1LEARNING OBJECTIVES

OBJECTIVE 1Describe the types and forms of businesses, business

strategies, value chains, and stakeholders.

OBJECTIVE 2Describe the three business activities of financing,

investing, and operating.

OBJECTIVE 3Define accounting, and explain its role in business.

OBJECTIVE 4Describe and illustrate the basic financial statements

and how they interrelate.

OBJECTIVE 5Describe eight basic accounting concepts underlying

financial reporting.

OBJECTIVE 6Describe and illustrate the use of horizontal analysis

to analyze and evaluate a company’sperformance.

Chapter 1

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Every day, you interact with businesses. You buy a Hershey’s candy bar, eat

lunch at McDonald’s or Burger King, order a cup of coffee from Starbucks or

Seattle Coffee, or fill up your car with gas at an ExxonMobil or BP gas station.

How do these businesses influence you to buy their products? What are their

underlying business strategies?

As we begin our study of accounting in this chapter, we first discuss the nature,

types, activities, and strategies of businesses such as these. In doing so, we

describe business stakeholders and the way businesses add value for their

customers (you). We conclude the chapter by discussing the role of accounting

in business, including financial statements, basic accounting concepts, and how

you can use financial statements to evaluate a business’ performance.

The Role of Accounting in Business

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The Nature of BusinessYou are familiar with many large companies, such as General Motors, Barnes &Noble, and AT&T. You are also familiar with many local businesses, such as gasstations, grocery stores, and restaurants. You may work for one of these businesses.What do they have in common that identifies them as businesses?

In general, a business is an organization in which basic resources (inputs), suchas materials and labor, are assembled and processed to provide goods or services (out-puts) to customers.1 Businesses come in all sizes, from a local coffee house to GeneralMotors, which sells several billion dollars’ worth of cars and trucks each year. The cus-tomers of a business are individuals or other businesses that purchase goods or ser-vices in exchange for money or other items of value. In contrast, a church is not abusiness because those who receive its services are not obligated to pay for them.

The objective of most businesses is to maximize profits. Profit is the difference be-tween the amounts received from customers for goods or services provided and theamounts paid for the inputs used to provide the goods or services. Some businessesoperate with an objective other than to maximize profits. The objective of such not-for-profit businesses is to provide some benefit to society, such as medical research orconservation of natural resources. In other cases, governmental units such as citiesoperate water works or sewage treatment plants on a not-for-profit basis. Our focusin this text will be on businesses operated to earn a profit. However, many of the con-cepts and principles also apply to not-for-profit businesses.

Types of BusinessesThree different types of businesses are operated for profit: manufacturing, merchan-dising, and service businesses. Each type of business has unique characteristics.

Manufacturing businesses change basic inputs into products that are sold to in-dividual customers. Examples of manufacturing businesses and some of their prod-ucts follow:

Manufacturing Business ProductGeneral Motors Automobiles, trucks, vansGeneral Mills Breakfast cerealsBoeing Jet aircraftNike Athletic shoesCoca-Cola BeveragesSony Stereos, televisions, radios

Merchandising businesses also sell products to customers. However, they do notmake the products but purchase them from other businesses (such as manufacturers).In this sense, merchandisers bring products and customers together. Examples ofmerchandising businesses and some of the products they sell are shown here:

Merchandising Business ProductWal-Mart General merchandiseToys “R” Us ToysBarnes & Noble BooksBest Buy Consumer electronicsAmazon.com Books

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g™OBJECTIVE 1Describe the types andforms of businesses,business strategies,value chains, andstakeholders.

1A glossary of terms appears at the end of each chapter in the text.

Service businesses provide services rather than products to customers. These areexamples of service businesses and the types of services they offer:

Service Business ServiceDisney EntertainmentDelta Air Lines TransportationMarriott Hotels Hospitality and lodgingMerrill Lynch FinancialSprint Telecommunications

Forms of BusinessA business is normally organized as one of three different forms: proprietorship, part-nership, or corporation. A proprietorship is owned by one individual. More than70% of the businesses in the United States are organized as proprietorships. The pop-ularity of this form is due to the ease and low cost of organizing. The primary disad-vantage of proprietorships is that the financial resources available to the business arelimited to the individual owner’s resources. Small local businesses such as hardwarestores, repair shops, laundries, restaurants, and maid services are often organized asproprietorships.

As a business grows and requires more financial and managerial resources, it maybecome a partnership. A partnership is owned by two or more individuals. Like pro-prietorships, small local businesses such as automotive repair shops, music stores,beauty shops, and men’s and women’s clothing stores can be organized as partner-ships. Currently, about 10% of the businesses in the United States are organized aspartnerships.

Like proprietorships, a partnership can outgrow its ability to finance its opera-tions. As a result, it can become a corporation. A corporation is organized under stateor federal statutes as a separate legal entity. The ownership of a corporation is dividedinto shares of stock. A corporation issues the stock to individuals or other businesses,who then become owners, or stockholders, of the corporation.

A primary advantage of the corporate form is the ability to obtain large amountsof resources by issuing stock. For this reason, most companies that require largeinvestments in equipment and facilities are organized as corporations. For exam-ple, Toys “R” Us has raised more than $800 million by issuing shares of commonstock to finance its operations. Other examples of corporations include GeneralMotors, Ford, International Business Machines (IBM), Coca-Cola, and GeneralElectric.

About 20% of the businesses inthe United States are organized ascorporations. However, since mostlarge companies are organized as cor-porations, more than 90% of the to-tal dollars of business receipts arereceived by corporations. Thus, cor-porations have a major influence onthe economy.

The three types of businesses wediscussed earlier—manufacturing,merchandising, and service—can beeither proprietorships, partnerships,

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In a partnership, the unethicalbehavior of one partner canbroadly impact the wholefirm. A partner of ArthurAndersen & Co., a majorpublic accounting firm,pleaded guilty to obstructionof justice in the destructionof documents related to the

Enron bankruptcy. As a resultof these events, the JusticeDepartment accused the entirefirm of obstruction of justice.The questionable actions of afew had severe implicationsfor many innocent Andersenpartners and employees.

E T H I C S I N A C T I O N

or corporations. However, because of the large amount of resources required tooperate a manufacturing business, most manufacturing businesses are corporations.Likewise, most large retailers such as Wal-Mart, Sears, and JC Penney are corpora-tions. Because most large businesses are corporations, they tend to dominate the eco-nomic activity in the United States. For this reason, we focus our attention in this texton the corporate form of organization. However, many of the concepts and princi-ples we discuss also apply to proprietorships and partnerships.

Business StrategiesHow does a business decide which products or services to offer its customers? Forexample, should Best Buy offer warranty and repair services to its customers? Manyfactors influence this decision, but ultimately it is made on the basis of whether it isconsistent with the overall business strategy of the company.

A business strategy is an integrated set of plans and actions designed to enablethe business to gain an advantage over its competitors and, in doing so, to maximizeits profits. The two basic strategies a business can use are a low-cost strategy and adifferentiation strategy.

Under a low-cost strategy, a business designs and produces products or servicesof acceptable quality at a cost lower than that of the competitors. Wal-Mart andSouthwest Airlines are examples of businesses with a low-cost strategy. Such busi-nesses often sell no-frills, standardized products to the most typical customer in theindustry. Following this strategy, businesses must continually focus on driving costslower.

Businesses try to achieve lower costs in a variety of ways. For example, a businesscan employ strict budgetary controls, use sophisticated training programs, implementsimple manufacturing technologies, or enter into cost-saving supplier relationships.Such supplier relationships may involve linking the supplier’s production process di-rectly to the client’s production processes to minimize inventory costs, variations inraw materials, and record keeping costs.

A primary concern of a business using a low-cost strategy is that a competitorcould replicate its low costs or develop technological advances that enable it to achieveeven lower costs. Another concern is that competitors could differentiate their prod-ucts in such a way that customers no longer desire a standardized, no-frills product.For example, local pharmacies most often try to compete with Wal-Mart on the ba-sis of personalized service rather than cost.

Under a differentiation strategy, a business designs and produces products orservices that possess unique attributes or characteristics for which customers are willingto pay a premium price. For the differentiation strategy to be successful, a product orservice must be truly unique or perceived as unique in quality, reliability, image, ordesign. To illustrate, Maytag attempts to differentiate its appliances on the basis ofreliability, and Tommy Hilfiger differentiates its clothing on the basis of image.

Businesses using a differentiation strategy often implement information systemsto capture and analyze customer buying habits and preferences. For example, manygrocery stores such as Kroger and Safeway issue magnetic cards to preferred cus-tomers that allow the consumer to receive special discounts on purchases. In additionto establishing brand loyalty, the cards allow the stores to track consumer preferencesand buying habits to use in purchasing and advertising campaigns.

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Companies can enhance differen-tiation by investing in manufactur-ing and service technologies, such asflexible manufacturing methods thatallow timely product design and de-livery. Some companies use market-ing and sales efforts to promoteproduct differences. Other efforts in-clude using unique credit-grantingarrangements, emphasizing personalrelationships with customers, and of-fering extensive training and after-sales service programs for customers.

A business using a differentiation strategy wants customers to pay a premiumprice for the differentiated features of its products. However, a business could pro-vide features that exceed the customers’ needs. In this case, competitors may be ableto offer customers less differentiated products at lower costs. Also, customers’ per-ceptions of the differentiated features can change. As a result, customers could not bewilling to continue to pay a premium price for the products. For example, as TommyHilfiger clothing becomes more commonplace, customers may become unwilling topay a premium price for it. Over time, customers may also become better educatedabout the products and the value of the differentiated features. For example, IBM per-sonal computers were once viewed as being differentiated on quality. However, asconsumers have become better educated and more experienced with personal com-puters, Dell and Gateway computers have also become perceived as high quality.

A business can attempt to implement a combination strategy that includes ele-ments of both the low-cost and differentiation strategies. That is, a business attemptsto develop a differentiated product at competitive, low-cost price. For example, An-dersen Windows allows customers to design their own windows through the use ofits proprietary manufacturing software. By using flexible manufacturing, AndersenWindows can produce a variety of windows in small quantities with a low or moder-ate cost. Thus, Andersen windows sell at a higher price than standard low-cost win-dows but at a lower price than a fully customized window built on site.

As you might expect, a danger of a business using a combination strategy is thatits products could not adequately satisfying either end of the market. That is, becauseits products are differentiated, it cannot establish itself as the low-cost leader, and, atthe same time, its products cannot be differentiated enough that customers are will-ing to pay a premium price. In other words, the business can become “stuck in themiddle.” For example, JC Penney has difficulty competing as a low-cost leader againstWal-Mart, Kmart, Goody’s Family Clothing, Fashion USA, T.J. Maxx, and Target.At the same time, JC Penney cannot adequately differentiate its stores and merchan-dise from such competitors as The Gap, Old Navy, Eddie Bauer, and Talbot’s in or-der to charge higher prices.

A business can also attempt to implement different strategies for different mar-kets. For example, Toyota segments the market for automobiles by offering the Lexusto image- and quality-conscious buyers. To reinforce this image, Toyota developed aseparate dealer network. At the same time, Toyota offers a low-cost automobile, theEcho, to cost-conscious buyers.

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One method to create differen-tiation is to use advertising tocommunicate the unique fea-tures of a product. However,making unsubstantiated claimsabout products or services isfraudulent. For example, theFederal Trade Commission(FTC) recently warned makers

of devices and additives thatclaim to “improve gas mileageup to 300 percent” to ceasefrom making such “false andgrossly exaggerated” claims.

Source: Reuters English News Service, USA: FTC says gas-savinggadgets inflate online claims, April18, 2002.

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Exhibit 1 summarizes the characteristics of the low-cost, differentiation, and com-bination strategies. In addition, some common examples of businesses that employeach strategy are also listed.

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I ntel develops and produces micro-

processors for use in electronic equip-

ment, including personal computers and

organizers. Beginning with the 8086

processor and continuing with the 286,

386, and 486, Intel’s processors were

widely used in personal computers during

the 1980s and 1990s. Intel’s competitors,

however, also developed and sold 386 and

486 processors. In doing so, its competitors

were able to erode Intel’s market share. In

responding, Intel named its next micro-

processor the “Pentium,” rather than the

586, and registered Pentium as a trademark.

By doing so, Intel prevented its competitors

from selling their products as Pentiums.

Thus, Intel developed a “differentiated”

brand name that its competitors were un-

able to duplicate.

It’s All in the Name

B U S I N E S S S T R A T E G Y

EXHIBIT 1Business Strategies andIndustries

Business Strategy IndustryFinancial

Airline Freight Automotive Retail Services HotelUnion

Low cost Southwest Pacific Saturn Sam’s Clubs Schwab Super 8Virgin Federal Morgan Ritz

Differentiated Atlantic Express BMW Talbot’s Stanley CarltonUnitedPostal Merrill

Combination Delta Service Ford Target Lynch Marriott

Value Chain of a BusinessOnce a business has chosen a strategy, it must implement the strategy in its valuechain. A value chain is the way a business adds value for its customers by processinginputs into a product or service, as shown in Exhibit 2.

EXHIBIT 2 The Value Chain

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To illustrate, Delta Air Lines’ value chain consists of taking inputs, such as peo-ple, aircraft, and equipment, and processing these inputs into a service of transport-ing goods and passengers throughout the world. The extent to which customers valueDelta’s passenger service is reflected by the air fares Delta is able to charge as well aspassenger load factors (percentage of seats occupied). For example, the extent towhich Delta can, on average, charge higher fares than discount airlines, such as AirTran, implies that passengers value Delta’s services more than Air Tran’s. These ser-vices include newer, more comfortable aircraft, the ability to earn frequent flyer miles,more convenient passenger schedules, passenger lounges for frequent flyers, and in-ternational connections.

The value chain of a business can be divided into primary and supporting processes.Primary processes are those that are directly involved in creating value for customers.Examples of primary processes include manufacturing, selling, and customer service.Supporting processes are those that facilitate the primary processes. Examples of sup-port processes include purchasing, personnel, and accounting.2 For Delta Air Lines,primary processes include aircraft maintenance, pilot and flight attendant training,ticketing, and flight operations. Secondary processes for Delta Air Lines include the ac-counting and finance functions, contracting for fuel deliveries, and investor relations.

Business StakeholdersA company’s business strategy and how well the company implements it directly affectits economic performance and its stakeholders. For example, Kmart was unsuccessfulin implementing a business strategy that would allow it to compete effectively againstWal-Mart. The result was that Kmart filed for bankruptcy protection in early 2002,and Kmart stakeholders, including employees, creditors, and stockholders, suffered.

A business stakeholder is a person or entity that has an interest in the economicperformance and well-being of a business. For example, stockholders, suppliers, cus-tomers, and employees are all stakeholders in a corporation. Business stakeholderscan be classified into one of the four categories illustrated in Exhibit 3.

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2The value chain is described and illustrated in most management textbooks. A more advanceddiscussion of the value chain can be found in Michael E. Porter, Competitive Advantage (NewYork: The Free Press, 1985).

EXHIBIT 3Business Stakeholders Business Stakeholder Interest in the Business Examples

Capital market stakeholders Providers of major financing for the business Banks, owners,stockholders

Product or service market Buyers of products or services and vendors Customers andstakeholders to the business suppliersGovernment stakeholders Collectors of taxes and fees from the Federal, state, and city

business and its employees governmentsInternal stakeholders Individuals employed by the business Employees and

managers

Capital market stakeholders provide the major financing so that the business canbegin and continue its operations. Banks and other long-term creditors have an eco-nomic interest in recovering the amount they have loaned the business plus interest.Owners and stockholders want to maximize the economic value of their investments

and thus also have an economic interest in the business. Capital market stakeholdersexpect to receive a return on their investments proportionate to the degree of risk theyare taking on their investments. Since banks and long-term creditors have first pref-erence to the assets in case the business fails, their risk is less than that of the ownersand stakeholders, and thus their overall return is lower.

Product or service market stakeholders include customers who purchase the prod-ucts or services of the business as well as the vendors who supply inputs to it. Cus-tomers have an economic interest in the continued success of the business. Forexample, customers of the Internet provider @home.com were temporarily unable toretrieve their e-mail or connect with the Internet when @home.com declared bank-ruptcy. Customers who purchase advance tickets on Southwest Airlines have an eco-nomic interest in whether Southwest will continue in business. Similarly, suppliers arestakeholders in the continued success of their customers. Suppliers may invest intechnology or other capital equipment to meet a customer’s buying and manufactur-ing specifications. If a customer fails or cuts back on purchases during downturns,suppliers could see their businesses suffer.

Various governments have an interest in the economic performance of businesses.City, county, state, and federal governments collect taxes from businesses within theirjurisdictions. The better a business does, the more taxes the government can collect.In addition, workers are taxed on their wages. In contrast, workers who are laid offand are unemployed can file claims for unemployment compensation, which resultsin a financial burden for the government. City and state governments often provideincentives for businesses to locate in their jurisdictions.

Internal stakeholders include individuals employed by the business. The managersare those individuals who the owners have authorized to operate the business. Managersare primarily evaluated on the economic performance of the business. The managers ofbusinesses that perform poorly are often fired by the owners. Thus, managers have anincentive to maximize the economic value of the business. Owners may offer managerssalary contracts that are tied directly to how well the business performs. For example, amanager might receive a percentage of the profits or the increase in profits.

The employees provide services to the company they work for in exchange fortheir pay. Thus, employees have an interest in the economic performance of the busi-ness because their jobs depend on it. During business downturns, it is not unusual fora business to lay off workers for extended periods of time. In the extreme, a businesscan fail and its employees lose their jobs permanently. Employee labor unions oftenuse the good economic performance of a business to argue for wage increases. In con-trast, businesses often use poor economic performance to argue for employee con-cessions such as wage decreases.

Business ActivitiesRegardless of whether the company is Microsoft or General Motors, all businessesare engaged in the activities of financing, investing, and operating. First, a businessmust obtain the necessary funds to finance the costs to organize, pay legal fees, andpay other start-up costs. Next, a business must invest funds in the necessary assetssuch as building and equipment to begin operations. For example, Milton Hershey,who founded Hershey Foods Corporation, invested in the German chocolate–making

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OBJECTIVE 2Describe the threebusiness activities offinancing, investing,and operating.

machinery he saw at the Chicago International Exposition. Finally, a business mustutilize its assets and resources to implement its business strategy. Hershey’s businessstrategy is to mass-produce chocolate candies at an affordable cost.

As we discuss later in this chapter, a major role of accounting is to provide stake-holders with information on the financing, investing, and operating activities of busi-nesses. Financial statements represent one source of such information.

Financing ActivitiesFinancing activities involve obtaining funds to begin and operate a business. Busi-nesses seek financing through the use of the capital markets. This financing takes theform of borrowing or issuing shares of ownership. Most major businesses use bothmeans of financing.

When a business borrows money, it incurs a liability. A liability is a legal obliga-tion to repay the amount borrowed according to the terms of the borrowing agree-ment. For example, when you use your credit card, you incur an obligation to pay theissuer (bank). When a business borrows from a vendor or supplier, the liability iscalled an account payable. In such cases, the business is buying on credit and promis-ing to pay according to the terms set forth by the vendor or supplier. Most vendorsand suppliers require payment within a relatively short time, such as 30 days. As ofDecember 31, 2001, Hershey Foods Corporation reported approximately $150 mil-lion of accounts payable.

A business can borrow money by issuing bonds. Bonds are sold to investors andnormally require repayment with interest at a specific time in the future. Bonds are atype of long-term financing, with a face amount that is normally due years into thefuture. For example, Lucent Technologies currently has bonds due in 2028. In con-trast, the interest on bonds is normally paid semiannually. Bond obligations are re-ported as bonds payable, and any interest that is due is reported as interest payable.Examples of well-known companies that have bonds outstanding include AmericanTelephone and Telegraph (AT&T), John Deere, and Xerox.

Most large corporations also borrow money by issuing commercial paper and ne-gotiating lines of credit with financial institutions. Commercial paper refers to debtobligations that are sold to investors, such as banks and insurance companies, basedon the general creditworthiness of the corporation. Similarly, lines of credit are ne-gotiated with financial institutions in such a way that the corporation can borrow onthe line of credit as needed. For example, Hershey Foods has a $500 million line ofcredit with a syndicate of banks, and, as of December 31, 2001, it had borrowedslightly more than $250 million on its credit line. When a corporation issues com-mercial paper or borrows on a line of credit, it incurs a note payable. A note payablerequires the payment of the amount borrowed plus interest. Notes payable can be is-sued either on a short-term or a long-term basis.

A business also can finance its operations by issuing shares of ownership. For acorporation, shares of ownership are issued in the form of shares of stock. Althoughcorporations may issue a variety of different types of stock, the basic type of stock is-sued to owners is called common stock. For our purposes, we will use the term cap-ital stock to include all the types of stock a corporation may issue.3 Investors whopurchase the stock are referred to as stockholders.

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3Types of stock are discussed in Chapter 8, “Liabilities and Stockholders’ Equity.”

The claims of creditors and stockholders on the assets of the corporation are dif-ferent. In case of a corporation’s liquidation or bankruptcy, creditors have first claimon its assets. Only after the creditors’ claims have been satisfied can the stockholdersobtain corporate assets. In addition, although creditors expect to receive timely pay-ments of their claims, which may include interest, stockholders are not entitled to reg-ular payments. However, many corporations distribute earnings to stockholders on aregular basis as long as the claims of creditors are being satisfied. These distributionsof earnings to stockholders are called dividends. During 2001, Hershey paid stock-holders almost $130 million in dividends.

Investing ActivitiesOnce financing has been obtained, a business must use investing activities to obtainthe necessary resources to start and operate the business. Depending on the nature ofthe business, a variety of different resources must be purchased. For example, MiltonHershey purchased the German chocolate–making machinery and later constructed abuilding to house the Hershey operations. In addition to machinery and buildings,other resources could include computers, office furnishings, trucks, and automobiles.Although most resources have physical characteristics, such as equipment, some re-sources are intangible in nature. For example, a business can purchase patent rightsfor use in a manufacturing process or product.

The resources that a business owns are called assets. A business may acquire as-sets through its financing, investing, and operating activities. Assets are acquiredthrough financing activities when the business obtains cash through borrowing or is-suing shares of stock. Assets are acquired through investing activities by purchasingresources, as in the preceding paragraph. Finally, assets can be acquired through op-erating activities as we describe in the next section.

Assets can be in a variety of different forms. For example, tangible assets includecash, land, property, plant, and equipment. Assets also include intangible items, suchas rights to patents and rights to payments from customers. The right to paymentfrom customers is called an account receivable. Other intangible assets, such asgoodwill, copyrights, and patents, are often grouped and reported as a group as in-tangible assets. A business can also pay in advance for items such as insurance orrent. Such items, which are assets until they are consumed, are normally reported asprepaid expenses.

Operating ActivitiesOnce resources have been acquired, a business uses operating activities to imple-ment its business strategy. Hershey’s strategy was to mass-produce and distributechocolate candies at affordable prices. When Hershey sold its chocolates, it receivedrevenue from its customers. Revenue is the increase in assets from selling productsor services. Revenues are often identified according to their source. For example, rev-enues received from selling products are called sales. Revenues received from provid-ing services are called fees.

To earn revenue, a business incurs costs, such as wages of employees, salaries ofmanagers, rent, insurance, advertising, freight, and utilities. Costs used to earn rev-enue are called expenses. Depending on the nature of the cost, expenses can be iden-

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tified in a variety of ways. For example, the cost of products sold is often referred toas the cost of merchandise sold, cost of sales, or cost of goods sold. Other expenses are of-ten classified as either selling expenses or administrative expenses. Selling expenses in-clude those costs directly related to selling a product or service. For example, sellingexpenses include costs such as sales salaries, sales commissions, freight, and advertis-ing costs. Administrative expenses include other costs not directly related to the sell-ing, such as officer salaries and other costs of the corporate office.

As we discuss later in this chapter, you can determine whether the business earnednet income or incurred a net loss by comparing its revenues for a period with the re-lated expenses. A net income results when revenues exceed expenses. A net loss re-sults when expenses exceed revenues.

What Is Accounting and Its Role in Business?How do stakeholders get information about the financing, investing, and operat-ing activities of a business? The role of accounting is to provide this information.Accounting provides data for managers to use in operating the business and forother stakeholders to use in assessing the economic performance and condition ofthe business.

In a general sense, accounting can be defined as an information system that pro-vides reports to stakeholders about the economic activities and condition of a busi-ness. We focus our discussions in this text on accounting and its role in business.However, many concepts in this text also apply to individuals, governments, andother types of organizations. For example, individuals must account for activities suchas hours worked, checks written, and bills due. Stakeholders for individuals includecreditors, dependents, and the government. A main interest of the government ismaking sure that individuals pay their proper taxes.

Accounting is sometimes called the language of business because it is the means bywhich business information is communicated to the stakeholders. For example, ac-counting reports summarizing the profitability of a new product help Coca-Cola’smanagement decide whether to continue selling the new product. Likewise, financialanalysts use accounting reports in deciding whether to recommend the purchase ofCoca-Cola’s stock. Banks use accounting reports in deciding the amount of credit toextend to Coca-Cola. Suppliers use accounting reports in deciding whether to offercredit to Coca-Cola for its purchases of supplies and raw materials. State and federalgovernments use accounting reports as a basis for assessing taxes on Coca-Cola.

As we described, accounting serves many purposes for business. A primary pur-pose is to summarize a firm’s financial performance for external users, such as banksand governmental agencies. The branch of accounting that is associated with prepar-ing reports for users external to the business is termed financial accounting. Ac-counting also can be used to guide management in making decisions about thebusiness. This branch is called managerial accounting. Financial and managerial ac-counting overlap in many areas. For example, managers often use financial reportsfor external users in considering the impact of their decisions.

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OBJECTIVE 3Define accounting,and explain its role inbusiness.

In this text, we focus on financial accounting. The two major objectives of finan-cial accounting are

1. To report the financial condition of a business at a point in time.2. To report changes in the financial condition of a business over a period of time.

The relationship between the two financial accounting objectives is shown in Ex-hibit 4. You may think of the first objective as a still photograph (snapshot) of thebusiness and the second objective as a moving picture (video) of the business. Thefirst objective measures the financial status of the business. Stakeholders use this mea-sure to evaluate its financial health at a point in time. The second objective measuresthe change in the financial condition of the business for a period of time. Stakehold-ers use this measure to predict how a business may perform in the future.

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EXHIBIT 4Objectives of FinancialAccounting

The objectives of accounting are satisfied by (1) recording the economic events af-fecting a business and then (2) summarizing the impact of these events on the busi-ness in financial reports, called financial statements. We will describe and illustratethe basic financial statements next.

Financial StatementsFinancial statements report the financial condition of a business at a point in time andchanges in the financial condition over a period of time. The four basic financial state-ments and their relationship to the two objectives of financial accounting follow4:

OBJECTIVE 4Describe and illustratethe basic financialstatements and howthey interrelate.

4Instead of the retained earnings statement, companies may prepare a statement of stockholders’equity. This statement reports changes in retained earnings as well as changes in other stockholders’equity items.

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Financial Statement Financial Accounting ObjectiveIncome statement Reports change in financial conditionRetained earnings statement Reports change in financial conditionBalance sheet Reports financial conditionStatement of cash flows Reports change in financial condition

The income statement is normally prepared first, followed by the retained earn-ings statement, the balance sheet, and the statement of cash flows. The nature of eachstatement is described here:

� Income statement—A summary of the revenue and the expenses for a specificperiod of time, such as a month or a year.

� Retained earnings statement—A summary of the changes in the earningsretained in the corporation for a specific period of time, such as a month or ayear.

� Balance sheet—A list of the assets, liabilities, and stockholders’ equity as of aspecific date, usually at the close of the last day of a month or a year.

� Statement of cash flows—A summary of the cash receipts and cash paymentsfor a specific period of time, such as a month or a year.

The four financial statements are illustrated in Exhibits 5–8. The data for the state-ments were adapted from the annual report of Hershey Foods Corporation.5

Income StatementThe income statement reports the change in financial condition resulting from theoperations of a business. The time period covered by the income statement may vary,depending on the needs of the stakeholders. Public corporations are required to filequarterly and annual income statements with the Securities and Exchange Commis-sion. The income statement shown in Exhibit 5 for Hershey Foods Corporation is forthe year ended December 31, 2001.

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5The financial statements for Hershey Foods Corporation can be found at http://www.hersheys.comby clicking on “Investor Relations.”

EXHIBIT 5Income Statement:Hershey FoodsCorporation

HERSHEY FOODS CORPORATIONIncome Statement

For the Year Ended December 31, 2001(in thousands)

Revenues:Sales $4,557,241

Expenses:Cost of sales $2,665,566Selling and administrative 1,269,964Other expenses 209,077Interest 69,093Income taxes 136,385 4,350,085

Net income $ 207,156

Since the focus of business operations is to generate revenues, the income statementbegins by listing the revenues for the period. During 2001 Hershey Foods Corporationgenerated sales of more than $4.5 billion. These sales are listed under the revenue cap-tion. You should note that the numbers shown in Exhibit 5 are expressed in thou-sands of dollars. It is common for large corporations to express their financialstatements in thousands and, in some cases, millions of dollars.

Following the revenues, the expenses that were used in generating the revenues arelisted. For Hershey Foods, these expenses include cost of sales, selling and adminis-trative, other expenses, interest, and income taxes.6 By reporting the expenses and therelated revenues for a period, the expenses are said to be matched against the rev-enues. This is known in accounting as the matching concept. We will further discussthis concept later in this chapter.

When revenues exceed expenses for a period, the business has net income. If ex-penses exceed revenues, the business has a net loss. Reporting net income means thatthe business increased its net assets through its operations. That is, the assets createdby the revenues coming into the business exceeded the assets used to generate the rev-enues. The objective of most businesses is to maximize net income or profit. A netloss means that the business decreased its net assets through its operations. A busi-ness can survive in the short run by reporting net losses, but in the long-run, it mustreport net income to survive.

During 2001, Hershey Foods earned net income of more than $200 million dol-lars. Is this good or bad? Certainly, net income is better than a net loss. However,each stakeholder must assess the economic performance of the corporation accord-ing to its own standards. For example, a creditor might be satisfied that the net in-come is sufficient to ensure that it will be repaid. On the other hand, a stockholdermight not be satisfied if the corporation’s profitability is less than that of competi-tors. Throughout this text, we describe various methods and analyses of assessingcorporate performance.

Retained Earnings StatementThe retained earnings statement reports changes in financial condition due to changesin retained earnings during a period. Retained earnings is the portion of a corpora-tion’s net income that is retained in the business. A corporation may retain all of itsnet income for use in expanding operations, or it may pay a portion or all of its netincome to stockholders as dividends. For example, high growth companies such asMicrosoft and Amazon.com do not pay dividends to stockholders but retain profitsfor future expansion. In contrast, more mature corporations such as Coca-Cola andGeneral Electric routinely pay their stockholders a regular dividend. Thus, investorssuch as retirees who desire the comfort of a routine dividend payment might investin Coca Cola or General Electric. In contrast, younger and more aggressive growth-oriented investors might invest in Microsoft or Amazon.com.

Since retained earnings depend on net income, the time period covered by the re-tained earnings statement is the same period as that of the income statement. Thus,the retained earnings statement for Hershey Foods Corporation shown in Exhibit 6 isfor the year ended December 31, 2001.

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6Other expenses consist primarily of an asset impairment expense, which is discussed in advancedaccounting texts.

You should note that dividends are reported in Hershey’s retained earnings state-ment rather than its income statement. This is done because dividends are not an ex-pense but are a distribution of net income to stockholders. During 2001, Hershey paiddividends of approximately $155 million and retained approximately $52 million ofits net income in the business. Thus, Hershey’s retained earnings increased from$2,703 million to $2,755 million during 2001.

Balance SheetThe balance sheet reports a company’s financial condition as of a point in time. Thisis in contrast to the income statement, the retained earnings statement, and the state-ment of cash flows, which report changes in financial condition. The financial condi-tion of a business as of a point in time is measured by its total assets and claims orrights to those assets. Thus, the financial condition of a business can be representedas follows:

Assets � Claims (Rights to the Assets)

The claims on the assets of a business consist of rights of creditors who haveloaned money or extended credit to the business and the rights of stockholders whohave invested in the business. As we discussed earlier, the rights of creditors are lia-bilities. The rights of stockholders are referred to as stockholders’ equity or owner’sequity. Thus, the assets and the claims on those assets can be presented in equationform as follows:

Assets � Liabilities � Stockholders’ Equity

This equation is called the accounting equation. As you will discover in this andlater chapters, accounting information systems are developed using this equation astheir foundation.

The balance sheet, sometimes called the statement of financial condition, is pre-pared using the framework of the accounting equation. That is, assets are listed firstand added to arrive at total assets. Liabilities are then listed and added to arrive at to-tal liabilities. Stockholders’ equity items are listed next and added to arrive at totalstockholders’ equity. Finally, the total assets must equal the combined total liabilitiesand stockholders’ equity. In other words, the accounting equation must balance—thus, the name balance sheet. The balance sheet for Hershey Foods Corporation as ofDecember 31, 2001, is shown in Exhibit 7.

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EXHIBIT 6Retained EarningsStatement: HersheyFoods Corporation

HERSHEY FOODS CORPORATIONRetained Earnings Statement

For the Year Ended December 31, 2001(in thousands)

Retained earnings, January 1, 2001 $2,702,927Add net income $207,156Less dividends 154,750Increase in retained earnings 52,406Retained earnings, December 31, 2001 $2,755,333

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As of December 31, 2001, Hershey had total assets of approximately $3.2 billion,to which creditors had claims of $2.1 billion and stockholders had claims of $1.1 bil-lion. One use of the balance sheet by creditors is to determine whether the corpora-tion’s assets are sufficient to ensure that they will be paid their claims. In Hershey’scase, as of December 31, 2001, the assets of the corporation exceed the creditors’claims by $1.1 billion. Thus, the creditors are reasonably ensured that their claims willbe repaid.

Statement of Cash FlowsThe statement of cash flows reports the change in financial condition due to thechanges in cash during a period. During 2001, Hershey’s net cash increased by $102million, as shown in Exhibit 8.

Earlier in this chapter, we discussed the three business activities of financing, in-vesting, and operating. Any changes in cash must be related to one of these three ac-tivities. Thus, the statement of cash flows is organized by reporting the changes ineach of these three activities, as shown in Exhibit 8.

In the statement of cash flows, the cash flows from operating activities are re-ported first because they represent a primary analysis focus for most business stake-

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EXHIBIT 7Balance Sheet: HersheyFoods Corporation

HERSHEY FOODS CORPORATIONBalance Sheet

December 31, 2001(in thousands)

AssetsCash $ 134,147Accounts receivable 361,726Inventories 512,134Prepaid expenses 62,595Property, plant, and equipment 1,534,901Intangibles 429,128Other assets 212,799Total assets $ 3,247,430

LiabilitiesAccounts payable $ 133,049Accrued liabilities 462,901Notes and other debt 1,245,939Income taxes 258,337

Total liabilities $ 2,100,226

Stockholders’ EquityCapital stock $ 183,213Retained earnings 2,755,333Repurchased stock and other equity items (1,791,342)

Total stockholders’ equity $ 1,147,204Total liabilities and stockholders’ equity $ 3,247,430Thom

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holders. For example, creditors are interested in determining whether the company’soperating activities are generating enough positive cash flows to repay their debts.Likewise, stockholders are interested in the company’s ability to pay dividends. Abusiness cannot survive in the long term unless it generates positive cash flows fromoperating activities. Thus, employees, managers, and other stakeholders interested inthe long-term viability of the business also focus on the cash flows from operatingactivities. During 2001, Hershey’s operations generated a positive net cash flow ofapproximately $706 million.

Because of the impact that investing activities have on the operations of a busi-ness, the cash flows from investing activities are presented following the cash flowsfrom operating activities section. Any cash receipts from selling property, plant, andequipment are reported in this section. Likewise, any purchases of property, plant,and equipment are reported as cash payments. Companies that are expanding rapidly,such as start-up companies, normally report negative net cash flows from investingactivities. In contrast, companies that are downsizing or selling segments of the busi-ness could report positive net cash flows from investing activities.

As shown in Exhibit 8, Hershey reported negative net cash flows from investingactivities of approximately $124 million. Of this negative net cash flow, $187 millionwas from the purchase of property, plant, and equipment, and approximately $63million was related to the sale of property, plant, and equipment. Thus, it appears thatHershey is expanding operations.

Cash flows from financing activities are reported next. Any cash receipts from is-suing debt or stock are reported in this section as cash receipts. Likewise, paying debtor dividends is reported as a cash payment. Business stakeholders can analyze cashflows from financing activities to determine whether a business is changing its fi-nancing policies.

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EXHIBIT 8Statement of CashFlows: Hershey FoodsCorporation

HERSHEY FOODS CORPORATIONStatement of Cash Flows

For the Year Ended December 31, 2001(in thousands)

Net cash flows from operating activities $ 706,405Cash flows from investing activities:

Investments in property, plant, and equipment $(187,029)Proceeds from sale of property, plant, and equipment 63,042

Net cash flows used in investing activities $(123,987)Cash flows from financing activities:

Cash receipts from financing activities, including debt $ 30,589Dividends paid to stockholders (154,750)Repurchase of stock (40,322)Other, including repayment of debt (315,757)

Net cash flows used in financing activities $(480,240)Net increase in cash during 2001 $ 102,178Cash as of January 1, 2001 31,969Cash as of December 31, 2001 $ 134,147

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As shown in Exhibit 8, Hershey paid dividends of approximately $155 million andrepaid debt of approximately $316 million. Cash of approximately $31 million was re-ceived from financing activities that included additional borrowing from creditors. Fi-nally, Hershey purchased its own stock at a cost of approximately $40 million. Acompany purchases its own stock if the corporate management believes its stock isundervalued or decides to provide stock to employees or managers as part of an in-centive (stock option) plan.7

The statement of cash flows is completed by determining the increase or decreasein cash flows for the period by adding the net cash flows from operating, investing,and financing activities. Hershey reported a net increase in cash of approximately$102 million. This increase or decrease is added to or subtracted from the cash at thebeginning of the period to determine the cash as of the end of the period. Thus, Her-shey began the year with approximately $32 million in cash and ended the year with$134 million in cash.

So what does the statement of cash flows reveal about Hershey Foods Corporationduring 2001? The statement shows that Hershey generated more than $700 million incash flows from its operations while using cash to expand its operations and pay div-idends to stockholders. Overall, Hershey appears to be in a strong operating positionto generate cash and pay its creditors.

Interrelationships among Financial StatementsAs we mentioned earlier, financial statements are prepared in the order of the incomestatement, retained earnings statement, balance sheet, and statement of cash flows.Preparing them in this order is important because the financial statements are inter-related. The Hershey Foods Corporation financial statements in Exhibits 5–8 showthese interrelationships as follows8:

1. The income and retained earnings statements are interrelated. The net incomeor net loss appearing on the income statement also appears on the retainedearnings statement as either an addition (net income) to or deduction (net loss)from the beginning retained earnings. To illustrate, Hershey’s net income of$207,156 is also reported on the retained earnings statement as an addition tothe beginning retained earnings.

2. The retained earnings statement and the balance sheet are interrelated. The re-tained earnings at the end of the period on the retained earnings statement alsoappears on the balance sheet as a part of stockholders’ equity. To illustrate, Her-shey’s retained earnings of $2,755,333 as of December 31, 2001, is also reportedon the balance sheet.

3. The balance sheet and statement of cash flows are interrelated. The cash on thebalance sheet also appears as the end-of-the-period cash on the statement of cashflows. To illustrate, the cash of $134,147 reported on Hershey’s balance sheet isalso reported as the end-of-the-period cash on the statement of cash flows.

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7We discuss the accounting for a company’s purchase of its own stock in a later chapter.8Depending on the method of preparing cash flows from operating activities, net income may alsoappear on the statement of cash flows. This interrelationship and the method of preparing thestatement of cash flows, called the indirect method, is illustrated later in the text. In addition, aswe illustrate in Chapter 2 under the cash basis of accounting, cash flow from operating activitiesequals net income.

The preceding interrelationships are important in analyzing financial statementsand the possible impact of economic events or transactions on a business. In addi-tion, these interrelationships serve as a check on whether the financial statements havebeen prepared correctly. For example, if the ending cash on the statement of cashflows doesn’t agree with the balance sheet cash, an error exists.

Accounting ConceptsIn the preceding section, we described and illustrated the four basic corporate finan-cial statements. Just as the rules of football determine the proper manner of scoringtouchdowns, accounting “rules,” called generally accepted accounting principles(GAAP), determine the proper content of financial statements. GAAP are necessaryso that stakeholders can compare the financial condition and operating results acrosscompanies and across time. If managers of a company could prepare financial state-ments as they saw fit, the comparability between companies and across time periodswould be difficult, if not impossible. In other words, this would be like allowing afootball team to determine the point count for a touchdown every time it scored.

GAAP are established in the United States by the Financial Accounting Stan-dards Board (FASB).9 In establishing GAAP, the FASB publishes Statements of Fi-nancial Accounting Standards. Understanding the concepts that support the FASBpronouncements is essential for analyzing and interpreting financial statements. Wediscuss eight of the most important of these concepts next.

Business Entity ConceptA business entity could be an individual, a not-for-profit organization such as achurch, or a for-profit company such as a real estate agency. The business entity con-cept applies accounting to a specific entity for which stakeholders need economicdata. Once the entity is identified, the accountant can determine which economic dataand activities should be analyzed, recorded, and summarized in the financial state-ments for stakeholders.

The accounting for Hershey Foods Corporation, a for-profit corporation, is sep-arated from the accounting for other entities. For example, the accounting for trans-actions and events of individual stockholders, creditors, or other Hershey stakeholdersare not included in Hershey Foods Corporation’s financial statements. Only the trans-actions and events of the corporation as a separate entity are included in Hershey’s fi-nancial statements.

Cost ConceptThe cost concept determines the amount initially entered into the accounting recordsfor purchases. For example, assume that Hershey purchased land for $2 million as asite for a future plant. The cost of the land to Hershey is the amount that would beentered into the accounting records. The seller could have been asking $2.3 million

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9The Securities and Exchange Commission also has authority to set accounting principles for pub-licly held corporations. In almost all cases, the SEC adopts the principles established by the FASB.

for the land up to the time of the sale, and the land could have been assessed for prop-erty tax purposes at $1.5 million. A month after purchasing the land, Hershey couldhave received an offer of $2.4 million for the land. The only amount that affects theaccounting records and the financial statements, however, is the $2 million purchaseprice.

Going Concern ConceptIn most cases, the amount of time that a business will be able to continue in opera-tion is not known, so an assumption must be made. A business normally expects tocontinue operating for an indefinite period of time. This is called the going concernconcept.

The going concern concept affects the recording of transactions and thus affectsthe financial statements. For example, the going concern concept justifies the use ofthe cost concept for recording purchases, such as the land purchased by Hershey inthe preceding example. In this example, Hershey plans to build a plant on the land.Since Hershey does not plan to sell the land, reporting changes in the market value ofthe land is irrelevant. That is, the amount Hershey could sell the land for if it dis-continued operations or went out of business is not important because Hershey plansto continue its operations.

If, however, there is strong evidence that a business is planning to discontinue itsoperations, the accounting records should show the values expected to be received.For example, the assets and liabilities of businesses in receivership or bankruptcy arevalued from a quitting concern or liquidation point of view rather than from the go-ing concern point of view.

Matching ConceptIn accounting, revenues for a period are matched with the expenses incurred in gen-erating those revenues. Under this matching concept, revenues are normally recordedat the time of the sale of the product or service. This recording of revenues is oftenreferred to as revenue recognition. At the point of sale, the sale price has been agreedon, the buyer acquires ownership of the product or acquires the service, and the sellerhas a legal claim against the buyer for payment.

The following excerpt from the notes to Hershey’s annual report describes whenHershey records sales:

. . . . The Corporation records sales when . . . a . . . customer order with a fixed price hasbeen received . . . the product has been shipped . . . there is no further obligation to assistin the resale of the product, and collectibility [of the account receivable] is reasonablyassured.

Objectivity ConceptThe objectivity concept requires that entries in the accounting records and the datareported on financial statements be based on objective evidence. If this concept is ig-nored, the confidence of users of the financial statements cannot be maintained. Forexample, evidence such as invoices and vouchers for purchases, bank statements forthe amount of cash in the bank, and physical counts of supplies on hand support the

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accounting records. Such evidence is objective and verifiable. In some cases, judg-ments, estimates, and other subjective factors have to be used in preparing financialstatements. In such situations, the most objective evidence available should be used.

Unit of Measure ConceptIn the United States, the unit of measure concept requires that all economic data berecorded in dollars. Other relevant, nonfinancial information, such as terms of con-tracts, can also be recorded; however, only through using dollar amounts can the var-ious transactions and activities of a business be measured, summarized, reported, andcompared. Money is common to all business transactions, and thus the dollar is themonetary unit of measurement for reporting.

Adequate Disclosure ConceptFinancial statements, including related footnotes and other disclosures, should con-tain all relevant data that a reader needs to understand the financial condition andperformance of a business. This is called the adequate disclosure concept. Nonessen-tial data should be excluded to avoid clutter. For example, the balance of each cashaccount is usually not reported separately. Instead, the balances are grouped togetherand reported as one total.

Accounting Period ConceptThe process in which accounting data are recorded and summarized in financial state-ments is a period process. Data are recorded and the income statement, retained earn-ings statement, and statement of cash flows are prepared for a period of time such asa month or a year. The balance sheet is then prepared as of the end of the period. Af-ter the accounting process is completed for one period, a new one begins, and the ac-counting process is repeated for the new period. This process is based on theaccounting period concept. Hershey’s financial statements in Exhibits 5–8 illustratethe accounting period concept for the year ending December 31, 2001.

The financial history of a business is shown by a series of balance sheets and in-come statements. If the life of a business is expressed by a line moving from left toright, this series of financial statements may be graphed as follows:

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Horizontal AnalysisThe basic financial statements illustrated in this chapter are primary sources of in-formation that financial analysts use in evaluating a company’s performance. Onemethod of analyzing financial performance is to compute the percentage of increasesand decreases in related items in comparative financial statements. This type ofanalysis, called horizontal analysis, compares each item on the most recent finan-cial statement with the related item on one or more earlier statements. The amountof the increase or decrease in each item is shown along with the percentage of in-crease or decrease.

To illustrate, income statements for Hershey Corporation will be used for theyears ending December 31, 2001 and 2000. For analysis purposes, the statements havebeen condensed and adapted to emphasize the operating aspects of Hershey’s perfor-mance. For example, other expenses, interest expense, and income taxes have beenomitted from the income statements. This allows us to focus on the basic operatingaspects of Hershey’s business without being distracted by unusual items. The exclu-sion of income taxes helps simplify the analysis and recognizes that the amount ofincome taxes is largely beyond the operating control of the business. Interest expenseis omitted since it deals more with the financing than the operating aspects of thebusiness. The resulting comparative income statements are shown in Exhibit 9.

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OBJECT IVE 6Describe and illustratethe use of horizontalanalysis to analyzeand evaluate acompany’sperformance.

EXHIBIT 9Comparative IncomeStatements UsingHorizontal Analysis:Hershey FoodsCorporation

HERSHEY FOODS CORPORATIONIncome Statement

For the Years Ended December 31, 2001 and 2000(in thousands)

Increase (Decrease)2001 2000 Amount Percent

Sales $4,557,241 $4,220,976 $336,265 8.0%Cost of sales 2,665,566 2,471,151 194,415 7.9Gross profit $1,891,675 $1,749,825 $141,850 8.1Selling and administrative expenses 1,269,964 1,127,175 142,789 12.7Operating income before taxes $ 621,711 $ 622,650 $ (939) (0.2)%

The income statements shown in Exhibit 9 report gross profit as sales less thecost of sales. Gross profit represents the amount that Hershey marked up the cost ofits products in selling them to its customers. Gross profit is a useful performancemeasure in analyzing the profitability of the company’s products from one period tothe next.

Did Hershey improve its operations during the year ending December 31, 2001?Exhibit 9 indicates that Hershey increased its sales by 8% and that the cost of sales in-creased just under 8%. This combination of increases and decreases resulted in an in-crease in gross profit of just over 8%. Selling and administrative expenses increasedsignificantly more than sales. This could be due to the implementation of a new ad-vertising campaign, which could impact sales beyond just the current year.

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The overall impact on operations of these changes is that operating income beforetaxes decreased by 0.2%. Before arriving at a final conclusion on Hershey’s operatingresults for 2001, the reader should perform additional analyses and compare its re-sults with the operating results of competitors.10

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10Additional financial statement analyses will be discussed and illustrated throughout this text.

Key Points1. Describe the types and forms of businesses,

business strategies, value chains, and stake-holders.

The three types of businesses operated for profit in-clude manufacturing, merchandising, and servicebusinesses. Such businesses may be organized as pro-prietorships, partnerships, or corporations. The twobasic business strategies a business can use are lowcost and differentiation. Sometimes a business imple-ments a combination strategy that includes elementsof both the low-cost and differentiation strategies.Once a business has chosen a strategy, it must imple-ment the strategy in its value chain. A business’s valuechain is the way it adds value for its customers byprocessing inputs into a product or service. A com-pany’s business strategy and value chain are of inter-est to its stakeholders. Business stakeholders includefour categories: capital market stakeholders, productor service market stakeholders, government stake-holders, and internal stakeholders.

2. Describe the three business activities of financ-ing, investing, and operating.

All businesses engage in financing, investing, and op-erating activities. Financing activities involve obtain-ing funds to begin and operate a business. Investingactivities involve obtaining the necessary resources tostart and operate the business. Operating activities in-volve using the business’s resources according to itsstrategy.

3. Define accounting, and explain its role inbusiness.

Accounting is an information system that providesreports to stakeholders about the economic activities

and condition of a business. Accounting is the languageof business.

4. Describe and illustrate the basic financialstatements and how they interrelate.

The principal financial statements of a corporationare the income statement, the retained earnings state-ment, the balance sheet, and the statement of cashflows. The income statement reports a period’s netincome or net loss, which also appears on the retainedearnings statement. The ending retained earningsreported on the retained earnings statement is alsoreported on the balance sheet. The ending cash balanceis reported on the balance sheet and the statement ofcash flows.

5. Describe eight basic accounting concepts un-derlying financial reporting.

The eight basic accounting concepts discussed in thischapter include the business entity, cost, going con-cern, matching, objectivity, unit of measure, adequatedisclosure, and accounting period concepts.

6. Describe and illustrate the use of horizontalanalysis to analyze and evaluate a company’sperformance.

One method of analyzing financial performance is tocompute the percentage of increases and decreasesin related items in comparative financial statements.This type of analysis, called horizontal analysis, com-pares each item on the most recent financial state-ment with the related item on one or more earlierstatements.

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GlossaryAccount payable: The liability createdwhen a business borrows from a ven-dor or supplier.

Account receivable: Right to paymentfrom customers.

Accounting: An information systemthat provides reports to stakeholdersabout the economic activities andcondition of a business.

Accounting equation: Assets �Liabilities � Stockholders’ Equity.

Accounting period concept: An accounting concept in which account-ing data are recorded and summarizedin a period process.

Adequate disclosure concept: An ac-counting concept that requires finan-cial statements to include all relevantdata a reader needs to understand thefinancial condition and performanceof a business.

Assets: The resources owned by abusiness.

Balance sheet: A list of the assets, liabilities, and owner’s equity as of aspecific date, usually at the close of thelast day of a month or a year.

Bonds payable: A type of long-termdebt financing with a face amountthat is in the future with interest thatis normally paid semiannually.

Business: An organization in whichbasic resources (inputs), such as ma-terials and labor, are assembled andprocessed to provide goods or services(outputs) to customers.

Business entity concept: An account-ing concept that limits the economicdata in the accounting system of aspecific business or entity to data re-lated directly to the activities of thatbusiness or entity.

Business stakeholder: A person orentity who has an interest in the eco-nomic performance of a business.

Business strategy: An integrated setof plans and actions designed to en-able the business to gain an advantageover its competitors and in doing so,maximize its profits.

Capital stock: Types of stock a cor-poration may issue.

Combination strategy: A businessstrategy that includes elements ofboth the low-cost and differentiationstrategies.

Common stock: The basic type ofstock issued to stockholders of a cor-poration.

Corporation: A business organizedunder state or federal statutes as aseparate legal entity.

Cost concept: An accounting conceptthat determines the amount initiallyentered into the accounting recordsfor purchases.

Differentiation strategy: A businessstrategy in which a business designsand produces products or servicesthat possess unique attributes or char-acteristics for which customers arewilling to pay a premium price.

Dividends: Distributions of the earn-ings of a corporation to stockholders.

Expenses: Costs used to earn revenues.

Financial Accounting StandardsBoard (FASB): The authoritative bodythat has the primary responsibility fordeveloping accounting principles.

Financial statements: Financial re-ports that summarize the effects ofevents on a business.

Financing activities: Business activi-ties that involve obtaining funds tobegin and operate a business.

Generally accepted accounting prin-ciples (GAAP): Rules for the way fi-nancial statements should be prepared.

Going concern concept: An account-ing concept that assumes a businesswill continue operating for an indefi-nite period of time.

Horizontal analysis: A method ofanalyzing financial performance thatcomputes the percentage of increasesand decreases in related items incomparative financial statements.

Income statement: A summary of therevenue and expenses for a specificperiod of time, such as a month or ayear.

Intangible assets: Assets that arerights to future benefits such as patentor copyright rights.

Interest payable: A liability to pay in-terest on a due date.

Investing activities: Business activitiesthat involve obtaining the necessaryresources to start and operate thebusiness.

Liability: The right of a creditor thatrepresents a legal obligation to repayan amount borrowed according toterms of the borrowing agreement.

Low-cost strategy: A business strat-egy in which a business designs andproduces products of acceptable qual-ity at a cost lower than that of com-petitors.

Manufacturing: A type of businessthat changes basic inputs into prod-ucts that are sold to individual cus-tomers.

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Matching concept: An accountingconcept that requires expenses of aperiod to be matched with the rev-enue generated during that period.

Merchandising: A type of businessthat purchases products from otherbusinesses and sells them to cus-tomers.

Net income: The excess of revenuesover expenses.

Net loss: The excess of expenses overrevenues.

Note payable: A type of short- orlong-term financing that requirespayment of the amount borrowedplus interest.

Objectivity concept: An accountingconcept that requires accountingrecords and data reported in finan-cial statements be based on objectiveevidence.

Operating activities: Business activi-ties that involve using the business’sresources to implement its businessstrategy.

Owner’s equity: The financial rightsof the owner.

Partnership: A business owned bytwo or more individuals.

Prepaid expenses: An asset resultingfrom the prepayment of a future ex-pense such as insurance or rent.

Proprietorship: A business owned byone individual.

Retained earnings: Net income re-tained in a corporation.

Retained earnings statement: Asummary of the changes in the retainedearnings in a corporation for a specificperiod of time, such as a month or ayear.

Revenue: The increase in assets fromselling products or services to cus-tomers.

Service: A type of business that pro-vides services rather than products tocustomers.

Statement of cash flows: A summaryof the cash receipts and cash paymentsfor a specific period of time, such as amonth or a year.

Stockholders: Investors who purchasestock in a corporation.

Unit of measure concept: An account-ing concept requiring that economicdata be recorded in dollars.

Value chain: The way a business addsvalue for its customers by processinginputs into a product or service.

Self-Study Questions(Answers appear at end of chapter.)

1. A profit-making business operating as a separate legalentity and in which ownership is divided into sharesof stock is known as a:A. proprietorship. C. partnership.B. service business. D. corporation.

2. The resources owned by a business are called:A. assets.B. liabilities.C. the accounting equation.D. stockholders’ equity.

3. A listing of a business entity’s assets, liabilities, andstockholders’ equity as of a specific date is:A. a balance sheet.B. an income statement.C. a statement of owner’s equity.D. a statement of cash flows.

4. If total assets are $20,000 and total liabilities are$12,000, the amount of stockholders’ equity is:A. $32,000. C. $(8,000).B. $(32,000). D. $8,000.

5. If revenue was $45,000, expenses were $37,500, anddividends were $10,000, the amount of net incomeor net loss would be:A. $45,000 net income. C. $37,500 net loss.B. $7,500 net income. D. $2,500 net loss.

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Discussion Questions1. What is the objective of most businesses?

2. What is the difference between a manufacturingbusiness and a merchandising business? Give an ex-ample of each type of business.

3. What is the difference between a manufacturingbusiness and a service business? Is a restaurant amanufacturing business, a service business, or both?

4. Why are most large companies such as Microsoft,Pepsi, Caterpillar, and AutoZone organized as cor-porations?

5. Both KIA and Porche produce and sell automobiles.Describe and contrast their business strategies.

6. Assume that a friend of yours operates a family-owned pharmacy. A Super Wal-Mart that will offerpharmacy services is scheduled to open in the nextseveral months. What business strategy would yourfriend use to compete with the Super Wal-Martpharmacy?

7. How does eBay offer value to its customers?

8. A business’s stakeholders can be classified into capitalmarket, product or service market, government, andinternal stakeholders. Will the interests of all thestakeholders within a classification be the same? Usebankers and stockholders of the capital market as anexample in answering this question.

9. The three business activities are financing, investing,and operating. Using United Air Lines, give an exam-ple of a financing, investing, and operating activity.

10. What is the role of accounting in business?

11. Briefly describe the nature of the information pro-vided by each of the following financial statements:

the income statement, the retained earnings state-ment, the balance sheet, and the statement of cashflows. In your descriptions, indicate whether each ofthe financial statements covers a period of time or isfor a specific date.

12. For the year ending February 3, 2001, The LimitedInc. had revenues of $10,104,606,000 and total ex-penses of $9,676,701,000. Did The Limited (a) incura net loss or (b) realize net income?

13. What particular item of financial or operating dataappears on (a) both the income statement and theretained earnings statement, (b) both the balancesheet and the retained earnings statement, and (c)both the balance sheet and statement of cash flows?

14. Lynda Lyons is the owner of Fast Delivery Service.Recently, Lynda paid interest of $3,500 to FirstUnion on a personal loan of $60,000 that she used tobegin the business. Should Fast Delivery Servicerecord the interest payment? Explain.

15. On April 18, Neece Repair Service extended an offerof $95,000 for land that had been priced for sale at$100,000. On April 25, Neece Repair Service acceptedthe seller’s counteroffer of $97,500. Describe howNeece Repair Service should record the cost of theland.

16. Land with an assessed value of $200,000 for propertytax purposes was acquired by a business for$350,000. Seven years later, the plot of land has anassessed value of $240,000, and the business receivesan offer of $400,000 for it. Should the monetaryamount assigned to the land in the business recordsnow be increased?

ExercisesIndicate whether each of the following companies is primarily a service, merchandise, ormanufacturing business. If you are unfamiliar with the company, you may use the Internetto locate the company’s home page or use the finance web site of Yahoo.com.

1. Ford Motor2. Citigroup3. Sears, Roebuck4. AT&T5. H&R Block Inc.

EXERCISE 1-1Types of businesses

OBJECTIVE 1

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6. Boeing7. First Union Corporation8. Alcoa9. CVS

10. Caterpillar11. FedEx12. Dow Chemical13. The Gap14. Hilton Hotels15. Procter & Gamble

Identify the primary business strategy of each of the following companies as (a) a low-coststrategy, (b) a differentiation strategy, or (c) a combination strategy. If you are unfamiliarwith the company, you may use the Internet to locate the company’s home page or use thefinance web site of Yahoo.com.

1. Southwest Airlines2. Home Depot3. BMW4. Coca-Cola5. Target6. Goldman Sachs Group7. Sara Lee8. Delta Air Lines9. Circuit City Stores

10. Maytag11. Office Depot12. Nike13. Charles Schwab14. Dollar General15. General Motors

The total assets and total liabilities of Toys “R” Us Inc. and Estee Lauder Companies Inc.follow.

Toys “R” Us Estee Lauder Companies(in millions) (in millions)

Assets $8,003 $3,219Liabilities 4,585 1,867

Determine the stockholders’ equity of each company.

Determine the missing amounts (in millions) for the 2001 balance sheets (summarized below)for The Limited Inc., Federal Express Corporation, and Eastman Kodak Co.

Federal EastmanThe Limited Express Kodak

Assets $4,088 (b) $13,362Liabilities (a) $5,323 10,468Stockholders’ equity 2,317 4,248 (c)

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EXERCISE 1-2Business strategy

OBJECTIVE 1

EXERCISE 1-3Accounting equation

OBJECTIVE 4

EXERCISE 1-4Accounting equation

OBJECTIVE 4

✓ a. $1,771

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Four different corporations—W, X, Y, and Z—show the same balance sheet data at thebeginning and end of a year. These data, exclusive of the amount of stockholders’ equity, aresummarized as follows:

Total TotalAssets Liabilities

Beginning of the year $375,000 $150,000End of the year $600,000 $325,000

On the basis of these data and the following additional information for the year, determinethe net income (or loss) of each company for the year. (Hint: First determine the amount ofincrease or decrease in stockholders’ equity during the year.)

Company W: No additional capital stock was issued and no dividends were paid.Company X: No additional capital stock was issued, but dividends of $30,000 were paid.Company Y: Capital stock of $75,000 was issued, but no dividends were paid.Company Z: Capital stock of $75,000 was issued, and dividends of $30,000 were paid.

Staples, Inc., is a leading office products distributor with a total of 1,307 retail stores in theUnited States, Canada, the United Kingdom, the Netherlands, and Portugal. The followingfinancial statement data were taken from Staples’ financial statements as of February 3, 2001and 2000:

2001 2000(in thousands) (in thousands)

Total assets $3,989,413 $3,846,076Total liabilities (1) 2,017,263Total stockholders’ equity 1,763,830 (2)Retained earnings 1,008,021 948,309

Sales $10,673,671Cost of goods sold 8,097,166Operating and other expenses 2,332,320Income tax expense 184,473

a. Determine the missing data indicated for (1) and (2).b. Using the income statement data for 2001, determine the amount of net income or loss.c. Did Staples pay any dividends to stockholders during 2001? [Hint: Compare the change

in retained earnings to your answer for (b).]

The list of selected items taken from the records of Kagy Appliance Service as of a specificdate follow.

a. Identify those that would appear on the balance sheet.b. Identify those items that would appear on the income statement.

1. Utilities Expense 6. Cash2. Fees Earned 7. Supplies Expense3. Supplies 8. Land4. Wages Expense 9. Capital Stock5. Accounts Payable 10. Wages Payable

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EXERCISE 1-5Net income andstockholders’ equity forfour businesses

OBJECTIVE 4

✓ Company Y: Net loss,($25,000)

EXERCISE 1-6Accounting equation andincome statement

OBJECTIVE 4

✓ 1. $2,225,583

EXERCISE 1-7Balance sheet andincome statement items

OBJECTIVE 4

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Identify each of the following items as (a) an asset, (b) a liability, (c) revenue, (d) expense,or (e) dividend:

1. Supplies used2. Cash sales3. Equipment4. Cash paid to stockholders5. Amounts owed vendors6. Cash on hand7. Wages paid employees8. Sales commissions paid salespersons9. Amounts due from customers

10. Note payable owed to the bank

Financial information related to Douma Company for the month ended June 30, 2003, is asfollows:

Net income for June $ 91,250Dividends during June 15,000Retained earnings, June 1, 2003 317,500

Prepare a retained earnings statement for the month ended June 30, 2003.

Surgery Services was organized on April 1, 2003. A summary of the revenue and expensetransactions for April follows:

Fees Earned $165,800Wages Expense 71,500Miscellaneous Expense 2,250Rent Expense 25,000Supplies Expense 3,250

Prepare an income statement for the month ended April 30.

One item is omitted in each of the following summaries of balance sheet and income state-ment data for four different corporations, I, II, III, and IV.

I II III IVBeginning of the year:

Assets $600,000 $125,000 $100,000 (d)Liabilities 360,000 65,000 76,000 $150,000

End of the year:Assets 745,000 175,000 90,000 310,000Liabilities 325,000 55,000 80,000 170,000

During the year:Additional issue of capital stock (a) 25,000 10,000 50,000Dividends 40,000 8,000 (c) 75,000

Revenue 197,750 (b) 115,000 140,000Expenses 108,000 32,000 122,500 160,000

Determine the missing amounts, identifying them by letter. (Hint: First determine theamount of increase or decrease in stockholders’ equity during the year.)

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EXERCISE 1-8Financial statementitems

OBJECTIVE 4

EXERCISE 1-9Retained earningsstatement

OBJECTIVE 4

✓ Retained earnings, June 30, 2003: $393,750

EXERCISE 1-10Income statement

OBJECTIVE 4

✓ Net income: $63,800

EXERCISE 1-11Missing amounts frombalance sheet andincome statement data

OBJECTIVE 4

✓ (a) $130,250

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Financial information related to Revival Interiors for August and September of 2004 is asfollows:

August 31, 2004 September 30, 2004Accounts Payable $ 3,850 $ 4,150Accounts Receivable 8,500 9,780Capital Stock 10,000 10,000Retained Earnings ? ?Cash 15,000 25,500Supplies 750 600

a. Prepare balance sheets for Revival Interiors as of August 31 and as of September 30, 2004.b. Determine the amount of net income for September, assuming that no additional capital

stock was issued and no dividends were paid.c. Determine the amount of net income for September, assuming that no additional capital

stock was issued but dividends of $7,500 were paid.

Each of the following items is shown in the financial statements of ExxonMobil Corporation.Identify the financial statement (balance sheet or income statement) in which each itemwould appear.

a. Operating expenses h. Notes and loans payableb. Crude oil inventory i. Cash equivalentsc. Income taxes payable j. Long-term debtd. Sales k. Selling expensese. Investments l. Retained earningsf. Marketable securities m. Equipmentg. Exploration expenses

Indicate whether each of the following cash activities would be reported on the statement ofcash flows as (a) an operating activity, (b) an investing activity, or (c) a financing activity.

1. Paid for advertising2. Paid for office equipment3. Issued capital stock4. Paid officers’ salaries5. Collected accounts receivable6. Paid for supplies7. Paid dividends8. Issued a note payable.9. Paid accounts payable.

10. Sold excess office equipment.

Indicate whether each of the following activities would be reported on the statement of cashflows as (a) an operating activity, (b) an investing activity, or (c) a financing activity.

1. Cash received from investment by stockholders2. Cash paid for land3. Cash received from fees earned4. Cash paid for expenses

Cremation Services was organized on January 1, 2004. A summary of cash flows for Januaryfollows.

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EXERCISE 1-12Balance sheets, netincome

OBJECTIVE 4

✓ b. $11,330

EXERCISE 1-13Financial statements

OBJECTIVE 4

EXERCISE 1-14Statement of cash flows

OBJECTIVE 4

EXERCISE 1-15Statement of cash flows

OBJECTIVE 4

EXERCISE 1-16Statement of cash flows

OBJECTIVE 4

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Cash receipts:Cash received from customers $23,500Cash received for capital stock 90,000Cash received from note payable 10,000

Cash payments:Cash paid out for expenses $ 8,350Cash paid out for purchase of furnace 75,000Cash paid as dividends 5,000

Prepare a statement of cash flows for the month ended January 31, 2004.

The financial statement focus of a company’s stakeholders often differs. For example, somestakeholders focus primarily on the income statement, and others focus primarily on thestatement of cash flows or the balance sheet. For each of the following situations, indicatewhich financial statement would be the likely focus for the stakeholder. Choose either theincome statement, balance sheet, or the statement of cash flows and justify your choice.

Situation 1:Assume that you are a banker for Citigroup (capital market stakeholder), consideringwhether to grant a major credit line (loan) to Wal-Mart. The credit line would allow Wal-Mart to borrow up to $400 million for a five-year period at the market rate of interest.

Situation 2:Assume that you employed by Sara Lee Corporation (product market stakeholder) and areconsidering whether to extend credit for a 60-day period to a new grocery store chain thathas recently opened throughout the Midwest.

Situation 3:Assume that you are considering investing in Amazon.com (capital market stakeholder).

Situation 4:Assume that you are considering taking a job (internal stakeholder) with either Sears orJC Penney.

Situation 5:Assume that you are considering purchasing a personal computer from Gateway.

Starbucks Corporation purchases and roasts high-quality whole bean coffees and sells them,along with fresh, rich-brewed coffees, Italian-style espresso beverages, cold blended bever-ages, a variety of pastries and confections, coffee-related accessories and equipment, a selec-tion of premium teas, and a line of compact discs, primarily through company-operatedretail stores.

The following items were adapted from the annual report of Starbucks Corporation forthe period ending September 30, 2001:

In Thousands1. Accounts payable $ 127,9052. Accounts receivable 90,4553. Accrued expenses payable 244,7244. Additions to property, plant, and equipment 384,2155. Checks drawn in excess of bank balance 61,9876. Cost of sales 1,112,7857. General and administrative expenses 151,4168. Income tax expense 107,7129. Net cash provided by operating activities 460,826

(continued)

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EXERCISE 1-17Using financialstatements

OBJECTIVE 4

EXERCISE 1-18Financial statementitems

OBJECTIVE 4

✓ Net cash flow fromoperating activities: $15,150

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In Thousands10. Net sales 2,648,98011. Other operating expenses 256,82712. Other income (loss) 36,44313. Property, plant, and equipment 1,135,78414. Retained earnings (September 30, 2001) 589,71315. Store operating expenses 875,473

Using the following notation, indicate on which financial statement you would find each ofthe 15 items:

IS Income statementRE Retained earnings statementBS Balance sheetSCF Statement of cash flows

Based on the Starbucks Corporation financial statement data in Exercise 1-18, prepare anincome statement for the year ending September 30, 2001.

Based on the Starbucks Corporation financial statement data in Exercise 1-18, prepare aretained earnings statement for the year ending September 30, 2001. The retained earningsas of October 1, 2000, was $408,503, and Starbucks paid no dividends during the year.

The McDonald’s menu of hamburgers, cheeseburgers, the Big Mac, Quarter Pounder, Filet-O-Fish, and Chicken McNuggets is familiar, but McDonald’s financial statements probably arenot so familiar. The following items were adapted from a recent annual report of McDonald’sCorporation:

1. Accounts payable2. Accrued interest payable3. Cash4. Cash provided by operations5. Capital stock outstanding6. Food and packaging costs used in operations7. Income tax expense8. Interest expense9. Inventories

10. Long-term debt payable11. Net income12. Net increase in cash13. Notes payable14. Notes receivable15. Occupancy and rent expense16. Payroll expense17. Prepaid expenses not yet used in operations18. Property and equipment19. Retained earnings20. Sales

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EXERCISE 1-19Income statement

OBJECTIVE 4

✓ Net income: $181,210

EXERCISE 1-21Financial statementitems

OBJECTIVE 4

EXERCISE 1-20Retained earningsstatement

OBJECTIVE 4

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Identify the financial statement on which each of the preceding items would appear. An itemmay appear on more than one statement. Use the following notation:

IS Income statementRE Retained earnings statementBS Balance sheetSCF Statement of cash flows

Aspen Realty, organized February 1, 2004, is owned and operated by Lynn Soby. How manyerrors can you find in the following financial statements for Aspen Realty, prepared after itssecond month of operations?

Aspen RealtyIncome StatementMarch 31, 2004

Sales commissions $37,100Operating expenses:

Office salaries expense $23,150Rent expense 7,800Automobile expense 1,750Miscellaneous expense 550Supplies expense 225

Total operating expenses 33,475Net income $13,625

Lynn SobyRetained Earnings Statement

March 31, 2003Retained earnings, March 1, 2004 $ 2,450Less dividends during March 1,000

$ 1,450Net income for the month 13,625Retained earnings, March 31, 2004 $16,075

Balance SheetFor the Month Ended March 31, 2004

AssetsCash $ 2,350Accounts payable 2,300Total assets $ 4,650

LiabilitiesAccounts receivable $10,200Supplies 1,325

Stockholders’ EquityCapital stock $ 6,500Retained earnings 15,075 21,575Total liabilities and stockholders’ equity $33,100

Match each of the following statements with the appropriate accounting concept. Someconcepts can be used more than once, and others might not be used at all. Use the notationon the following page to indicate the appropriate accounting concept.

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EXERCISE 1-22Financial statements

OBJECTIVE 4

✓ Correct Amount ofTotal Assets is $13,875

EXERCISE 1-23Accounting concepts

OBJECTIVE 5

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Accounting Concept NotationAccounting period concept PAdequate disclosure concept DBusiness entity concept BCost concept CGoing concern concept GMatching concept MObjectivity concept OUnit of measure concept U

Statements1. ____ The changes in financial condition are reported for November.2. ____ Personal transactions of owners are kept separate from the business.3. ____ Land worth $500,000 is reported at its original purchase price of $120,000.4. ____ Assume that a business will continue forever.5. ____ This concept supports relying on an independent actuary (statistician), rather than

the chief operating officer of the corporation, to estimate a pension liability.6. ____ This concept justifies recording only transactions that are expressed in dollars.7. ____ Material litigation involving the corporation is described in a footnote.8. ____ December utilities costs are reported as expenses along with the December revenues.9. ____ If this concept were ignored, the confidence of users in the financial statements

could not be maintained.10. ____ Changes in the use of accounting methods from one period to the next are described

in the notes to the financial statements.

Bag-One Sports Inc. sells hunting and fishing equipment and provides guided hunting andfishing trips. Bag-One Sports Inc. is owned and operated by Marc Trailer, a well-knownsports enthusiast and hunter. Marc’s wife, Robin, owns and operates Red Bird Boutique Inc.,a women’s clothing store. Marc and Robin have established a trust fund to finance theirchildren’s college education. The trust fund is maintained by First Wyoming Bank in thename of the children, Sparrow and Trout.

For each of the following transactions, identify which of the entities listed should recordthe transaction in its records.

EntitiesB Bag-One Sports Inc.F First Wyoming BankR Red Bird Boutique Inc.X None of the above

1. Marc received a cash advance from customers for a guided hunting trip.2. Robin deposited a $5,000 personal check in the trust fund at First Wyoming Bank.3. Robin purchased three dozen spring dresses from a Denver designer for a special spring

sale.4. Marc paid a local doctor for his annual physical, which was required by the worker’s

compensation insurance policy carried by Bag-One Sports Inc.5. Marc paid for an advertisement in a hunters’ magazine.6. Robin purchased mutual fund shares as an investment for the children’s trust.7. Marc paid for dinner and a movie to celebrate their tenth wedding anniversary.8. Robin donated several dresses from inventory to a local charity auction for the benefit of

a women’s abuse shelter.9. Marc paid a breeder’s fee for an English springer spaniel to be used as a hunting guide dog.

10. Robin paid her dues to the Young Republican’s Club.

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EXERCISE 1-24Business entity concept

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ProblemsThe financial statements at the end of Magic Realty Inc.’s first month of operations follow.

Magic Realty Inc.Income Statement

For the Month Ended April 30, 2004Fees earned $ (a)Operating expenses:

Wages expense $4,250Rent expense 1,600Utilities expense (b)Supplies expense 900Miscellaneous expenses 550

Total operating expenses 8,800Net income $ (c)

Magic Realty Inc.Retained Earnings Statement

For the Month Ended April 30, 2004Net income for April $ (c)Less dividends 3,000Retained earnings, April 30, 2004 $ (d)

Magic Realty Inc.Balance SheetApril 30, 2004

AssetsCash $ 2,900Supplies 1,100Land 20,000Total assets $ (e)

LiabilitiesAccounts payable $ 800

Stockholders’ EquityCapital stock $20,000Retained earnings (f) (g)Total liabilities and stockholders’ equity $ (h)

Magic Realty Inc.Statement of Cash Flows

For the Month Ended April 30, 2004Cash flows from operating activities:

Cash received from customers $ (i)Deduct cash payments for expenses and payments to creditors 9,100Net cash flows from operating activities $ (j)

Cash flows from investing activities:Cash payment for purchase of land (k)

Cash flows from financing activities:Cash received from issuing capital stock (l)Deduct dividends (m)Net cash flows from financing activities (n)

Net cash flow and April 30, 2004 cash balance $ (o)

PROBLEM 1 1Missing amounts fromfinancial statements

OBJECTIVE 4

✓ a. $15,000

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Instructions1. Would you classify a realty business such as Magic Realty as a manufacturing, merchan-

dising, or service business?2. By analyzing the interrelationships between the financial statements, determine the

proper amounts for (a) through (o).

Following are the amounts of the assets and liabilities of Fly Away Travel Agency at December31, 2004, the end of the current year, and its revenue and expenses for the year. The retainedearnings were $4,500 and the capital stock was $10,000 on January 1, 2004, the beginning ofthe current year. During the current year, dividends of $30,000 were paid.

Accounts Payable $ 3,200Accounts Receivable 19,500Cash 7,200Fees Earned 117,480Miscellaneous Expense 1,750Rent Expense 27,000Supplies 1,865Supplies Expense 2,125Utilities Expense 10,240Wages Expense 35,500

Instructions1. Prepare an income statement for the current year ended December 31, 2004.2. Prepare a retained earnings statement for the current year ended December 31, 2004.3. Prepare a balance sheet as of December 31, 2004.

The following financial data were adapted from the annual report of Best Buy Inc. for theperiod ending March 31, 2001:

In ThousandsAccounts payable $ 1,772,722Accrued liabilities 827,036Capital stock 493,786Cash 746,879Cost of goods sold 12,267,459Income taxes 245,640Interest income 37,171Inventories 1,766,934Goodwill 385,355Other assets 183,370Other liabilities 417,901Property, plant, and equipment 1,444,172Receivables 209,031Retained earnings (February 26, 2000) 828,457Sales 15,326,552Selling, general, and administrative expenses 2,454,785

Instructions1. Prepare Best Buy’s income statement for the year ending March 31, 2001.2. Prepare Best Buy’s retained earnings statement for the year ending March 31, 2001.

(Note: During the year, Best Buy did not pay any dividends.)3. Prepare a balance sheet as of March 31, 2001, for Best Buy.

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PROBLEM 1 3Income statement,retained earningsstatement, and balancesheet

OBJECTIVE 4

✓ Net income: $395,839

PROBLEM 1 2Income statement,retained earningsstatement, and balancesheet

OBJECTIVE 4

✓ Net income: $40,865

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The following cash data were adapted from the annual report of Best Buy Inc. for the periodending March 31, 2001. The cash balance as of April 1, 2000, was $750,723 (in thousands).

Payments for property, plant, and equipment $657,706Payments for purchase of other long-term assets 372,096Payments for long-term debt 17,625Net cash flows from operating activities 808,204Receipts from issuing capital stock 235,379

InstructionsPrepare Best Buy’s statement of cash flows for the year ending March 31, 2001.

Lamar Corporation began operations on January 1, 2004, as an online retailer of computersoftware and hardware. The following financial statement data were taken from Lamar’srecords at the end of its first year of operations, December 31, 2004.

Accounts payable $ 30,000Accounts receivable 48,000Cash ?Cash receipts from operating activities 837,000Cash payments for operating activities 700,000Capital stock 250,000Cost of sales 400,000Dividends 25,000Income tax expense 140,000Income taxes payable 20,000Interest expense 15,000Inventories 90,000Note payable due in 2010 100,000Property, plant, and equipment 378,000Retained earnings ?Sales 885,000Selling and administrative expense 105,000

Instructions1. Prepare an income statement for the year ending December 31, 2004.2. Prepare a retained earnings statement for the year ending December 31, 2004.3. Prepare a balance sheet as of December 31, 2004.4. Prepare a statement of cash flows for the year ending December 31, 2004.

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PROBLEM 1 4Statement of cash flows

OBJECTIVE 4

✓ Net decrease in cash:$3,844

PROBLEM 1 5Financial statements,including statement ofcash flows

OBJECTIVE 4

✓ Net income: $225,000

ActivitiesAssume that you are the chief executive officer for Gold Kist Inc., a national poultry producer.The company’s operations include hatching chickens through the use of breeder stock andfeeding, raising, and processing the mature chicks into finished products. The finished productsinclude breaded chicken nuggets and patties and deboned, skinless and marinated chicken.Gold Kist sells its products to schools, military services, fast-food chains, and grocery stores.

In groups of four or five, discuss the following business strategy and risk issues:

1. In a commodity business like poultry production, what do you think is the dominantbusiness strategy? What are the implications for this dominant strategy for how youwould run Gold Kist? (continued)

Activity 1-1Business strategy

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2. Identify at least two major business risks for operating Gold Kist.3. How could Gold Kist try to differentiate its products?

Joel Phinney, president of Phinney Enterprises, applied for a $150,000 loan from BridgerNational Bank. The bank requested financial statements from Phinney Enterprises as a basisfor granting the loan. Joel has told his accountant to provide the bank a balance sheet. Joelhas decided to omit the other financial statements because there was a net loss during thepast year.

In groups of three or four, discuss the following questions:

1. Is Joel behaving in a professional manner by omitting some of the financial statements?2. a. What types of information about their businesses would owners be willing to provide

bankers? What types of information would owners not be willing to provide?b. What types of information about a business would bankers want before extending a

loan?c. What common interests are shared by bankers and business owners?

On January 3, 2004, Dr. Brittany North established Expert Opinion, a medical practice orga-nized as a proprietorship. The following conversation occurred the following August betweenDr. North and a former medical school classmate, Dr. Charles Ryder, at an American MedicalAssociation convention in Bermuda.

Dr. Ryder: Brittany, good to see you again. Why didn’t you call when you were in Las Vegas?We could have had dinner together.

Dr. North: Actually, I never made it to Las Vegas this year. My husband and kids went up toour Lake Tahoe condo twice, but I got stuck in New York. I opened a new consultingpractice this January and haven’t had any time for myself since.

Dr. Ryder: I heard about it . . . Expert . . . something . . . right?Dr. North: Yes, Expert Opinion. My husband chose the name.Dr. Ryder: I’ve thought about doing something like that. Are you making any money? I mean,

is it worth your time?Dr. North: You wouldn’t believe it. I started by opening a bank account with $30,000, and

my July bank statement has a balance of $180,000. Not bad for seven months—all pureprofit.

Dr. Ryder: Maybe I’ll try it in Las Vegas. Let’s have breakfast together tomorrow and you canfill me in on the details.

Comment on Dr. North’s statement that the difference between the opening bank balance($30,000) and the July statement balance ($180,000) is pure profit.

Obtain the annual reports for three well-known companies, such as Ford Motor Co.,General Motors, IBM, Microsoft, or Amazon.com. These annual reports can be obtainedfrom a library or the company’s 10-K filing with the Securities and Exchange Commissionat http://www.sec.gov/edgar.shtml.

To obtain annual report information, key in the company name on the “Search EDGARArchives” form. EDGAR will list the reports available for the company. Click on the 10-K(or 10-K405) report for the year you want to download. If you wish, you can save the whole10-K report to a file and then open it with your word processor.

Examine the balance sheet for each company and determine the total assets, liabilities, andstockholders’ equity. Verify that total assets equal the total of the liabilities plus stockholders’equity.

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Activity 1-2Ethics and professionalconduct in business

Activity 1-3Net income vs. cash flow

Activity 1-4The accounting equation

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The financial statements of Hershey Foods Corporation are shown in Exhibits 5 through 8of this chapter. Based upon these statements, answer the following questions.

1. What are Hershey’s sales (in thousands)?2. What is Hershey’s cost of sales (in thousands)?3. What is Hershey’s net income (in thousands)?4. What is Hershey’s percentage of the cost of sales to sales? Round to one decimal point.5. The percentage that a company adds to its cost of sales to determine the selling price is

called a markup. What is Hershey’s markup percentage? Round to one decimal point.6. What is the percentage of net income to sales for Hershey’s? Round to one decimal

point.

The following data were adapted from the December 31, 2001, financial statements of TootsieRoll Industries Inc.:

In ThousandsSales $423,496Cost of goods sold 216,657Net income 65,687

1. What is Tootsie Roll’s percentage of the cost of sales to sales? Round to one decimalpoint.

2. The percentage a company adds to its cost of sales to determine selling price is called amarkup. What is Tootsie Roll’s markup percentage? Round to one decimal point.

3. What is the percentage of net income to sales for Tootsie Roll? Round to one decimalpoint.

4. Compare your answers to (2) and (3) with those of Hershey Foods Corporation inActivity 1-5. What are your conclusions?

The following data were adapted from the January 31, 2000 and 1999, financial statements(in millions) of Kmart Corporation:

For year ending. . . .2000 1999

Sales $37,028 $35,925Cost of sales 29,658 28,111Selling, general, and administrative expenses 7,415 6,514

1. Prepare a horizontal analysis income statement for Kmart Corporation that includesgross profit and operating income before taxes. Round to one decimal place.

2. Comment on the results of your horizontal analysis of Kmart.

Enron Corporation, headquartered in Houston, Texas, until recently provided productsand services to natural gas, electricity, and communications wholesale and retail customers.Enron’s operations were conducted through a variety of subsidiaries and affiliates that in-volve transporting gas through pipelines, transmitting electricity, and managing energycommodities. The following data were taken from Enron’s December 31, 2000, financialstatements.

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Activity 1-5Hershey’s annual report

Activity 1-6Income statement analysis

Activity 1-7Horizontal analysis

Activity 1-8Financial analysis ofEnron Corporation

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In MillionsTotal revenues $100,789Total costs and expenses 98,836Operating income 1,953Net income $ 979

Total assets $ 65,503Total liabilities 54,033Total stockholders’ equity $ 11,470

Net cash flows from operating activities $ 4,779Net cash flows from investing activities (4,264)Net cash flows from financing activities 571Net increase in cash $ 1,086

At the end of 2000, the market price of Enron’s stock was approximately $83 per share. Asof March 15, 2002, Enron’s stock was selling for $0.22 per share.

Review the preceding financial statement data and search the Internet for articles onEnron Corporation. Briefly explain why Enron’s stock dropped so dramatically in such ashort time.

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Answers to Self-Study Questions1. D A corporation, organized in accordance with stateor federal statutes, is a separate legal entity in whichownership is divided into shares of stock (answer D). Aproprietorship (answer A) is an unincorporated businessowned by one individual. A service business (answer B)provides services to its customers. It can be organized asa proprietorship, partnership, or corporation. A partner-ship (answer C) is an unincorporated business owned bytwo or more individuals.

2. A The resources owned by a business are called assets(answer A). The debts of the business are called liabilities(answer B), and the equity of the owners is called owners’equity (answer D). The relationship between assets, lia-bilities, and owners’ equity is expressed as the accountingequation (answer C).

3. A The balance sheet is a listing of the assets, liabili-ties, and owner’s equity of a business at a specific date(answer A). The income statement (answer B) is a sum-mary of the revenue and expenses of a business for aspecific period of time. The retained earnings statement(answer C) summarizes the changes in retained earnings

during a specific period of time. The statement of cashflows (answer D) summarizes the cash receipts and cashpayments for a specific period of time.

4. D The accounting equation is:

Assets � Liabilities � Owners’ Equity

Therefore, if assets are $20,000 and liabilities are $12,000,stockholders’ equity is $8,000 (answer D), as indicated inthe following computation:

Liabilities �Assets � Stockholders’ Equity

�$20,000 � �$12,000 � Stockholders’ Equity�$20,000 � $12,000 � Stockholders’ Equity�$8,000 � Stockholders’ Equity

5. B Net income is the excess of revenue over expenses,or $7,500 (answer B). If expenses exceed revenue, thedifference is a net loss. Dividends are the opposite of thestockholders investing in the business and do not affectthe amount of net income or net loss.

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