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CHAPTER 1: INTRODUCTION TO FINANCIAL
STATEMENTS
© Dan Moore/iStockphoto
The Navigator
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Scan Learning Objectives
Read Feature Story
Scan Preview
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Read Text and Answer
p. 5
Work Using the Decision Toolkit
Review Summary of Learning Objectives
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Work Comprehensive
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Answer Self-Test Questions
Complete Assignments
Go to WileyPLUS for practice and tutorials
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p. 24
Read A Look at IFRS p. 43
LEARNING OBJECTIVES
p. 11
p. 18
p. 21
After studying this chapter, you should be able to:
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1 Describe the primary forms of business organization.
2 Identify the users and uses of accounting information.
3 Explain the three principal types of business activity.
4 Describe the content and purpose of each of the financial statements.
5 Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic
accounting equation.
6 Describe the components that supplement the financial statements in an annual report.
The Navigator is a learning system designed to prompt you to use the learning aids in
the chapter and to set priorities as you study.
Feature Story: KNOWING
THE NUMBERS
Many students who take this course do not plan to be accountants. If you are in that
group, you might be thinking, “If I’m not going to be an accountant, why do I need to
know accounting?” Well, consider this quote from Harold Geneen, the former chairman
of IT&T: “To be good at your business, you have to know the numbers—cold.” In
business, accounting and financial statements are the means for communicating the
numbers. If you don’t know how to read financial statements, you can’t really know your
business.
Many businesses agree with this view. They see the value of their employees being able
to read financial statements and understand how their actions affect the company’s
financial results. For example, consider Clif Bar & Company. The original Clif
Bar® energy bar was created in 1990 after six months of experimentation by Gary
Erickson and his mother in her kitchen. Today, the company has almost 300 employees
and is considered one of the leading Landor’s Breakaway Brands®.
Clif Bar is guided by what it calls its Five Aspirations–Sustaining Our Business, Our
Brands, Our People, Our Community, and the Planet. Its website documents its efforts
and accomplishments in these five areas. Just a few examples include the company’s use
of organic products to protect soil, water, and biodiversity; the “smart” solar array (the
largest in North America), which provides nearly all the electrical needs for its 115,000square-foot building; and the incentives Clif Bar provides to employees to reduce their
personal environmental impact, such as $6,500 toward the purchase of an efficient car
or $1,000 per year for eco-friendly improvements toward their homes.
One of the company’s proudest moments was the creation of an employee stock
ownership plan (ESOP) in 2010. This plan gives its employees 20% ownership of the
company (Gary and his wife Kit own the other 80%). The ESOP also resulted in Clif Bar
enacting an open-book management program, including the commitment to educate all
employee-owners about its finances. Armed with this basic financial knowledge,
employees are more aware of the financial impact of their actions, which leads to better
decisions.
Even in companies that do not practice open-book management, today’s employers
generally assume that managers in all areas of the company are “financially literate.” To
help prepare you for that, in this textbook you will learn how to read and prepare
financial statements, and how to use basic tools to evaluate financial results. In this first
chapter, we will introduce you to the financial statements of a real company whose
products you are probably familiar with–Tootsie Roll. Tootsie Roll’s presentation of its
financial results is complete, yet also relatively easy to understand.
INSIDE CHAPTER 1…
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The Scoop on Accounting (p. 6)
Spinning the Career Wheel (p. 7)
The Numbers Behind Not-for-Profit Organizations (p. 9)
Beyond Financial Statements (p. 16)
PREVIEW OF CHAPTER 1
How do you start a business? How do you determine whether your business is making
or losing money? How should you finance expansion—should you borrow, should you
issue stock, should you use your own funds? How do you convince banks to lend you
money or investors to buy your stock? Success in business requires making countless
decisions, and decisions require financial information.
The purpose of this chapter is to show you what role accounting plays in providing
financial information. The content and organization of the chapter are as follows.
Forms of Business Organization
Suppose you graduate with a business degree and decide you want to start your own
business. But what kind of business? You enjoy working with people, especially teaching
them new skills. You also spend most of your free time outdoors, kayaking, backpacking,
skiing, rock climbing, and mountain biking. You think you might be successful in
opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.
LEARNING OBJECTIVE 1
Describe the primary forms of business organization.
Your next decision is to determine the organizational form of your business. You have
three choices—sole proprietorship, partnership, or corporation.
You might choose the sole proprietorship form for your outdoor guide service. A
business owned by one person is a sole proprietorship. It is simple to set
up and gives you control over the business. Small owner-operated businesses such as
barber shops, law offices, and auto repair shops are often sole proprietorships, as are
farms and small retail stores.
Another possibility is for you to join forces with other individuals to form a partnership.
A business owned by two or more persons associated as partners is a partnership.
Partnerships often are formed because one individual does not have enough
economic resources to initiate or expand the business. Sometimes partners bring
unique skills or resources to the partnership. You and your partners should
formalize your duties and contributions in a written partnership agreement. Retail and
service-type businesses, including professional practices (lawyers, doctors, architects,
and certified public accountants), often organize as partnerships.
As a third alternative, you might organize as a corporation. A business organized as a
separate legal entity owned by stockholders is a corporation. Investors in a
corporation receive shares of stock to indicate their ownership claim. Buying stock in a
corporation is often more attractive than investing in a partnership because shares of
stock are easy to sell (transfer ownership). Selling a proprietorship or partnership
interest is much more involved. Also, individuals can becomestockholders by
investing relatively small amounts of money. Therefore, it is easier for corporations
to raise funds. Successful corporations often have thousands of stockholders, and
their stock is traded on organized stock exchanges like the New York Stock Exchange.
Many businesses start as sole proprietorships or partnerships and eventually
incorporate. For example, in 1896 Leo Hirshfield started Tootsie Roll as a sole
proprietorship, and by 1919 the company had incorporated.
Alternative Terminology
Stockholders are sometimes called shareholders.
Alternative Terminology notes present synonymous terms that you may come across
in practice.
Other factors to consider in deciding which organizational form to choose are taxes
and legal liability. If you choose a sole proprietorship or partnership, you generally
receive more favorable tax treatment than a corporation. However, proprietors and
partners are personally liable for all debts and legal obligations of the business;
corporate stockholders are not. In other words, corporate stockholders generally pay
higher taxes but have no personal legal liability. We will discuss these issues in more
depth in a later chapter.
Finally, while sole proprietorships, partnerships, and corporations represent the main
types of business organizations, hybrid forms are now allowed in all states. These hybrid
business forms combine the tax advantages of partnerships with the limited liability of
corporations. Probably the most common among these hybrids types are limited liability
companies (LLCs) and subchapter S corporations. These forms are discussed extensively
in business law classes.
The combined number of proprietorships and partnerships in the United States is more
than five times the number of corporations. However, the revenue produced by
corporations is eight times greater. Most of the largest businesses in the United States—
for example, Coca-Cola, ExxonMobil,General Motors, Citigroup, and Microsoft—are
corporations. Because the majority of U.S. business is done by corporations, the
emphasis in this textbook is on the corporate form of organization.
BUSINESS ORGANIZATION FORMS
In choosing the organizational form for your outdoor guide service, you should consider
the pros and cons of each. Identify each of the following organizational characteristics
with the organizational form or forms with which it is associated.
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1. Easier to raise funds.
2. Simple to establish.
3. No personal legal liability.
4. Tax advantages.
5. Easier to transfer ownership.
Do it! exercises prompt you to stop and review the key points you have just studied.
Action Plans give you tips about how to approach the problem.
Action Plan
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Know which organizational form best matches the business type, size, and preferences of
the owner(s).
Solution
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1. Easier to raise funds: Corporation.
2. Simple to establish: Sole proprietorship and partnership.
3. No personal legal liability: Corporation.
4. Tax advantages: Sole proprietorship and partnership.
5. Easier to transfer ownership: Corporation.
Related exercise material: BE1-1 and
1-1.
Users and Uses of Financial Information
The purpose of financial information is to provide inputs for decisionmaking. Accounting is the information system that identifies, records, and
communicates the economic events of an organization to interested users. Users of
accounting information can be divided broadly into two groups: internal users and
external users.
LEARNING OBJECTIVE 2
Identify the users and uses of accounting information.
INTERNAL USERS
Internal users of accounting information are managers who plan, organize, and run a
business. These include marketing managers, production supervisors, finance
directors, and company officers. In running a business, managers must answer
many important questions, as shown inIllustration 1-1.
Illustration 1-1: Questions that internal users ask
To answer these and other questions, you need detailed information on a timely basis.
For internal users, accounting provides internal reports, such as financial comparisons
of operating alternatives, projections of income from new sales campaigns, and forecasts
of cash needs for the next year. In addition, companies present summarized financial
information in the form of financial statements.
Illustrations help you visualize and apply the ideas as you study.
Accounting Across the Organization: The
Scoop on Accounting
Accounting can serve as a useful recruiting tool even for the human resources
department. Rhino Foods, located in Burlington, Vermont, is a manufacturer of
specialty ice cream. Its corporate website includes the following:
© Agnieszka Pastuszak-Maksim/iStockphoto
“Wouldn’t it be great to work where you were part of a team? Where your input and
hard work made a difference? Where you weren’t kept in the dark about what
management was thinking? … Well—it’s not a dream! It’s the way we do business …
Rhino Foods believes in family, honesty and open communication—we really care about
and appreciate our employees—and it shows. Operating results are posted and monthly
group meetings inform all employees about what’s happening in the Company.
Employees also share in the Company’s profits, in addition to having an excellent
comprehensive benefits package.”
Source: www.rhinofoods.com/workforus/workforus.html.
What are the benefits to the company and to the employees of making the
financial statements available to all employees? (See page 42.)
Accounting Across the Organization stories show applications of accounting
information in various business functions.
EXTERNAL USERS
There are several types of external users of accounting
information. Investors (owners) use accounting information to make decisions to buy,
hold, or sell stock. Creditors such as suppliers and bankers use accounting information
to evaluate the risks of selling on credit or lending money. Some questions that investors
and creditors may ask about a company are shown in Illustration 1-2.
Illustration 1-2: Questions that external users ask
The information needs and questions of other external users vary considerably. Taxing
authorities, such as the Internal Revenue Service, want to know whether the company
complies with the tax laws. Customers are interested in whether a company
like General Motors will continue to honor product warranties and otherwise support its
product lines. Labor unions, such as the Major League Baseball Players Association,
want to know whether the owners have the ability to pay increased wages and
benefits. Regulatory agencies, such as the Securities and Exchange Commission or
the Federal Trade Commission, want to know whether the company is operating within
prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energytrading companies reported record profits at the same time as California was paying
extremely high prices for energy and suffering from blackouts. This disparity caused
regulators to investigate the energy traders to make sure that the profits were earned by
legitimate and fair practices.
Accounting Across the Organization:
Spinning the Career Wheel
How will the study of accounting help you? A working knowledge of accounting is
desirable for virtually every field of business. Some examples of how accounting is used
in business careers include:
Josef Volavka/iStockphoto
General management: Managers of Ford Motors, Massachusetts General Hospital,
California State University–Fullerton, a McDonald’s franchise, and a Trek bike shop all
need to understand accounting data in order to make wise business decisions.
Marketing: A marketing specialist at Procter & Gamble must be sensitive to costs and
benefits, which accounting helps them quantify and understand. Making a sale is
meaningless unless it is a profitable sale.
Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman
Sachs, or a stock broker for Merrill Lynch? These fields rely heavily on accounting
knowledge to analyze financial statements. In fact, it is difficult to get a good job in a
finance function without two or three courses in accounting.
Real estate: Are you interested in being a real estate broker for Prudential Real Estate?
Because a third party—the bank—is almost always involved in financing a real estate
transaction, brokers must understand the numbers involved: Can the buyer afford to
make the payments to the bank? Does the cash flow from an industrial property justify
the purchase price? What are the tax benefits of the purchase?
How might accounting help you? (See page 42.)
ETHICS IN FINANCIAL REPORTING
People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t “play”
the stock market if they think stock prices are rigged. At one time, the financial press
was full of articles about financial scandals at Enron, WorldCom, HealthSouth, and AIG.
As more scandals came to light, a mistrust of financial reporting in general seemed to be
developing. One article in the Wall Street Journal noted that “repeated disclosures
about questionable accounting practices have bruised investors’ faith in the reliability of
earnings reports, which in turn has sent stock prices tumbling.”1 Imagine trying to carry
on a business or invest money if you could not depend on the financial statements to be
honestly prepared. Information would have no credibility. There is no doubt that a
sound, well-functioning economy depends on accurate and dependable financial
reporting.
United States regulators and lawmakers were very concerned that the economy would
suffer if investors lost confidence in corporate accounting because of unethical financial
reporting. Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical
corporate behavior and decrease the likelihood of future corporate scandals. As a result
of SOX, top management must now certify the accuracy of financial information. In
addition, penalties for fraudulent financial activity are much more severe. Also, SOX
increased the independence of the outside auditors who review the accuracy of
corporate financial statements, and increased the oversight role of boards of directors.
Ethics Note
Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.”
What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing
cards) help ensure that fraud will not occur.
Effective financial reporting depends on sound ethical behavior. To sensitize you to
ethical situations and to give you practice at solving ethical dilemmas, we address ethics
in a number of ways in this textbook. (1) A number of the Feature Stories and other
parts of the text discuss the central importance of ethical behavior to financial reporting.
(2) Ethics Insight boxes and marginalEthics Notes highlight ethics situations and issues
in actual business settings. (3) Many of thePeople, Planet, and Profit Insight boxes focus
on ethical issues that companies face in measuring and reporting social and
environmental issues. (4) At the end of the chapter, an Ethics Casesimulates a business
situation and asks you to put yourself in the position of a decision-maker in that case.
When analyzing these various ethics cases and your own ethical experiences, you should
apply the three steps outlined in Illustration 1-3.
Illustration 1-3: Steps in analyzing ethics cases
Ethics Insight: The Numbers Behind Notfor-Profit Organizations
Accounting plays an important role for a wide range of business organizations
worldwide. Just as the integrity of the numbers matters for business, it matters at least
as much at not-for-profit organizations. Proper control and reporting help ensure that
money is used the way donors intended. Donors are less inclined to give to an
organization if they think the organization is subject to waste or theft. The accounting
challenges of some large international not-for-profits rival those of the world’s largest
businesses. For example, after the Haitian earthquake, the Haitian-born musician
Wyclef Jean was criticized for the poor accounting controls in a relief fund that he
founded. In response, he hired a new accountant and improved the transparency
regarding funds raised and spent.
Gemunu Amarasinghe/AP Photo
What benefits does a sound accounting system provide to a not-for-profit
organization? (Seepage 43.)
Insights provide examples of business situations from various perspectives—ethics,
investor, international, and corporate social responsibility.
Business Activities
All businesses are involved in three types of activity—financing, investing, and
operating. For example, Leo Hirshfield, the founder of Tootsie Roll, obtained cash
through financing to start and grow his business. Some of this financing came from
personal savings, and some likely came from outside sources like banks. Hirshfield
then invested the cash in equipment to run the business, such as mix …
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