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Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only) 1-
CHAPTER 1
Introduction to
Financial Statements
Study Objectives
- Describe the primary forms of business organization.
- Identify the users and uses of accounting information.
- Explain the three principal types of business activity.
- Describe the content and purpose of each of the financial statements.
- Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation.
- Describe the components that supplement the financial statements in an annual report.
1-2 Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only)
Chapter Outline
Study Objective 1 - Describe the Primary Forms of Business Organization.
A business may be organized as a sole proprietorship , partnership , or corporation.
♦ Sole proprietorship - a business owned by one person Advantages
- simple to establish
- owner controlled
- tax advantages that are more favorable than a corporation
Disadvantages
- proprietor personally liable for all business debts
- financing may be difficult
- transfer of ownership may be difficult
♦ Partnership - a business owned by two or more people Advantages
- simple to establish
- shared control
- broader skills and resources
- tax advantages that are more favorable than a corporation
Disadvantages
- partners personally liable for all business debts
- transfer of ownership may be difficult
♦ Corporation - a separate legal entity owned by stockholders Advantages
- easier to transfer ownership
- easier to raise funds
- lower legal liability – no personal liability for stockholders
Disadvantages
- unfavorable tax treatment resulting in higher taxes paid by stockholders
The emphasis of this text is the corporate form of business.
TEACHING TIP
There is a passage in the text that states, “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 enterprises in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations.” Why do you think this is true?
1-4 Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only)
Study Objective 3 - Explain the Three Principal Types of Business Activity.
All businesses are involved in three types of activity. The accounting information system keeps track of the results of each of these activities.
♦ Financing activities – Cash is often obtained from outside sources to start or expand a business. The two primary sources are: Borrowing from creditors which creates a liability
- bank loan (note payable)
- debt securities (bonds payable)
- goods on credit from suppliers (accounts payable)
Issuing ownership interests in the corporation to investors (selling stock to shareholders)
In addition, financing activities include using cash to pay dividends to stockholders.
TEACHING TIP
At this point, ask students to assume they have extra money to invest and ask them how they would prefer to invest the money. Would they consider loaning money to a corporation or would they rather buy shares of stock in the company? Then ask students why they made the decision to lend or buy.
♦ Investing activities – Cash raised through financing activities is used for investing in resources (assets) needed to operate the business (i.e., land, buildings, delivery trucks, equipment, computers, furniture, etc.).
♦ Operating activities – Once a business has the assets it needs to get started, it begins its operations. Operating activities involve revenue and expenses. Revenue is the increase in assets resulting from sales or services – related assets include accounts receivable, inventory, supplies, prepaid insurance Expenses are the cost of assets consumed or services used in generating revenues – related liabilities include accounts payable, wages payable, interest payable, sales taxes payable, income taxes payable
TEACHING TIP
Stress the fact that just because a business is making money is no reason to assume that the business has a lot of money in the bank. Focus students’ attention on the three types of business activity and let them think about what could have happened to the money the business has made. You might also ask students how a business reporting a net loss could have money in the bank.
TEACHING TIP
Ask students to think about some of the ‘dotcom’ businesses. Many of these companies received large amounts of cash from stockholders and creditors (financing activities). The cash was spent on salaries, advertising, entertainment, equipment and other expenses and assets (investing and operating activities). Unfortunately, many of these businesses were unable to generate sufficient revenues. When the cash ran out, many of the businesses went under. Many shareholders lost their investments and many creditors were unable to collect on debts.
Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only) 1-
Study Objective 4 - Describe the Content and Purpose of Each of the Financial
Statements.
Accounting information is communicated through four financial statements :
♦ Income Statement Reports the success or failure of the company’s operations during the period. Summarizes all revenue and expenses for period—month, quarter, or year. If revenues exceed expenses , the result is a net income. If expenses exceed revenue , the result is a ( net loss ). Dividends are payments to the stockholders and are not expenses. Amounts received from issuing stock or obtaining loans are not revenues.
♦ Retained Earnings Statement Reports the amount paid out in dividends and the amount of net income or net loss for period. Shows changes in the retained earnings balance during period covered by statement. Ending retained earnings represents net income since the inception of the business that has not been paid out as dividends.
♦ Balance Sheet Shows the relationship between assets and equities at a specific point in time. Equities include liabilities (claims of the creditors) and stockholders’ equity (claims of the owners). Assets and equities ( liabilities and stockholders’ equity) must balance.
♦ Statement of Cash Flows Provides information about cash receipts and cash payments for a specific period of time. Reports the cash effects of a company’s operations for a period of time. Shows cash increases and decreases from investing and financing activities. Indicates the increase or decrease in cash as well as the ending cash balance.
♦ Interrelationship of Statements
- Retained earnings statement depends on results of the income statement.
- Balance sheet and retained earnings statement are also interrelated.
- Statement of cash flows relates to balance sheet information.
TEACHING TIP
Ask students to prepare a personal income statement, balance sheet, and/or statement of cash flows. This activity allows them to relate to the text material. They may be encouraged to pay closer attention to their uses of cash and timing and amounts of expenditures.
Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only) 1-
Study Objective 6 - Describe the Components that Supplement the Financial
Statements in an Annual Report.
U.S. Companies that are publicly traded must provide shareholders with an annual report which always includes financial statements. In addition, the annual report includes the following information:
♦ Management Discussion and Analysis - covers three aspects of a company:
- Its ability to pay near-term obligations (liquidity)
- Its ability to fund operations and expansion (capital resources)
- Its results of operations
♦ Notes to the Financial Statements Clarify information presented in the financial statements Provide additional detail (i.e. Describe accounting policies or explain uncertainties and contingencies)
♦ Auditor’s Report An auditor, a CPA, conducts an independent examination of the company’s financial statements. The auditor gives an unqualified opinion if the financial statements present the financial position, results of operations, and cash flows in accordance with generally accepted accounting principles.
TEACHING TIP
Encourage students to obtain annual report information from web sites. Explain to them that many companies are omitting the financial statements and notes from their annual reports on their web sites. The financial statements and notes can be obtained from the SEC fillings.
1-8 Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only)
IFRS
A Look at IFRS
Most agree that there is a need for one set of international accounting standards. Here is why:
Multinational corporations. Today’s companies view the entire world as their market. For example, Coca-Cola, Intel, and McDonald’s generate more than 50% of their sales outside the United States, and many foreign companies, such as Toyota, Nestle, and Sony, find their largest market to be the United States.
Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann suggest that we will see even more such business combinations in the future.
Information technology. As communication barriers continue to topple through advances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another.
Financial markets. Financial markets are of international significance today. Whether it is currency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.
KEY POINTS
- International standards are referred to as International Financial Reporting Standards ( IFRS ), developed by the International Accounting Standards Board (IASB).
- Recent events in the global capital markets have underscored the importance of financial disclosure and transparency not only in the United States but in markets around the world. As a result, many are examining which accounting and financial disclosure rules should be followed. Much of the World has voted for the standards issued by the IASB. Over 115 countries require or permit use of IFRS.
- U.S. standards, referred to as generally accepted accounting principles (GAAP), are developed by the Financial Accounting Standards Board (FASB). The fact that there are differences between what is in this textbook (which is based on U.S. standards) and IFRS should not be surprising because the FASB and IASB have responded to different user needs. In some countries, the primary users of financial statements are private investors; in others, the primary users are tax authorities or central government planners. It appears that the United States and the international standard-setting environment are primarily driven by meeting the needs of investors and creditors.
- The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is a continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation. Debate about international companies (non-U.S.) adopting SOX-type standards centers on whether the benefits exceed the costs. The concern is that the higher costs of SOX compliance are making the U.S. securities markets less competitive.
- The textbook mentions a number of ethics violations, such as Enron, WorldCom, and AIG. These problems have also occurred internationally, for example, at Satyam Computer Services (India), Parmalat (Italy), and Royal Ahold (the Netherlands).
1-10 Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only)
Chapter 1 Review
Describe the three primary forms of business organization and list advantages and disadvantages of each.
Identify the users of accounting information. How do they use this information?
Explain the three types of business activity.
Describe the content and purpose of each of the financial statements.
Define assets, liabilities, and stockholders’ equity, and state the basic accounting equation.
Describe the components that supplement the financial statements in an annual report.
Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only) 1-
Vocabulary Quiz Name _______________
Chapter 1
- The process of identifying, recording, and communicating the economic events of a business to interested users of the information.
- Debts and obligations of a business.
- Resources owned by a business.
- The amount by which expenses exceed revenues.
- A business organized as a separate legal entity having ownership divided into transferable shares of stock.
- The amount of net income kept in the corporation for future use, not distributed to stockholders as dividends.
- Assets = Liabilities + Stockholders’ Equity.
- Payments of cash from a corporation to its stockholders.
- The cost of assets consumed or services used in the process of ongoing operations to generate resources.
- A financial statement that reports the assets, liabilities, and stockholders’ equity at a specific date.
Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only) 1-
Multiple Choice Quiz Name _______________
Chapter 1
- All of the following are characteristics of a sole proprietorship except: a. a business owned by one person. b. owner has control of the business. c. a separate legal entity. d. small owner-operated business.
- All of the following are characteristics of a corporation except: a. a separate legal entity. b. ownership evidenced by shares of stock. c. produce eight times more revenue than sole proprietorships and partnerships in the United States. d. owners have unlimited liability.
- Corporations may issue several classes of stock, but the stock representing the primary ownership interest is: a. common stock. b. retrained earnings. c. financing activity. d. dividends.
- Resources owned by a business and used in carrying out its operating activities are: a. liabilities. b. stockholders’ equity. c. revenues. d. assets.
- Acquiring long-term assets necessary to operate the business is called a(n): a. financing activity. b. operating activity. c. revenue activity. d. investing activity.
- Debt securities sold to investors and due to be repaid at a particular date some years in the future are called: a. bonds payable. b. accounts payable. c. wages payable. d. notes payable.
1-14 Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only)
- The term used to describe the total assets that Starbucks receives in exchange for its coffee is: a. cash. b. revenue. c. inventory. d. accounts receivable.
- The financial statement which presents a picture at a point in time of what a business owns and owes is a(n): a. income statement. b. retained earnings statement. c. balance sheet. d. statement of cash flows.
- Net income shown on the income statement is added to the beginning balance of retained earnings in the: a. income statement. b. retained earnings statement. c. balance sheet. d. statement of cash flows.
- To report the success or failure of the company’s operations during the period is the purpose of the: a. income statement. b. retained earnings statement. c. balance sheet. d. statement of cash flows.
1-16 Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only)
Exercise 1 - Research and Communication Activity
Chapter 1
You and your college roommate have decided to go into business together after graduation. Your roommate contends that you have always gotten along and therefore do not need a partnership agreement. You, however, feel somewhat uncomfortable about not having a formal partnership agreement. Not wanting to argue, you decide to write your roommate a memo to (1) explain why you need a formal agreement and (2) outline the issues that need to be addressed in the agreement.
Solution:
DATE: 5/1/0X
TO: My Roommate
FROM: Marketing Student
SUBJECT: Partnership Agreement
After conducting research, speaking with a number of professionals, and considering the venture we are about to undertake, I am even more confident that we need a partnership agreement. Although we have remained friends during the four years of college, a misunderstanding concerning the partnership could jeopardize our friendship.
At a minimum, the partnership agreement should address:
- Exact name of the business
- Specific nature of the venture
- Names and addresses of partners
- Duties and responsibilities of partners
- Division of profits or losses
- Addition of new partners
- Withdrawal of existing partner
- Additional investments
If there are other issues you would like to see addressed, please let me know. I am excited about our new business undertaking. However, I am more concerned that our friendship stay intact.
Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only) 1-
Exercise 2 - Research and Communication Activity
Chapter 1
In your textbook you will find a passage that reads, “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 enterprises in the United States—for example Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations.
Given these facts, chances are that at some point in your life you may work for a corporation or want to form a corporation.
- List the advantages of the corporate form of organization.
- Search the web or call the Secretary of State in your state to determine how you would go about forming a corporation in your state. Outline the major steps in forming a corporation. Provide the source of your information.
Solution:
1. Easy transfer of ownership, greater raising capital potential, and lower **legal liability.
- In the Commonwealth of Kentucky, one or more persons may act as an** incorporator or incorporators of a corporation by delivering articles of incorporation to the Secretary of State for filing.
The articles of incorporation of a business corporation must set forth:
a. The name of the corporation that satisfies the requirements of the Commonwealth of Kentucky; b. The number of shares the corporation is authorized to issue; c. The street address of the corporation’s initial registered office and the name of its initial registered agent at that office; d. The mailing address of the corporation’s principal office; and e. The name and mailing address of each incorporator.
The articles of incorporation may set forth:
a. The names and mailing addresses of the individuals who will serve as the initial directors. b. Other provisions not inconsistent with the laws of the Commonwealth of Kentucky.
Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only) 1-
Exercise 3 - Financial Statement and Creative Activity (Continued)
Chapter 1
Name of Company
Type of Business
Amount Need to Borrow
Reason for Applying for the Loan
1-20 Copyright © 2011 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 6/e, Instructor’s Manual (For Instructor Use Only)
Exercise 3 - Financial Statement and Creative Activity (Continued)
Chapter 1
LOAN APPLICATION FORM
Name of Company
Address
Phone Number
Annual Income
Revenues Cost of goods sold
Operating expenses Rent Utilities Wages Advertising Others
Net income (loss)
Assets
Cash Account receivable Inventory Property, plant, & equipment Other
Total assets
Liabilities
Account payable Notes payable Other
Total liabilities
Stockholders’ Equity
Total stockholders’ equity
Total liabilities & stockholders’ equity
