CHAPTER 1

Introduction to Financial Statements

Learning Objectives

1. Identify the forms of business organization and the uses of accounting information.
2. Explain the three principal types of business activity.
3. Describe the four financial statements, and how they are prepared.

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 1.2

(a) 4 Investors in common stock

(b) 3 Marketing managers
(c) 2 Creditors
(d) 5 Chief Financial Officer
(e) 1 Internal Revenue Service

BRIEF EXERCISE 1.3

O (a) Cash received from customers.

F (b) Cash paid to stockholders (dividends).
F (c) Cash received from issuing new common stock.
O (d) Cash paid to suppliers.
I (e) Cash paid to purchase a new office building.

BRIEF EXERCISE 1.4

E (a) Advertising expense

R (b) Service revenue
E (c) Insurance expense
E (d) Salaries and wages expense
D (e) Dividends
R (f) Rent revenue
E (g) Utilities expense
NSE (h) Cash purchase of equipment
C (i) Issued common stock for cash.
BRIEF EXERCISE 1.6

IS (a) Income tax expense

BS (b) Inventory
BS (c) Accounts payable
BS (d) Retained earnings
BS (e) Equipment
IS (f) Sales revenue
IS (g) Cost of goods sold
BS (h) Common stock
BS (i) Accounts Receivable
IS (j) Interest expense

BRIEF EXERCISE 1.7

IS (a) Revenue during the period.

BS (b) Supplies on hand at the end of the year.
SCF (c) Cash received from issuing new bonds during the period.
BS (d) Total debts outstanding at the end of the period.

BRIEF EXERCISE 1.8

(a) $90,000 + $230,000 = $320,000 (Total assets)

(Liabilities + Stockholder’s equity = Assets)
($90,000 + $230,000 = $320,000)

(b) $170,000 – $80,000 = $90,000 (Total liabilities)

(Assets – Stockholder’s equity = Liabilities)
($170,000 - $80,000 = $90,000)

(c) $800,000 – 0.25($800,000) = $600,000 (Stockholders’ equity)

(Assets – (1/4 × Assets) = Stockholder’s equity)
[$800,000 – (0.25 x $800,000) = $600,000]
EXERCISE 1.2

a. 8 Assets = Liabilities + Stockholders’ Equity.

b. 1 An individual who has met certain criteria and is thus allowed to
perform audits of corporations.
c. 4 Payments of cash from a corporation to its stockholders.
d. 9 The cost of assets consumed or services used in the process of
generating revenues.
e.10 Amounts owed to creditors in the form of debts and other
obligations.
f. 2 A section of the annual report that presents management’s views
on the company’s ability to pay near-term obligations, its ability to
fund operations and expansion, and its results of operations.
g. 6 The amount by which expenses exceed revenues.
h. 3 The increase in assets or decrease in liabilities resulting from the
sale of goods or the performance of services in the normal course
of business.
i. 11 Regulations passed by Congress to reduce unethical corporate
behavior.
j. 7 A business owned by one person.
k. 5 The owner’s claim to assets.

EXERCISE 1.6

(a) MERCK AND CO.

Income Statement
For the Year Ended December 31, 2022
(in millions)

Revenues
Sales revenue.................................................. $38,576.0
Expenses
Cost of goods sold.......................................... $ 9,018.9
Selling and administrative expenses............. 8,543.2
Research and development expense............. 5,845.0
Income tax expense........................................   2,267.6
 Total expenses.............................................  25,674.7
Net income................................................................ $12,901.3

(Sales rev. – Tot. exp. = Net inc.)

[$38,576.0 – ($9,018.9 + $8,643.2 + $5,845.0 + $2,267.6) = $12,901.3]
 MERCK AND CO.
Retained Earnings Statement
For the Year Ended December 31, 2022
(in millions)

Retained earnings, January 1.................................. $43,698.8

Add: Net income.................................................... 12,901.3
56,600.1
Less: Dividends....................................................... 3,597.7
Retained earnings, December 31............................ $53,002.4

(Beg. ret. earn. + Net inc. – Div. = End. ret. earn.)

($43,698.8 + $12,901.3 - $3,597.7 = $53,002.4]

(b) The short-term implication would be a decrease in expenses of $2,922.5

($5,845 X 50%) resulting in a corresponding increase in income (ignoring
income taxes). If all other revenues and expenses remain unchanged,
decreasing research and development expenses would produce 22.7%
more net income ($2,922.5 ÷ $12,901.3).

The long-term implications would be more difficult to quantify but it is

safe to predict that a reduction in research and development expenses
would probably result in lower sales revenues in the future. Pharma-
ceutical companies are usually able to charge higher prices for newly
developed products while lower cost generic versions usually replace
older products. Decreasing research and development activities will
probably mean fewer new products.

The stock market’s initial reaction might be positive since Merck’s net
income would increase significantly. Such a reaction would probably
be very short-lived as more knowledgeable investors reviewed Merck’s
financial statements and discovered the cause of the increase.
EXERCISE 1.8

Randall Inc.
Balance Sheet
December 31, 2022

Assets
Cash........................................................................... $6,250
Accounts receivable.................................................  2,400
Inventory....................................................................   2,840
Supplies..................................................................... 3,760
Equipment (net).........................................................   108,200
    Total assets........................................................... $123,450

Liabilities and Stockholders’ Equity

Liabilities
Accounts payable......................................... $ 3,700
Notes payable................................................  31,500
Interest payable.............................................  580
Unearned service revenue...........................        850
    Total liabilities.................................................. $36,630
Stock holders’ equity
Common Stock.............................................. 50,700
Retained earnings**......................................   36,120
    Total stockholders’ equity*.............................    86,820
Total liabilities and stockholders’ equity. $123,450

*Tot. liabl. and SE – Total liabl. = Tot.al SE

$123,450 – $36,630 = $86,820
**Tot. SE – Common stk. = Ret. earn.
$86,820 – $50,700 = $36,120

EXERCISE 1.12

First note that the retained earnings statement shows that (b) equals $27,000.

Accounts payable + Common stock + Retained earnings = Total liabilities and stockholders’ equity

$5,000 + a + $27,000 = $62,000

a + $32,000 = $62,000
a = $30,000
Beginning retained earnings + Net income – Dividends = Ending retained earnings

$12,000 + e – $5,000 = $27,000

$7,000 + e = $27,000
e = $20,000

From above, we know that net income (d) equals $20,000.

Revenue – Cost of goods sold – Salaries and wages expense = Net income

$85,000 – c – $10,000 = $20,000

$75,000 – c = $20,000
c = $55,000

EXERCISE 1.21

(a) Financial statements

(b) Auditor’s opinion
(c) Notes to the financial statements
(d) Financial statements
(e) Management discussion and analysis
(f) Not disclosed

SOLUTIONS TO PROBLEMS

PROBLEM 1.1A

(a) The concern over legal liability would make the corporate form a better
choice over a partnership. Also, the corporate form will allow the busi-
ness to raise cash more easily, which may be of importance in a rapidly
growing industry.

(b) Bob should run his business as a sole proprietor. He has no real need
to raise funds, and he doesn’t need the expertise provided by other
partners. The sole proprietorship form would provide the easiest form.
One should avoid a more complicated form of business unless the
characteristics of that form are needed.

(c) The fact that the combined business expects that it will need to raise
significant funds in the near future makes the corporate form more
desirable in this case.
(d) It is likely that this business would form as a partnership. Its needs for
additional funds would probably be minimal in the foreseeable future.
Also, the three know each other well and would appear to be con-
tributing equally to the firm. Service firms, like consulting businesses,
are frequently formed as partnerships.

(e) One way to ensure control would be for Don to form a sole proprietor-
ship. However, in order for this business to thrive it will need a
substantial investment of funds early. This would suggest the corpo-
rate form of business. In order for Don to maintain control over the
business he would need to own more than 50 percent of the voting
shares of common stock. In order for the business to grow, he may
have to be willing to give up some control.

PROBLEM 1.2A

(a) In deciding whether to extend credit for 30 days, The North Face would
be most interested in the balance sheet because the balance sheet
shows the assets on hand that would be available for settlement of the
debt in the near-term.

(b) In purchasing an investment that will be held for an extended period,

the investor must try to predict the future performance of Amazon.com.
The income statement provides the most useful information for pre-
dicting future performance.

(c) In extending a loan for a relatively long period of time, the lender is most
interested in the probability that the company will generate sufficient
income to meet its interest payments and repay its principal. The lender
would therefore be interested in predicting future net income using the
income statement. It should be noted, however, that the lender would
also be very interested in both the balance sheet and statement of cash
flows—the balance sheet because it would show the amount of debt the
company had already incurred, as well as assets that could be liquidated
to repay the loan. And the company would be interested in the statement
of cash flows because it would provide useful information for predicting
the company’s ability to generate cash to repay its obligations.
(d) The president would probably be most interested in the statement of
cash flows since it shows how much cash the company generates and
how that cash is used. The statement of cash flows can be used to
predict the company’s future cash-generating ability.

PROBLEM 1.4A

REESE INC
Income Statement
For the Month Ended October 31, 2022

Revenues:
Service revenue.................................................. $20,920
Expenses:
Salaries and Wages expense............................. $2,500
Interest expense................................................. 410
Supplies expense............................................... 380
Depreciation expense......................................... 270
Total expense.................................................     3,560
Net Income $17,360

(Serv. rev. – Tot. exp. = Net inc.)

[$20,920 – ($2,500 + $410 + $380 + $270) = $17,360]

REESE INC
Retained Earnings Statement
For the Month Ended October 31, 2022

Retained earnings, October 1................................. $         0

Add: Net income......................................................   17,360
Retained earnings, October 31 $17,360

(Beg. ret. earn. + Net inc. = End. ret. earn)

($0 + $17,360 = $17,360)

REESE INC
Balance Sheet
October 31, 2022

Assets
Cash.......................................................................... $ 3,950
Accounts receivable................................................     1,300
 Supplies....................................................................     2,460
Equipment (net)........................................................    48,200
Total assets $55,910

Liabilities and Stockholders’ Equity

Liabilities
Bonds Payable.................................................... $21,500
Accounts Payable...............................................     3,300
Unearned Service revenue.................................     4,065
Salaries and wages payable..............................        445
Interest Payable..................................................        140
Total Liabilities $  29,450
Stockholders’ Equity
Common Stock....................................................     9,100
Retained Earnings..............................................   17,360
Total Stockholders’ Equity     26,460
Total liabilities and Stockholders’ Equity $  55,910

(Assets = Liabl. + SE)

[($3,950 + $1,300 + $2,460 + $48,200) = (($21,500 + $3,300 + $4,065 + $445 + $140) + ($9,100 + $17,360))]
LO 3 BT: AP Difficulty: Medium TOT: 30 min. AACSB: Analytic AICPA FC: Reporting