. Financial state-
Examining both the rela-
ment analysis is both diagnosis, identifying where a firm has problems, and prognosis, predict-
tionships among financial
ing how a firm will perform in the future.
statement amounts and the
Relationships between financial statement amounts are called financial ratios. For exam-
trends in those numbers
ple, net income divided by sales is a financial ratio called return on sales. Return on sales tells
over time.
50 f51
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview


you how many pennies of profit a company makes on each dollar of sales. The return on sales
financial ratios Ratios that
show relationships between for MICROSOFT is 28.9%, meaning that Microsoft makes $0.289 worth of profit for every
financial statement dollar of software sold. There are hundreds of different financial ratios, each shedding light on
amounts.
a different aspect of the health of a company. Some of the more common ratios are introduced
in the following section. The numbers from the SAFEWAY balance sheet (Exhibit 2-3) and in-
come statement (Exhibit 2-6) will be used to illustrate the ratio calculations.

Debt Ratio
Comparing the amount of liabilities to the amount of assets shows the extent to which a com-
pany has borrowed money to leverage the owners investments and increase the size of the com-
pany. One frequently used measure of leverage is the debt ratio, computed as total liabilities di-
debt ratio A measure of
leverage, computed by di- vided by total assets. The debt ratio represents the proportion of borrowed funds used to acquire
viding total liabilities by to-
the company s assets. For Safeway, the 1999 debt ratio is computed as follows:
tal assets.

Total Liabilities $10,814.5
Debt Ratio: §§ §§ 72.6%
Total Assets $14,900.3

In other words, Safeway borrowed 72.6% of the money it needed to buy its assets.
Is 72.6% a good debt ratio, a bad debt ratio, or is it impossible to tell? If you are a banker
thinking of lending money to Safeway, you want Safeway to have a low debt ratio; a smaller
amount of other liabilities increases your chances of being repaid. If you are a Safeway stock-
holder, you want a higher debt ratio; you want the company to add borrowed funds to your in-
vestment dollars to expand the business. There is some middle ground where the debt ratio is
not too high for creditors, nor too low for investors. The general rule of thumb is that debt ra-
tios should be around 50%. However, this general benchmark varies widely from one industry
to the next. The 72.6% debt ratio for Safeway is not unusual for a supermarket chain.

Current Ratio
An important concern about any company is its liquidity. If a firm cannot meet its short-term
obligations, it may not live to enjoy the long run. The most commonly used measure of liquidity
is the current (or working capital) ratio, a comparison of the current assets (cash, receivables, and
current (working capital)
ratio A measure of the liq- inventory) to the current liabilities. The current ratio is computed by dividing total current assets
uidity of a business; equal by total current liabilities. For Safeway, the 1999 current ratio is computed as follows:
to current assets divided by
current liabilities.
Current Assets $3,052.1
Current Ratio: §§§ §§ 0.852
Current Liabilities $3,582.6

Historically, a current ratio below 2.0 suggests the possibility of liquidity problems. How-
ever, advances in information technology have enabled companies to be much more effective in
minimizing the need to hold cash, inventories, and other current assets. As a result, current ra-
tios for successful companies are frequently less than 1.0. The 0.852 current ratio for Safeway
is similar to that for other supermarket chains.
Minimum current ratio requirements are frequently included in loan agreements. A typical
agreement might state that if the current ratio falls below a certain level, the lender can declare
the loan in default and require immediate repayment. This type of minimum current ratio re-
striction forces the borrower to maintain its liquidity and gives the lender increased assurance
that the loan will be repaid.

Asset Turnover
The balance sheet of Safeway reveals total assets of $14,900.3 million at December 28, 1999.
Are those assets being used efficiently? The asset turnover ratio gives an overall measure of com-
asset turnover A measure
of company efficiency, pany efficiency and is computed as follows:
computed by dividing sales
by total assets.
Sales $28,859.9
Asset Turnover: §§ §§ 1.94
Total Assets $14,900.3
51
f52 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle


Safeway s 1999 asset turnover ratio of 1.94 means that for each dollar of assets, Safeway is
able to generate $1.94 in sales. The higher the asset turnover ratio, the more efficient the com-
pany is at using its assets to generate sales.

Return on Sales
As mentioned at the beginning of this section, Microsoft makes 28.9 cents of profit on each dol-
lar of sales. This ratio is called return on sales and (using Safeway s 1999 numbers) is computed
return on sales A measure
of the amount of profit as follows:
earned per dollar of sales,
Net Income $970.9
Return on Sales: §§ §§
computed by dividing net 3.36%
Sales $28,859.9
income by sales.

Clearly, the return on sales for Safeway of 3.36 cents per dollar is dramatically below that
for Microsoft. As with all ratios, however, the return on sales value for Safeway must be evalu-
ated within the appropriate industry. Return on sales in the supermarket industry is frequently
between 1% and 2%; so, the Safeway value is very good indeed. In addition, Safeway s 1999 re-
turn on sales of 3.36% represents a small improvement over its 1998 return on sales of 3.29%.

Return on Equity
What investors really want to know is how much profit they earn for each dollar they invest.
This amount, called the return on equity, is the overall measure of the performance of a com-
return on equity A measure
of the amount of profit pany. Return on equity for Safeway for 1999 is computed as follows:
earned per dollar of invest-
ment, computed by divid-
Net Income $970.9
Return on Equity: §§ §§
ing net income by equity. 23.8%
Owners Equity $4,085.8


Safeway s return on equity of 23.8% means that 23.8 cents of profit was earned for each
dollar of stockholder investment in 1999. If your intuition tells you that this seems high, you
are right. Good companies typically have return on equity values between 15% and 25%. Safe-
way had a good year in 1999.

Price-Earnings Ratio
If a company earned $100 this year, how much should you pay to buy that company? If you
expect the company to make more in the future, you would be willing to pay a higher price
than if you expected the company to make less. Also, you would probably be willing to pay a
bit more for a stable company than for one experiencing wild swings in earnings. The price-
price-earnings (PE) ratio A
measure of growth poten- earnings (PE) ratio measures the relationship between the market value of a company and that
tial, earnings stability, and company s current earnings. This ratio is computed by dividing the market price per share of
management capabilities;
stock by the earnings per share. Safeway s PE ratio at the end of 1999 was:
computed by dividing mar-
ket price per share by earn-
Market Price per Share $35.75
ings per share.
PE Ratio: §§§ § 18.33
Earnings per Share $1.95


In the United States, PE ratios typically range between 5 and 30. High PE ratios are asso-
ciated with firms for which strong growth is predicted in the future. Refer back to Exhibits
2-4 and 2-5 and notice that CISCO SYSTEMS and ORACLE are included in the list of com-
panies with the highest market values but are not among those with high net incomes. The rea-
son Cisco Systems and Oracle are valued so highly is that they are expected to continue to grow
rapidly; their current incomes are small compared to what investors are expecting in the future.
This expected future growth is reflected in the PE ratios for these companies, which, on August
9, 2000, were 123.6 for Cisco Systems and 39.5 for Oracle.
A summary of the financial ratios discussed in this section is presented in Exhibit 2-12. The
values of financial ratios are most meaningful when they are compared with similar values for
other companies. A comparison of ratio values for several large U.S. corporations is presented
in Exhibit 2-13.
52 f53
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview



Summary of Selected Financial Ratios
exhibit 2-12


Total liabilities
§§
1. Debt ratio Proportion of borrowed funds
Total assets
used to purchase assets.

Current assets
§§§
2. Current ratio Measure of liquidity; number
Current liabilities
of times current assets could
cover current liabilities.

Sales
§§
3. Asset turnover Number of dollars of sales
Total assets
generated by each dollar of
assets.

Net income
§§
4. Return on sales Number of cents earned on
Sales
each dollar of sales.

Net income
§§
5. Return on equity Number of cents earned on
Owners equity
each dollar invested.

Market price per share
§§§
6. Price-earnings ratio Amount investors are willing to
Earnings per share
pay for each dollar of earnings;
indication of growth potential.




Selected Ratios for Several Large U.S. Corporations for 1999
exhibit 2-13



Asset
Current Return
Debt Return Price“Earnings
Turnover
Ratio on Equity
Ratio on Sales Ratio

Microsoft 0.23 2.32 0.53 0.39 0.28 66.82
Cisco Systems 0.2 1.54 0.83 0.27 0.29 208.95
General Electric 0.92 1.09 0.15 0.12 0.27 48.33
Intel 0.26 2.51 0.67 0.25 0.22 62.53
ExxonMobil 0.56 0.8 1.26 0.043 0.125 34.67




to summarize
This overview of financial ratios is intended to emphasize that the preparation
of the financial statements by the accountant is not the end of the process, but
just the beginning. Those financial statements are then analyzed by investors,
creditors, and management to detect signs of existing deficiencies in perfor-
mance and to predict how the firm will perform in the future. Proper interpre-
tation of a ratio depends on comparing a firm s ratio value to the value for the
same firm in the previous year, as well as to values for other firms in the same
industry.
53
f54 Financial Statements: An Overview
Part 1 Financial Reporting and the Accounting Cycle



5 FUNDAMENTAL CONCEPTS AND ASSUMPTIONS
Explain the fundamental
Certain fundamental concepts and assumptions underlie financial accounting practice and the
concepts and assumptions
that underlie financial resulting financial statements. These ideas are so fundamental to any economic activity that they
accounting.
usually are taken for granted in conducting business. Nevertheless, it is important to be aware
of them because these assumptions, together with certain basic concepts and procedures, deter-
mine the rules and set the boundaries of accounting practice. They indicate which events will
be accounted for and in what manner. In total, they provide the essential characteristics of the
traditional accounting model.
accounting model The ba-
sic accounting assump- This section will describe the separate entity concept, the assumption of arm s-length trans-
tions, concepts, principles,
actions, the cost principle, the monetary measurement concept, and the going concern assump-
and procedures that deter-
tion. The concept of double-entry accounting was already introduced on page 34 as the basis
mine the manner of record-
for the accounting equation. As noted, this concept will be explained in much more detail in
ing, measuring, and report-
Chapter 3. Additional concepts and assumptions will be covered in later chapters. Remember
ing a company s
transactions. that accounting is the language of business, and it takes time to learn a new language. The terms
and concepts we introduce here will become much more familiar as your study continues.

The Separate Entity Concept
Because business involves the exchange of goods or services between entities, it follows that ac-
counting records should be kept for those entities. For accounting purposes, an entity is defined
entity An organizational
unit (a person, partnership, as the organizational unit for which accounting records are maintained for example, IBM
or corporation) for which CORPORATION. It is a focal point for identifying, measuring, and communicating account-
accounting records are kept
ing data. Furthermore, the entity is considered to be separate from its individual owners.
and about which account-
We are all engaged in a variety of economic activities. For example, John Scott works for
ing reports are prepared.
a large corporation, owns some real estate, is president of the local Little League baseball orga-
nization, and manages the family estate on behalf of his brothers and sister. The separate en-
separate entity concept The
idea that the activities of an tity concept is the idea that, when John Scott is called upon to report the financial activities of
entity are to be separated the local Little League, he must make sure not to include any of his personal or family finan-
from those of the individual
cial activities in the results. Similarly, the accounting records of a small business must be kept
owners.
separate from the personal finances of the owner.
Applying the separate entity concept to large corporations can also be difficult. Large cor-
porations, such as GENERAL ELECTRIC and IBM, own networks of subsidiaries (and those
subsidiaries own subsidiaries) with complex business ties among the members of the group. A
key part of the accounting process for such an organization is carefully defining what is part of
General Electric and what is not. For example, one difficult accounting issue (covered in ad-
vanced accounting courses) is deciding how much of another company General Electric must
own (20%? 45%? 51%? 100%?) before that other company is considered part of the General
Electric reporting entity.

The Assumption of Arm s-Length Transactions
Accounting is based on the recording of economic transactions. Viewed broadly, transactions
transactions Exchange of
goods or services between include not only exchanges of economic resources between separate entities, but also events that
entities (whether individu- have an economic impact on a business independently. The borrowing and lending of money
als, businesses, or other or-
and the sale and purchase of goods or services are examples of the former. The loss in value of
ganizations), as well as
equipment due to obsolescence or fire is an example of the latter. Collectively, transactions pro-
other events having an
vide the data that are included in accounting records and reports.
economic impact on a
business. Accounting for economic transactions enables us to measure the success of an entity. How-
ever, the data for a transaction will not accurately represent that transaction if any bias is in-
volved. Therefore, unless there is evidence to the contrary, accountants assume arm s-length
arm s-length transactions
Business dealings between transactions. That is, they make the assumption that both parties for example, a buyer and a
independent and rational seller are rational and free to act independently; each trying to make the best deal possible in
parties who are looking out
establishing the terms of the transaction.
for their own interests.
To illustrate, assume you are preparing a personal balance sheet and want to list the value
of your minivan. You bought the three-year-old minivan for $5,000. Of course, you should list
54 f55
Financial Statements: An Overview Chapter 2
Financial Statements: An Overview


the minivan on your balance sheet at the $5,000 price you paid for it. That should be a good
reflection of the value of the vehicle. But, what if you bought the minivan from your brother
(who gave you a good deal) and the real market value of the minivan is $11,000? The problem
historical cost The dollar here is that the $5,000 price negotiated between you and your brother is not a market price.
amount originally ex-
Market prices can be thought of as prices negotiated between two strangers who are both com-
changed in an arm s-length
peting to get the best deal possible. Thus, a necessary assumption for financial statements to be
transaction; an amount as-
informative is that the reported financial results come from arm s-length transactions. Without
sumed to reflect the fair
this assumption, the numbers in the financial statements (like the $5,000 for the minivan you
market value of an item at
the transaction date. bought from your brother) do not reflect true values.
An illustration of the accounting problems that can arise from the lack of arm s-length trans-
cost principle The idea that
actions is provided by the labor problems of major league baseball. The team owners and the
transactions are recorded at
players are always arguing about the profitability of the teams. The players do not believe the
their historical costs or ex-
change prices at the trans- numbers in the owners financial statements; many important transactions reported are between
action date.
the baseball teams and other businesses controlled by the owners, such as television stations.
Since the revenues received in these deals (between the baseball teams and related busi-
nesses) are not from arm s-length transactions, the players question whether the full value
caution
of the deals is reflected in the owners financial reports.
When reading accounting re-
ports, remember that many re-
The Cost Principle
ported values are historical costs,
To further ensure objective measurements, accountants record transactions at historical
reflecting exchange prices at var-
cost, the amount originally paid or received for goods and services in arm s-length trans-
ious transaction dates.
actions. The historical cost is assumed to represent the fair market value of the item at the
date of the transaction because it reflects the actual use of resources by independent par-
ties. In accounting, this convention of recording transactions at cost is often referred to as the
monetary measurement cost principle.
The idea that money, as the
common medium of ex-
The Monetary Measurement Concept
change, is the accounting
unit of measurement, and Accountants do not record all the activities of economic entities. They record only those that
that only economic activi-
can be measured in monetary terms. Thus, the concept of monetary measurement becomes an-
ties measurable in mone-
other important characteristic of the accounting model. For example, employee morale cannot
tary terms are included in
be measured directly in monetary terms and is not reported in the accounting records. Wages
the accounting model.



Major league baseball
salary disputes are fre-
quently in the news. The
lack of arm s-length trans-
actions may contribute
to some of the friction
between players and
owners.
55
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Part 1 EOC Financial Reporting and the Accounting Cycle


paid or owed, however, are quantifiable in terms of money and are reported. In accounting, all
transactions are recorded in monetary amounts, whether or not cash is involved. In the United
States, the dollar is the unit of exchange and is thus the measuring unit for accounting purposes.
As noted earlier in discussing the limitations of a balance sheet, the listed values may not
be the same as actual market values for two reasons. The first is due to the cost principle. Be-
cause of such factors as inflation (an increase in the general price level of goods and services),
the recorded amount of an item may be quite different from the amount required at a later time
to buy or replace the item. The second reason results from the monetary measurement concept.
Not all economic assets are recorded, because they are too difficult or impossible to measure in
monetary amounts.

The Going Concern Assumption
The SAFEWAY balance sheet in Exhibit 2-3 was prepared under the assumption that Safeway
would continue in business for the foreseeable future. This is called the going concern as-
going concern assumption
The idea that an accounting sumption. Without this assumption, preparation of the balance sheet would be much more dif-
entity will have a continu-
ficult. For example, the $2.4 billion inventory for Safeway in 1999 is reported at the cost orig-
ing existence for the fore-
inally paid to purchase the inventory. This is a reasonable figure because, in the normal course
seeable future.
of business, Safeway can expect to sell the inventory for this amount, plus some profit. But if it
were assumed that Safeway would go out of business tomorrow, the inventory would suddenly
be worth a lot less. Imagine the low prices you could get on Safeway merchandise if it had to
conduct a one-day, going-out-of-business sale! The going concern assumption allows the ac-
countant to record assets at what they are worth to a company in normal use, rather than what
they would sell for in a liquidation sale.



to summarize
In conducting economic activities, entities enter into transactions that form the
basis of accounting records. An accounting model has been developed for
recording, measuring, and reporting an entity s transactions. This model is
founded on certain fundamental concepts and several important assumptions,
principles, and procedures. First, the organizational unit being accounted for
is a separate entity. The entity may be small or large, but it is the organiza-
tional unit for which accounting records are kept and financial reports prepared.
Second, the transactions are assumed to be arm s-length. Third, transactions
are recorded at historical cost. Fourth, transactions must be measurable in mon-
etary amounts. Fifth, the accounting entity is assumed to be a going concern.




review of learning objectives

Understand the basic elements and formats of the The income statement shows the major sources of rev-
1 three primary financial statements balance sheet, enues generated and the expenses associated with those rev-
income statement, and statement of cash flows. The bal- enues. The difference between revenues and expenses is net in-
ance sheet provides a summary of the financial position of a come or net loss. The income statements of corporations must
company at a particular date. It lists a company s assets, lia- also include earnings per share.
bilities, and owners equity. Assets and liabilities are usually The statement of cash flows shows the significant cash in-
classified as either current or long-term. For a corporation, flows (receipts) and cash outflows (payments) of a company
owners equity consists of directly invested funds as well as re- for a period of time. These cash flows are classified according
tained earnings. to operating, investing, and financing activities.
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Recognize the need for financial statement notes and mance. Financial statements are analyzed by investors, credi-
2 identify the types of information included in the notes. tors, and management to detect signs of existing deficiencies
The notes to the financial statements contain additional infor- in performance and to predict how the firm will perform in
mation not included in the financial statements themselves. The the future. Proper interpretation of a financial ratio depends
notes explain the company s accounting assumptions and prac- on comparing a firm s ratio value to the value for the same
tices, provide details of financial statement summary numbers firm in the previous year, as well as to values for other firms
and additional disclosure about complex events, and report sup- in the same industry.
plementary information required by the SEC and the FASB.
Explain the fundamental concepts and assumptions
5
Describe the purpose of an audit report and the in- that underlie financial accounting. Certain funda-
3 centives the auditor has to perform a good audit. An mental concepts underlie the practice of accounting. First, a
audit report is issued by an independent CPA firm attesting business must be accounted for as an economic entity separate
to the conformity of a set of financial statements with gener- from the personal affairs of the owners and separate from other
ally accepted accounting principles. CPA firms have an eco- businesses. Second, the transactions are assumed to be arm s-
nomic incentive to perform credible audits in order to preserve length, so that the negotiated prices reflect true market values
their reputations and to avoid lawsuits. at the dates of the transactions. Third, transactions are recorded
at historical cost. Fourth, only those transactions and events
Use financial ratios to identify a company s strengths that can be measured in monetary terms are reported. Fifth,
4 and weaknesses and to forecast its future perfor- the accounting entity is assumed to be a going concern.




key terms and concepts

accounting equation 34 double-entry accounting 34 net assets 33
accounting model 54 earnings (loss) per share (EPS) 42 net income (net loss) 40
arm s-length transactions 54 entity 54 notes to the financial statements 47
articulation 45 expenses 40 operating activities 44
asset turnover 51 financial ratios 50 owners equity 33
assets 33 financial statement analysis 50 price-earnings (PE) ratio 52
audit report 49 financing activities 44 primary financial statements 32
balance sheet (statement of gains (losses) 41 retained earnings 34
financial position) 32 going concern assumption 56 return on equity 52
book value 37 gross profit (gross margin) 40 return on sales 52
capital stock 34 historical cost 55 revenue 40
classified balance sheet 37 income statement (statement of separate entity concept 54
comparative financial statements 37 earnings) 32 statement of cash flows 32
comprehensive income 42 investing activities 44 statement of retained earnings 42
cost principle 55 liabilities 33 stockholders (shareholders) 33
current assets 37 liquidity 37 stockholders equity 33
current (or working capital) ratio 51 long-term assets 37 transactions 54
debt ratio 51 market value 37
dividends 34 monetary measurement 55
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f58 Financial Statements: An Overview
Part 1 EOC Financial Reporting and the Accounting Cycle




review problem

Shirley Baum manages The Copy Shop. She has come to you for help in preparing an income
The Income Statement and
statement and a balance sheet for the year ended December 31, 2003. Several amounts, deter-
the Balance Sheet
mined as of December 31, 2003, are presented below. No dividends were paid this year.
Capital stock (10,000 shares Mortgage payable . . . . . . . . . . . . . . $72,000
outstanding). . . . . . . . . . . . . . . . . $ 40,000 Accounts payable . . . . . . . . . . . . . . 6,000
Retained earnings (12/31/02) . . . . . . 12,400 Land . . . . . . . . . . . . . . . . . . . . . . . . 24,000
Advertising expense . . . . . . . . . . . . 2,000 Supplies . . . . . . . . . . . . . . . . . . . . . 2,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . 17,000 Salary expense . . . . . . . . . . . . . . . . 20,000
Rent expense. . . . . . . . . . . . . . . . . . 2,400 Revenues. . . . . . . . . . . . . . . . . . . . . 42,000
Building (net). . . . . . . . . . . . . . . . . . 100,000 Other expenses . . . . . . . . . . . . . . . . 1,300
Interest expense . . . . . . . . . . . . . . . 700 Accounts receivable . . . . . . . . . . . . . 3,000

1. Prepare an income statement for the year ended December 31, 2003, including EPS.
Required
2. Determine the amount of retained earnings at December 31, 2003.
3. Prepare a classified balance sheet as of December 31, 2003.
4. Calculate the current ratio for The Copy Shop. What does the current ratio tell you about
the company?
1. Income Statement
Solution
The first step in solving this problem is to separate the balance sheet items from the income state-
ment items. Asset, liability, and owners equity items reflect the company s financial position and
appear on the balance sheet; revenues and expenses are reported on the income statement.

Balance Sheet Items Income Statement Items

Capital stock Advertising expense
Retained earnings Rent expense
Cash Interest expense
Building (net) Salary expense
Mortgage payable Revenues
Accounts payable Other expenses
Land
Supplies
Accounts receivable


After the items have been separated, the income statement and the balance sheet may be
prepared using a proper format.


The Copy Shop
Income Statement
For the Year Ended December 31, 2003

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $42,000
Expenses:
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700
Salary expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300 26,400
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,600
EPS $15,600 10,000 shares $1.56
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Financial Statements: An Overview


2. Retained Earnings
The amount of Retained Earnings at December 31, 2003, may be calculated as follows:

Retained earnings (12/31/02) $12,400)
Add: Net income for year 15,600)
Subtract: Dividends for year (0)
Retained earnings (12/31/03) $28,000)

Since no dividends were paid during 2003, the ending balance in Retained Earnings is simply
the beginning balance plus net income for the year.

3. Balance Sheet

The Copy Shop
Balance Sheet
December 31, 2003

Assets Liabilities and Owners Equity

Current assets: Current liabilities:
Cash . . . . . . . . . . . . . $ 17,000 Accounts payable. . . $ 6,000*
Accounts receivable. . 3,000
Supplies . . . . . . . . . . 2,000 $ 22,000 Long-term liabilities:
Mortgage payable . . 72,000*
Long-term assets: Total liabilities. . . . . . . $ 78,000
Land . . . . . . . . . . . . . $ 24,000
Building (net). . . . . . . 100,000 124,000 Owners equity:
Capital stock . . . . . . $40,000*
Retained earnings . . 28,000* 68,000
Total liabilities and
Total assets . . . . . . . . . $146,000 owners equity . . . . $146,000

*See item 2 for calculation.

4. Current Ratio
CR Current Assets/Current Liabilities
CR $22,000/$6,000 3.67
The current ratio shows the relationship of total current assets to total current liabilities. It in-
dicates whether a company can pay its current obligations with its current assets and therefore
helps short-term creditors assess a company s liquidity. The amount of The Copy Shop s cur-
rent assets is almost four times its current liabilities (3.67:1). In other words, The Copy Shop
has $3.67 of current assets for every $1 of current liabilities, which shows a favorable liquidity
position.




discussion questions

1. As an external user of financial statements, perhaps an 3. Assume you want to invest in the stock market, and
investor or creditor, what type of accounting informa- your friends tell you about a company s stock that is
tion do you need? guaranteed to have an annual growth rate of 150 per-
2. What is the major purpose of: cent. Should you trust your friends and invest immedi-
a. A balance sheet? ately, or should you research the company s financial
b. An income statement? statements before investing? Explain.
c. A statement of cash flows?
59
f60 Financial Statements: An Overview
Part 1 EOC Financial Reporting and the Accounting Cycle


4. Why are classified and comparative financial statements 12. Some people think that auditors are responsible for en-
generally presented in annual reports to shareholders? suring the accuracy of financial statements. Are they
5. Why are owners equity and liabilities considered the correct? Why or why not?
sources of assets? 13. What are the four general types of financial statement
6. Owners equity is not cash; it is not a liability; and it notes typically included in annual reports to stockhold-
generally is not equal to the current worth of a busi- ers?
ness. What is the nature of owners equity? 14. What are the primary purposes of financial statement
7. What are the limitations of the balance sheet? Why is it analysis?
important to be aware of them when evaluating a com- 15. Indicate how each of the following financial ratios is
pany s growth potential? computed and describe what the ratio is attempting to
8. Some people feel that the income statement is more im- explain:
portant than the balance sheet. Do you agree? Why or a. Debt ratio
why not? b. Current ratio
9. How might an investor be misled by looking only at c. Asset turnover
the bottom line (the net income or EPS number) on d. Return on sales
an income statement? e. Return on equity
10. Why is it important to classify cash flows according to f. Price-earnings ratio
operating, investing, and financing activities? 16. Explain why each of the following is important in ac-
11. You are thinking of investing in one of two companies. counting:
In one annual report, the auditor s opinion states that a. The separate entity concept
the financial statements were prepared in accordance b. The assumption of arm s-length transactions
with generally accepted accounting principles. The c. The cost principle
other makes no such claim. How important is that to d. The monetary measurement concept
you? Explain. e. The going concern assumption




discussion cases

CASE 2-1 CREDITOR AND INVESTOR INFORMATION NEEDS
Ink Spot is a small company that has been in business for two years. Wilford Smith, the presi-
dent of the company, has decided that it is time to expand. He needs $10,000 to purchase ad-
ditional equipment and to pay for increased operating expenses. Wilford can either apply for a
loan at First City Bank, or he can issue more stock (1,000 shares are outstanding) to new in-
vestors. Assuming that you are the loan officer at First City Bank, what information would you
request from Ink Spot before deciding whether to make the loan? As a potential investor in Ink
Spot, what information would you need to make a good investment decision? What financial
ratios might you consider as a potential lender or investor before making a decision?


CASE 2-2 ANALYZING TRENDS AND KEY FINANCIAL RELATIONSHIPS
An investor may choose from several investment opportunities: the stocks of different compa-
nies; rental property or other real estate; or savings accounts, money market certificates, and sim-
ilar financial instruments. When considering an investment in the stock of a particular com-
pany, comparative financial data presented in the annual report to stockholders helps an investor
identify key relationships and trends. As an illustration, comparative operating results for Prime
Properties, Inc., from its 2003 annual report are provided. (Dollars are presented in thousands
except for earnings per share.)
60 f61
Financial Statements: An Overview EOC Chapter 2
Financial Statements: An Overview



Year Ended December 31
2003 2002 2001

Revenues:
Property management fees . . . . . . . . . . . . . . . . . . $058,742 $063,902 $066,204
Appraisal fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,641 60,945 62,320
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . $114,383 $124,847 $128,524
Expenses:
Selling and advertising. . . . . . . . . . . . . . . . . . . . . . $064,371 $075,403 $080,478
Administrative expenses . . . . . . . . . . . . . . . . . . . . 30,671 31,115 31,618
Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,265 9,540 9,446
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,047 1,468 26
Total expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . $106,354 $117,526 $121,568
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . $008,029 $007,321 $006,956
Income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,409 2,196 2,087
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $005,620 $005,125 $004,869
*Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . $2.25 $2.05 $1.95

*2.5 million shares outstanding


What trends are indicated by the comparative income statement data for Prime Properties, Inc.?
Which of these trends would be of concern to a potential investor? What additional informa-
tion would an investor need in order to make a decision about whether to invest in this com-
pany?

CASE 2-3 ACCOUNTING FOR THE PROPER ENTITY
You have been hired to prepare the financial reports for White River Building Supply, a pro-
prietorship owned by Bill Masters. Upon encountering several payments made from the com-
pany bank account to a nearby university, you contact Bill Masters to find out how to classify
these payments. Masters explains that those checks were written to pay his daughter s tuition
and to purchase her textbooks and miscellaneous supplies. He then tells you to include the pay-
ments with other expenses of the business. This way, he explains, I can deduct the payments
on my tax return. Why not, since it all comes out of the same pocket? How would you re-
spond to Masters?




exercises

EXERCISE 2-1 CLASSIFICATION OF FINANCIAL STATEMENT ELEMENTS
Indicate for each of the following items whether it would appear on a balance sheet (BS) or
an income statement (IS). If a balance sheet item, is it an asset (A), a liability (L), or an own-
ers equity item (OE)?
1. Accounts Payable 8. Land 15. Buildings
2. Sales Revenue 9. Capital Stock 16. Salaries & Wages
3. Accounts Receivable 10. Rent Expense Expense
4. Advertising Expense 11. Equipment 17. Retained Earnings
5. Cash 12. Interest Receivable 18. Utilities Expense
6. Supplies 13. Mortgage Payable
7. Consulting Revenue 14. Notes Payable
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f62 Financial Statements: An Overview
Part 1 EOC Financial Reporting and the Accounting Cycle



EXERCISE 2-2 ACCOUNTING EQUATION
Compute the missing amounts for companies A, B, and C.


A B C

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000 $09,000 $12,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 15,000 7,000
Land and buildings . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 ?00, 40,000
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . ?00, 6,000 14,000
Mortgage payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 10,000 15,000
Owners equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 30,000 ?00,




EXERCISE 2-3 COMPREHENSIVE ACCOUNTING EQUATION
Assuming no additional investments by or distributions to owners, compute the missing
amounts for companies X, Y, and Z.


X Y Z

Assets: January 1, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360 $,,?0 $230
Liabilities: January 1, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . 280 460 ?0
Owners equity: January 1, 2003 . . . . . . . . . . . . . . . . . . . . . . . ?0 620 150
Assets: December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . 380 ?0 310
Liabilities: December 31, 2003. . . . . . . . . . . . . . . . . . . . . . . . . ?0 520 90
Owners equity: December 31, 2003 . . . . . . . . . . . . . . . . . . . . ?0 720 ?0
Revenues in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 ?0 400
Expenses in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 116 ?0




EXERCISE 2-4 COMPUTING ELEMENTS OF OWNERS EQUITY
From the information provided, determine:
1. The amount of retained earnings at December 31.
2. The amount of revenues for the period.


Totals January 1 December 31

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $005,000 $010,000
All other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 160,000
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 30,000
Capital stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 ?000
Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 ?000



Additional data:
Expenses for the period were $35,000.
Dividends paid were $7,500.
Capital stock increased by $5,000 during the period.


EXERCISE 2-5 BALANCE SHEET RELATIONSHIPS
Correct the following balance sheet.
62 f63
Financial Statements: An Overview EOC Chapter 2
Financial Statements: An Overview



Canfield Corporation
Balance Sheet
December 31, 2003
Assets Liabilities and Owners Equity
Cash. . . . . . . . . . . . . . . . . . $ 55,000 Buildings . . . . . . . . . . . . . . . . . . . . . $325,000
Accounts payable . . . . . . . . 65,000 Accounts receivable . . . . . . . . . . . . . 75,000
Interest receivable . . . . . . . 20,000 Mortgage payable. . . . . . . . . . . . . . . 150,000
Capital stock. . . . . . . . . . . . 200,000 Sales revenue . . . . . . . . . . . . . . . . . . 350,000
Rent expense . . . . . . . . . . . 60,000 Equipment . . . . . . . . . . . . . . . . . . . . 85,000
Retained earnings. . . . . . . . 145,000 Utilities expense . . . . . . . . . . . . . . . . 5,000
Total liabilities and
Total assets. . . . . . . . . . . $545,000 owners equity. . . . . . . . . . . . . . . . $990,000



EXERCISE 2-6 BALANCE SHEET PREPARATION
From the following data, prepare a classified balance sheet for Low Price Company at Decem-
ber 31, 2003.
Accounts payable . . . . . . . . . . . . . . . . . . . $046,500
Accounts receivable . . . . . . . . . . . . . . . . . 99,000
Buildings . . . . . . . . . . . . . . . . . . . . . . . . . 325,500
Owners equity, 1/1/03 . . . . . . . . . . . . . . . 150,000
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116,250
Distributions to owners during 2003 . . . . . 18,750
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . 2,250
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165,000
Mortgage payable . . . . . . . . . . . . . . . . . . 412,500
Net income for 2003. . . . . . . . . . . . . . . . . 117,750
Owners equity, 12/31/03 . . . . . . . . . . . . . ?00,


EXERCISE 2-7 INCOME STATEMENT COMPUTATIONS
Following are the operating data for an advertising firm for the year ended December 31,
2003.
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $175,000
Supplies expense. . . . . . . . . . . . . . . . . . . . . . . . . 45,000
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 70,000
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Administrative expense . . . . . . . . . . . . . . . . . . . . 6,000
Income taxes (30% of income before taxes) . . . . . ?00,

For 2003, determine:
1. Income before taxes.
2. Income taxes.
3. Net income.
4. Earnings per share (EPS), assuming there are 15,000 shares of stock outstanding.

EXERCISE 2-8 INCOME STATEMENT PREPARATION
The following selected information is taken from the records of Sel Tec Corporation.
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . $ 25,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . 49,000
Advertising expense. . . . . . . . . . . . . . . . . . . . . . . 7,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,500
Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 23,000
(continued)
63
f64 Financial Statements: An Overview
Part 1 EOC Financial Reporting and the Accounting Cycle


Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000
Utilities expense. . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Income taxes (30% of income before taxes) . . . . . ?00,
Miscellaneous expense . . . . . . . . . . . . . . . . . . . . 2,200
Owners equity. . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 88,000
Fees (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . 242,000

1. Prepare an income statement for the year ended December 31, 2003. (Assume that 5,000
shares of stock are outstanding.)
2. Explain what the EPS ratio tells the reader about Sel Tec Corporation.

EXERCISE 2-9 CASH FLOW COMPUTATIONS
From the following selected data, compute:
1. Net cash flow provided (used) by operating activities.
2. Net cash flow provided (used) by investing activities.
3. Net cash flow provided (used) by financing activities.
4. Net increase (decrease) in cash during the year.
5. The cash balance at the end of the year.
Cash receipts from:
Customers . . . . . . . . . . . . . . . . . . . . . $270,000
Investments by owners. . . . . . . . . . . . 54,000
Sale of building . . . . . . . . . . . . . . . . . 90,000
Proceeds from bank loan . . . . . . . . . . 60,000
Cash payments for:
Wages . . . . . . . . . . . . . . . . . . . . . . . . $ 82,000
Utilities. . . . . . . . . . . . . . . . . . . . . . . . 3,000
Advertising. . . . . . . . . . . . . . . . . . . . . 4,000
Rent . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . 67,000
Dividends . . . . . . . . . . . . . . . . . . . . . . 20,000
Repayment of principal on loan . . . . . 40,000
Purchase of land . . . . . . . . . . . . . . . . 106,000
Cash balance at beginning of year . . . . . $386,000


EXERCISE 2-10 INCOME AND RETAINED EARNINGS RELATIONSHIPS
Assume that retained earnings increased by $240,000 from December 31, 2002, to December
31, 2003, for Miller Corporation. During the year, a cash dividend of $140,000 was paid.
1. Compute the net income for the year.
2. Assume that the revenues for the year were $920,000. Compute the expenses incurred for
the year.

EXERCISE 2-11 RETAINED EARNINGS COMPUTATIONS
During 2003, Safe Lite Corporation had revenues of $180,000 and expenses, including in-
come taxes, of $100,000. On December 31, 2002, Safe Lite had assets of $400,000, liabilities
of $100,000, and capital stock of $250,000. Safe Lite paid a cash dividend of $40,000 in
2003. No additional stock was issued. Compute the retained earnings on December 31, 2002,
and 2003.

EXERCISE 2-12 PREPARATION OF INCOME STATEMENT AND RETAINED
EARNINGS STATEMENT
Prepare an income statement and a statement of retained earnings for Big Sky Corporation
for the year ended June 30, 2003, based on the following information:
64 f65
Financial Statements: An Overview EOC Chapter 2
Financial Statements: An Overview


Capital stock (1,500 shares @ $100). . . . . . . . . . . . . . . . . . . . . . . . . . $150,000
Retained earnings, July 1, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76,800
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500
Ski rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77,900
Expenses:
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,600
Utilities expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400
Advertising expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Miscellaneous expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,700
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,100 64,300


EXERCISE 2-13 ARTICULATION: RELATIONSHIPS BETWEEN A BALANCE
SHEET AND AN INCOME STATEMENT
The total assets and liabilities of Roloflex Company at January 1 and December 31, 2003, are
presented below.

January 1 December 31

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $76,000 $112,000
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000 28,800



Determine the amount of net income or loss for 2003, applying each of the following as-
sumptions concerning the additional issuance of stock and dividends paid by the firm. Each
case is independent of the others.
1. Dividends of $10,800 were paid and no additional stock was issued during the year.
2. Additional stock of $4,800 was issued and no dividends were paid during the year.
3. Additional stock of $62,000 was issued and dividends of $15,600 were paid during the
year.

EXERCISE 2-14 CASH FLOW CLASSIFICATIONS
For each of the following items, indicate whether it would be classified and reported under
the Operating Activities (OA), Investing Activities (IA), or Financing Activities (FA) section
of a statement of cash flows:
a. Cash receipts from selling merchandise
b. Cash payments for wages and salaries
c. Cash proceeds from sale of stock
d. Cash purchase of equipment
e. Cash dividends paid
f. Cash received from bank loan
g. Cash payments for inventory
h. Cash receipts from services rendered
i. Cash payments for taxes
j. Cash proceeds from sale of property no longer needed as expansion site

EXERCISE 2-15 CURRENT RATIO
Using the data in Exercise 2-6, compute the current ratio for Low Price Company. What
does the current ratio show?

EXERCISE 2-16 DEBT RATIO
Using the data in Exercise 2-6, compute the debt ratio for Low Price Company. What does
the debt ratio explain?
65
f66 Financial Statements: An Overview
Part 1 EOC Financial Reporting and the Accounting Cycle



EXERCISE 2-17 RETURN ON EQUITY AND PRICE-EARNINGS RATIO
Using the data in Exercise 2-6, and assuming 20,000 shares of stock outstanding and a mar-
ket price per share of $36.00, compute the return on equity and PE ratios for Low Price
Company. Does the PE ratio seem reasonable relative to other U.S. stocks?

EXERCISE 2-18 NOTES TO FINANCIAL STATEMENTS
Refer to MICROSOFT s annual report in Appendix A at the end of the book. How impor-
tant are the notes to financial statements? What are the major types of notes that Microsoft
includes in its annual report?

EXERCISE 2-19 THE COST PRINCIPLE
On January 1, 2003, Save-More Construction Company paid $150,000 in cash for a parcel
of land to be used as the site of a new office building. During March, the company petitioned
the city council to rezone the area for professional office buildings. The city council refused,
preferring to maintain the area as a residential zone. After nine months of negotiation, Save-
More Construction convinced the council to rezone the property for commercial use, thus
raising its value to $200,000.
For accounting purposes, what value should be used to record the transaction on January
1, 2003? At what value would the property be reported at year-end, after the city council re-
zoning? Explain why accountants use historical costs to record transactions.

EXERCISE 2-20 THE MONETARY MEASUREMENT CONCEPT
Many successful companies, such as FORD MOTOR COMPANY, EXXONMOBIL, and
MARRIOTT CORPORATION, readily acknowledge the importance and value of their em-
ployees. In fact, the employees of a company are often viewed as the most valued asset of the
company. Yet in the asset section of the balance sheets of these companies there is no men-
tion of the asset Employees. What is the reason for this oversight and apparent inconsistency?

EXERCISE 2-21 THE GOING CONCERN ASSUMPTION
Assume that you open an auto repair business. You purchase a building and buy new equip-
ment. What difference does the going concern assumption make with regard to how you
would account for these assets?




problems

PROBLEM 2-1 BALANCE SHEET CLASSIFICATIONS AND RELATIONSHIPS
Tu aa Corporation has the following balance sheet elements as of December 31, 2003.
Land . . . . . . . . . . . . . . . . . . . . . . . . $ 69,000 Mortgage payable . . . . . . . . . . . . . . $300,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . ? Capital stock . . . . . . . . . . . . . . . . . . 135,000
Building . . . . . . . . . . . . . . . . . . . . . 178,000 Retained earnings . . . . . . . . . . . . . . 88,000
Accounts payable . . . . . . . . . . . . . . 100,000 Supplies . . . . . . . . . . . . . . . . . . . . . 17,000
Notes payable (short-term) . . . . . . . 105,000 Accounts receivable . . . . . . . . . . . . 88,000
Equipment . . . . . . . . . . . . . . . . . . . 350,000

Compute the total amount of:
Required:
1. Current assets.
2. Long-term assets.
3. Current liabilities.
4. Long-term liabilities.
5. Stockholders equity
66 f67
Financial Statements: An Overview EOC Chapter 2
Financial Statements: An Overview



PROBLEM 2-2 PREPARATION OF A CLASSIFIED BALANCE SHEET
Following are the December 31, 2003, account balances for Siraco Company.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950
Accounts receivable . . . . . . . . . . . . . . . . 2,500
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
Equipment . . . . . . . . . . . . . . . . . . . . . . . 11,275
Accounts payable . . . . . . . . . . . . . . . . . . 3,450
Wages payable . . . . . . . . . . . . . . . . . . . . 250
Dividends paid . . . . . . . . . . . . . . . . . . . . 1,500
Capital stock . . . . . . . . . . . . . . . . . . . . . . 775
Retained earnings, January 1, 2003. . . . . 12,000
Revenues . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Miscellaneous expense . . . . . . . . . . . . . . 1,550
Supplies expense . . . . . . . . . . . . . . . . . . 3,700
Wages expense . . . . . . . . . . . . . . . . . . . 2,200

1. Prepare a classified balance sheet as of December 31, 2003.
Required:
2. Interpretive Question: On the basis of its 2003 earnings, was this company s decision to
pay dividends of $1,500 a sound one?

PROBLEM 2-3 BALANCE SHEET PREPARATION WITH A MISSING ELEMENT
The following data are available for Sunshine Products Inc., as of December 31, 2003.
Cash. . . . . . . . . . . . . . . . . $10,000
Accounts payable . . . . . . . 14,000
Capital stock. . . . . . . . . . . 35,200
Accounts receivable . . . . . 20,000
Building . . . . . . . . . . . . . . 28,000
Supplies . . . . . . . . . . . . . . 1,200
Retained earnings. . . . . . . ?00
Land. . . . . . . . . . . . . . . . . 10,000

Required: 1. Prepare a balance sheet for Sunshine Products Inc.
2. Determine the amount of retained earnings at December 31, 2003.
3. Interpretive Question: In what way is a balance sheet a depiction of the basic account-
ing equation?

PROBLEM 2-4 INCOME STATEMENT PREPARATION
Listed below are the results of Rulon Candies operations for 2002 and 2003. (Assume 4,000
shares of outstanding stock for both years.)

2003 2002

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $350,000
Utilities expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 8,500
Employee salaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000 110,000
Advertising expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 20,000
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 36,500
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 15,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000 85,000
Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000


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