Chapter 1

CHAPTER 1
Accounting as a Form
of Communication
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Estimated
Time in
Learning Outcomes Exercises Minutes Level
1. Identify the primary users of accounting information and their 1 5 Mod
needs. 12* 10 Mod
14* 15 Mod
2. Explain the purpose of each of the financial statements 2 5 Easy

and the relationships among them, and prepare a set of 3 15 Mod
simple statements. 4 10 Mod
5 10 Mod
6 15 Easy
7 10 Easy
8 20 Diff
9 15 Mod
12* 10 Mod
13* 10 Mod
3. Identify and explain the primary assumptions made in 10 10 Mod

preparing financial statements. 13* 10 Mod
4. Explain the critical role that ethics play in providing useful

financial information.
5. Describe the various roles of accountants in organizations. 11 5 Easy

14* 15 Mod
*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
1-1
1-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Problems Estimated
and Time in
Learning Outcomes Alternates Minutes Level
1. Identify the primary users of accounting information and their 1 30 Mod
needs. 2 20 Mod
10 20 Mod
2. Explain the purpose of each of the financial statements 3 30 Easy

and the relationships among them, and prepare a set of 4 30 Easy
simple statements. 5 60 Mod
6 45 Mod
7 60 Diff
8 25 Mod
11* 45 Diff
3. Identify and explain the primary assumptions made in 11* 45 Diff

preparing financial statements.

financial information.
5. Describe the various roles of accountants in organizations. 9 15 Easy

CHAPTER 1 • ACCOUNTING AS A FORM OF COMMUNICATION 1-3
Estimated
Time in
Learning Outcomes Cases Minutes Level
1. Identify the primary users of accounting information and their 1* 25 Mod
needs. 4 30 Mod
6* 75 Diff
2. Explain the purpose of each of the financial statements 1* 25 Mod

and the relationships among them, and prepare a set of 2 20 Mod
simple statements. 3* 30 Mod
5 60 Diff
6* 75 Diff
3. Identify and explain the primary assumptions made in

preparing financial statements.

financial information. 3* 30 Mod
6* 75 Diff
7* 20 Mod
5. Describe the various roles of accountants in organizations. 7* 20 Mod

QUESTIONS
1. Accounting is a communication process. Its purpose is to provide economic informa-

tion about an organization that will be useful to those who need to make decisions
regarding that entity. For example, information provided by an accountant about an
entity is useful to a banker in reaching a decision about whether to loan money to a
business.
2. Financial accounting and management accounting differ with regard to the users of
the information provided by the two branches of the discipline. Management ac-
counting is the branch of accounting that provides management with information to
facilitate the planning and control functions. The information provided by a manage-
ment accounting system can be tailored to meet the needs of managers. Alterna-
tively, financial accounting is concerned with the preparation of general purpose fi-
nancial statements for use by both management and outsiders. Because the infor-
mation provided by financial accounting must meet the needs of many different
groups, it is necessary to rely on a set of generally accepted accounting principles in
preparing the financial statements.
3. Many different groups rely on accounting information in making decisions. For exam-
ple, investors and potential investors rely on financial statements and related disclo-
sures in deciding whether to sell or buy stock in a company. This group is particu -
larly concerned with the recent profitability of the company as shown on the income
statement. Bankers and other creditors need information to decide whether to loan
money to a company or whether to extend an existing loan. Many different govern-
ment agencies have information needs that are specified by law. The Internal Rev-
enue Service needs to know about a company’s profitability in levying taxes on it.
The Securities and Exchange Commission, the Interstate Commerce Commission,
and the Federal Trade Commission also depend on the information provided by ac-
countants in making decisions. Labor unions need information about a company’s
profitability and financial position in negotiating contracts with the company for the
employees. Trade associations rely on the information provided in financial state-
ments in compiling information for use by their members.
4. Stockholders’ equity or owners’ equity is the difference between the assets of an en -
tity and its liabilities. Thus, it represents the claims of the owners to the assets of the
business.
5. The two distinct elements of owners’ equity in a corporation are contributed capital
and retained earnings. Contributed capital, as represented by capital stock, is the
original contribution to the company by the owners. Retained earnings represents
the claims of the owners to the assets of the business. These claims result from the
earnings of the company that have not been paid out in dividends.
6. The purpose of a balance sheet is to show the financial position of an entity as of a
particular point in time. It consists of three distinct elements: assets, liabilities, and
owners’ equity.
7. A balance sheet should be dated as of a particular day. It is a statement of financial

position and shows the assets, liabilities, and owners’ equity of a business at a par-
ticular point in time. Unlike an income statement, it is not a flow statement and there-
fore is not dated for a particular period of time. Balance sheets are typically prepared
to coincide with the end of an accounting period, such as the end of the month or the
end of the year.
8. The cost principle is an accounting requirement to record an asset at the cost to ac-
quire it and report it on subsequent balance sheets at this amount.
9. The purpose of an income statement is to summarize the revenues and expenses of
a company for a period of time. It is an indicator of the profitability of an entity.
10. An income statement should be dated for a particular period of time: for example, for
the month of June or for the year ended December 31, 2007. The income statement
is a flow statement because it summarizes revenues and expenses for a period of
time. Unlike a balance sheet, it is not an indication of position at any one particular
point in time.
11. If a company has $55,000 in Retained Earnings to begin the year and net income for
the year of $27,000, the ending balance in Retained Earnings would be $82,000 if
no dividends were paid during the year. Because the ending balance in Retained
Earnings is $70,000, the company must have paid $12,000 in dividends.
12. The purpose of the statement of cash flows is to summarize a company’s cash re-
ceipts and cash payments during the period from operating, investing, and financing
activities.
13. A controller is usually the chief accounting professional of a corporation and is re-
sponsible for the operation of the accounting system and the preparation of the fi-
nancial statements. The treasurer is responsible for the safeguarding and efficient
use of a company’s cash and other liquid resources. Check writing and the deposit
of cash into bank accounts are usually the responsibility of the treasurer’s office.
14. Public accounting firms provide auditing, tax, and management consulting services.
15. The auditors may be in an excellent position to evaluate a company, but not be-
cause they have prepared the financial statements. The preparation of the state-
ments is the responsibility of management. The role of the auditor is to perform vari-
ous tests and procedures as a basis for rendering an opinion on the fairness of the
presentation of the statements.
16. We assume in the absence of evidence to the contrary that a business will continue
indefinitely. This assumption, known as the going concern assumption, helps to jus -
tify the use of historical costs in the statements. For example, if we knew that a com-
pany was in the process of liquidation, it would not be appropriate to use historical
costs in assigning an amount to such assets as land and buildings. Instead, the cur-
rent or market values of the assets would be more meaningful to a user of the bal -
ance sheet. Because the normal assumption is that a business will continue indefi-
nitely, the objectivity of historical cost makes it more attractive as a basis for valua -
tion.
17. Inflation, as evidenced by the changing value of the dollar, poses a problem for the
accountant. Accountants make the assumption in preparing a set of financial state-
ments that the dollar is a stable measuring unit. This assumption, called the mone-
tary unit assumption, may or may not be accurate, depending on the level of inflation
in the economy. The higher the rate of inflation, the less reliable is the dollar as a
measuring unit.
18. Any profession must have a set of standards that govern the practice of the profes -
sion. In accounting, generally accepted accounting principles, or GAAP, are those
methods, rules, practices, and other procedures that have evolved over time and
that govern the preparation of financial statements. Two important points are worth
noting about GAAP. First, these principles are not static but rather change in re-
sponse to changes in the ways companies conduct business. Second, there is not a
single, identifiable source of GAAP. Both the private and public sectors have contrib -
uted to the development of generally accepted accounting principles.
19. Although the Securities and Exchange Commission has the ultimate authority to de-
termine the rules in preparing financial statements, it has to a large extent allowed
the accounting profession, through the Financial Accounting Standards Board, to es-
tablish its own rules. The SEC has at times taken an active role in the setting of ac-
counting standards. It has stepped in when it has believed that the profession has
not acted quickly enough or in the correct manner. Since its inception in 1934, the
commission has been more involved in the enforcement of GAAP as a means of
protecting the rights of investors than it has been in setting standards.
EXERCISES
LO 1 EXERCISE 1-1 USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS
1. Company management
2. Stockholder
3. Labor union
4. Securities and Exchange Commission
5. Banker
6. Supplier
7. Internal Revenue Service
LO 2 EXERCISE 1-2 THE ACCOUNTING EQUATION
A = L + SE
Case 1: $125,000 = $75,000 + SE
SE = $50,000
A = L + SE
Case 2: $400,000 = L + $100,000
L = $300,000
A = L + SE
Case 3: A = $320,000 + $95,000
A = $415,000
1. A = L + SE
$500,000 = $250,000 + SE
SE = $250,000
2. A = L + SE
($500,000 + $100,000) = ($250,000 + $77,000) + SE
SE = $273,000
3. A = L + SE
A = ($250,000 + $33,000) + ($250,000* – $58,000)
A = $283,000 + $192,000
A = $475,000
*From 1. above
4. A = L + SE
$1,000,000 = L + $250,000*
L = $750,000
*From 1. above
1. A = L + SE
Beginning of year $100,000 = $80,000 + $20,000
+ Net income + $25,000
– Dividends – 0
Stockholders’ equity at end of year $45,000
2. A = L + SE
End of year $60,000 = $40,000 + $20,000
Reduce by half to beginning
of year: divided by 2
Assets, beginning of year $30,000
3. A = L + SE
Beginning of year $30,000 = $20,000 + $10,000
Triples during year × 3
Liabilities, end of year $60,000
LO 2 EXERCISE 1-5 CHANGES IN STOCKHOLDERS’ EQUITY
1. First compute the amount of stockholders’ equity at the end of each year. Then,
compute the change.
A = L + SE
2005: $25,000 = $12,000 + SE
SE = $13,000
A = L + SE
2006: $79,000 = $67,000 + SE
SE = $12,000
A = L + SE
2007: $184,000 = $137,000 + SE
SE = $47,000
Change in stockholders’ equity during 2006:
$12,000 – $13,000 = ($1,000)
Change in stockholders’ equity during 2007:
$47,000 – $12,000 = $35,000
2. 2006:
($1,000) = Income – $0 in dividends
Net loss = $1,000
3. 2007:
$35,000 = Income – $10,000 in dividends
Net Income = $45,000
(In thousands of dollars)
A = L + CS + (Beg. RE + Income – Div.)
Case 1:
40 = L + 10 + (15 + 8 – 2)
Liabilities = 9
Case 2:
A = 15 + 5 + (8 + 7 – 1)
Assets = 34
Case 3:
75 = 25 + 20 + (10 + Income – 3)
Income = 23
Case 4:
50 = 10 + 15 + (20 + 9 – Div.)
Dividends = 4
LO 2 EXERCISE 1-7 CLASSIFICATION OF FINANCIAL STATEMENT ITEMS
Appears on the Classified as

1. IS E
2. BS A
3. BS L
4. IS R
5. BS SE
6. BS A
7. BS A
8. IS E
9. BS SE
LO 2 EXERCISE 1-8 NET INCOME (OR LOSS) AND RETAINED EARNINGS
1. Revenue – Expenses = Net Income

$25,000 – ($6,500 + $12,000) = $6,500
2. Retained Retained
Earnings Net Earnings
Beginning of + Income – Dividends = End of
Year Year
$8,500 + $6,500 – $3,000 = $ 12,000
3. Total Assets:
Cash $13,000
Accounts receivable 4,000
Supplies 500
Office equipment 7,500
Total assets $ 25,000
4. Total Liabilities:
Accounts payable $ 5,000
5. Stockholders’ Equity:
Capital stock + Retained earnings = Stockholders’ equity
$8,000 + $12,000 = $20,000
(Or $25,000 in total assets less $5,000 in total liabilities.)
6. A = L + SE
$25,000 = $5,000 + $20,000
LO 2 EXERCISE 1-9 STATEMENT OF RETAINED EARNINGS
ACE CORPORATION
STATEMENT OF RETAINED EARNINGS
FOR THE MONTH ENDED FEBRUARY 28, 2007
Beginning balance, February 1, 2007 $229,800*
Add: Net income 14,000**
Deduct: Cash dividends 5,000
Ending balance, February 28, 2007 $238,800
*$235,800 + $83,000 – $89,000
**$96,000 – $82,000
LO 3 EXERCISE 1-10 ACCOUNTING PRINCIPLES AND ASSUMPTIONS
1. Going concern (also economic entity)

2. Cost principle
3. Economic entity
4. Monetary unit
5. Time period
LO 5 EXERCISE 1-11 ORGANIZATIONS AND ACCOUNTING
1. Securities and Exchange Commission

2. American Accounting Association
3. Financial Accounting Standards Board
4. American Institute of Certified Public Accountants
5. International Accounting Standards Board
MULTI-CONCEPT EXERCISES
LO 1,2 EXERCISE 1-12 USERS OF ACCOUNTING INFORMATION AND THE FINANCIAL

STATEMENTS
USER FINANCIAL STATEMENT

Stockholder IS
Banker BS
Banker SCF
Supplier BS
Stockholder RE
Advertising account manager SCF *
Banker BS
*Amount spent on advertising would appear on the statement of cash flows (assuming
use of the direct method). Amount incurred would appear on the income statement.
LO 2,3 EXERCISE 1-13 FINISH LINE’S LAND
The amount of Finish Line’s Land at February 25, 2006, is $1,557,000. The amount rep-
resents how much the company paid for the land, that is, its cost. Under current stan -
dards, the company is required to carry its land at historical cost rather than market
value. The subjectivity inherent in determining market value supports the practice of car-
rying assets at their cost.
LO 1,5 EXERCISE 1-14 ROLES OF ACCOUNTANTS
The students’ comments reflect several common misconceptions about the work of an
accountant:
 Accounting is much more than “bean counting” or bookkeeping. What separates

bookkeeping and accounting are the judgments that must be made by the
accountant.
 People skills are extremely important in the accounting profession because
accountants must be able to communicate with management, with clients, and
with other users of the statements.
 Investors, creditors, analysts, and many other groups rely on the statements pre-
pared by accountants.
 Not all accountants are experts in tax law. Taxes are one important part of the
profession, but other accountants specialize in corporate reporting, in auditing, or
in management consulting.
As stated earlier, many groups rely on the statements accountants prepare. Among the
users are management, stockholders, creditors, government agencies, suppliers, trade
associations, and labor unions.
PROBLEMS
LO 1 PROBLEM 1-1 YOU WON THE LOTTERY
Obviously, there is no single, correct answer to this problem. Students should start by
considering their personal circumstances and preference for risk. They should also con-
sider their liquidity requirements. From this point, it is appropriate to consider sources of
information.
Students should provide specific justification for their chosen investments. The “bot -
tom line” is that students should justify their selections using financial information from
as many sources as is cost effective and relate their choices to their preference or aver-
sion to risk.
Following are guidelines to be used:
Options
Issues Stock Bonds Bank deposit
Risk High Medium Low
Information Market price Market price Interest rate

needed Dividends Interest rate
Maturity date
Information Annual reports Same as for Bank

sources Investor news- the stock advertising
letters Newspaper
Newspapers, articles
business
periodicals
Additional Earnings Alternative Penalties for

information forecasts rates withdrawal
needed Brokerage fees Brokerage fees
This problem provides the instructor with an opportunity to introduce the concept of the
time value of money. Certainly it would be preferable to receive $1 million today, rather
than $200,000 over each of the next five years. If a lump sum is received immediately, it
could be put into one of the investments chosen, as opposed to needing to spread the
investment over a five-year period.
LO 1 PROBLEM 1-2 USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS
Information Management Stockholders Banker

1. a. b. a.
2. a. c. a.
3. a. c. a.
4. a. b. a.
5. a. b. b.
LO 2 PROBLEM 1-3 BALANCE SHEET
FREESCIA CORPORATION
BALANCE SHEET
DECEMBER 31, 2007
Assets Liabilities and Stockholders’ Equity
Cash $ 4,220 Accounts payable $ 12,550
Accounts receivable 23,920 Notes payable 50,000
Office equipment 12,000 Capital stock 25,000
Buildings 85,000 Retained earnings 37,590
Total liabilities and
Total assets $125,140 stockholders’ equity $125,140
Items not shown on a balance sheet and where they would appear:
Advertising expense—income statement
Salary and wage expense—income statement
Sales revenue—income statement
LO 2 PROBLEM 1-4 CORRECTED BALANCE SHEET
1. AVON CONSULTING INC.

BALANCE SHEET
DECEMBER 31, 2007
Cash $21,000 Accounts payable $13,000
Accounts receivable 16,000 Capital stock 20,000
Supplies 9,000 Retained earnings 56,000*
Furniture and equip-
ment 43,000 Total liabilities and
*$72,000 – $16,000
2. Memorandum to the company president:

TO: Company president
FROM: Student’s name
DATE: January 1, 2008
SUBJECT: Corrected balance sheet
Attached please find the original balance sheet your assistant prepared, along with a
corrected version of that same statement. The differences can be explained as fol-
lows:
1. The balance sheet is always as of a certain date, in this case, December 31,
2007, rather than a period of time, such as a year.
2. Accounts payable should be classified as a liability.
3. Cash dividends paid do not belong on the balance sheet; this amount should ap-
pear instead on the statement of retained earnings for the year.
4. Accounts receivable should be classified as an asset.
5. Net income for 2007 does not belong on the balance sheet; this amount should
appear instead on the statement of retained earnings for the year.
6. Supplies should be classified as an asset.
7. Retained earnings should appear with capital stock as a component of stockhold-
ers’ equity on the balance sheet. Since this is the first year of operations, the re-
tained earnings balance comprises the net income for the year less the cash divi-
dends paid.
8. Totals were added as necessary to provide summary information.
LO 2 PROBLEM 1-5 INCOME STATEMENT, STATEMENT OF RETAINED EARNINGS,

AND BALANCE SHEET
1. MAPLE PARK THEATRES CORP.

INCOME STATEMENT
FOR THE MONTH ENDED SEPTEMBER 30, 2007
Revenues:
Ticket sales $95,100
Concessions revenue 60,300 $155,400
Expenses:
Rent expense—movies $50,600
Cost of concessions sold 23,450
Advertising 14,500
Salaries and wages 46,490
Water, gas, and electricity 6,700 141,740
Net income $ 13,660

FOR THE MONTH ENDED SEPTEMBER 30, 2007
Beginning balance, September 1, 2007 $73,780
Add: September net income 13,660
Deduct: September dividends 8,400
Ending balance, September 30, 2007 $79,040

BALANCE SHEET
SEPTEMBER 30, 2007
Buildings 60,000 Capital stock 50,000
Furniture and Retained earnings 79,040
fixtures 34,000
Land 26,000
Projection equipment 25,000 Total liabilities and
PROBLEM 1-5 (Concluded)
4. On the basis of these statements alone, Maple Park would appear to be a good can-
didate for an investment. It is operating at a profit and is paying dividends. Before
one makes an investment in Maple Park stock, it would be useful to see the state -
ment of cash flows. Information about the current market price of the stock, the com-
petitors, the general outlook for the industry, the age of the various long-term assets,
and the due date of the note payable would also be useful before one makes an in-
vestment. The financial statements of earlier periods would be helpful for purposes
of making comparisons.
LO 2 PROBLEM 1-6 INCOME STATEMENT AND BALANCE SHEET
1. GREEN BAY CORPORATION

INCOME STATEMENT
FOR THE MONTH ENDED JULY 31, 2007
Revenues:
Fishing revenue $21,300
Passenger service revenue 12,560 $33,860
Expenses:
Rent $ 4,000
Salaries and wages 18,230 22,230
Net income $11,630
2. GREEN BAY CORPORATION

BALANCE SHEET
JULY 31, 2007
Cash $ 7,730 Notes payable $ 60,000
Boats 80,000 Retained earnings 6,230*
*Beginning retained earnings + net income – dividends:
$0 + $11,630 – $5,400
3. To fully assess Green Bay’s long-term viability, you would need the following infor-
mation about the $60,000 note payable:
 When is it due?
 What is the interest rate?
 Is interest paid periodically or only at maturity?
 Have any assets been offered as collateral for the loan?
LO 2 PROBLEM 1-7 CORRECTED FINANCIAL STATEMENTS
1. HOMETOWN CLEANERS INC.

INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2007
Revenues:
Cleaning revenue—credit sales $26,200
Cleaning revenue—cash sales 32,500 $58,700
Expenses:
Utilities $12,200
Net income $29,400

Beginning balance, January 1, 2007 $42,700
Add: Net income 29,400
Ending balance, December 31, 2007 $68,100

BALANCE SHEET
DECEMBER 31, 2007
Building and equipment 80,000 Capital stock 20,000
Land 40,000 Retained earnings 68,100

SUBJECT: Corrected income statement
Attached please find the original income statement you prepared, along with a cor-
rected version of that same statement. Fortunately, your disappointment with the
2007 net income is not warranted, as you will see from my revised statement. The
difference between the net income on the original income statement of $9,900 and
the revised amount of $29,400, or $19,500, can be explained as follows:
1. Accounts receivable of $15,200 does not belong on the income statement; in-
stead, services provided on account of $26,200 should be shown on the state-
ment; the difference is $11,000.
2. Dividends are not an expense, and thus they do not belong on the income state-
ment: $4,000.
3. Accounts payable is a liability and appears on a balance sheet: $4,500.
These corrections result in increased income of $19,500. Also note that notes
payable should be reported on the balance sheet as a liability, not as an offset to
building and equipment. Please let me know if I can be of any further assistance in
interpreting the results of our operations for 2007.
LO 2 PROBLEM 1-8 STATEMENT OF RETAINED EARNINGS FOR THE WALT DISNEY

COMPANY
1. THE WALT DISNEY COMPANY

FOR THE YEAR ENDED SEPTEMBER 30, 2004
Beginning balance, September 30, 2003 $13,817,000,000
Deduct: 2004 net income 2,345,000,000
Deduct: 2004 dividends (430,000,000)
Ending balance, September 30, 2004 $15,732,000,000
2. The statement of stockholders’ equity would include all changes in stockholders’ eq-
uity such as issuances and retirements of stock in addition to the information nor-
mally provided in a retained earnings statement.
LO 5 PROBLEM 1-9 ROLE OF THE ACCOUNTANT IN VARIOUS ORGANIZATIONS
B = Business NB = Nonbusiness T = Tax

F = Financial M = Managerial NP = Not-for-profit
1. B – F, M 6. B – M
2. B – F, T 7. B or NB – M
3. B – M 8. NB – F, M, NP
4. B – F, M, T 9. B – F, M
5. B – F, M, T 10. B – M, NP
LO 1 PROBLEM 1-10 INFORMATION NEEDS AND SETTING ACCOUNTING STANDARDS
The Financial Accounting Standards Board would have been targeting external users
with this standard. Because these users would not otherwise have access to information
about the separate operating areas of a diversified company, this standard required
such disclosure. Most groups of external users would be interested in how much of the
business is concentrated in one segment, and thus subject to market fluctuations.
MULTI-CONCEPT PROBLEM
LO 2,3 PROBLEM 1-11 PRIMARY ASSUMPTIONS MADE IN PREPARING FINANCIAL

STATEMENTS
Assumptions violated:
1. Economic entity—Should have separated his personal affairs from those of the
business.
2. Cost principle—Should have recorded the new equipment at the amount paid to
acquire it, not its list price.
3. Matching principle—Even though this principle has not yet been introduced in the
first chapter, it can be pointed out that not all of the cost of the tools should be ex -
pensed in the first year. Instead, the cost of the tools and the equipment should be
depreciated over their useful lives. Because no useful lives are given in the problem,
depreciation is ignored in the solution that follows.
JOE’S MACHINE REPAIR SHOP

INCOME STATEMENT
Repair revenue $2,900
Rent expense 300
Net income $2,600
JOE’S MACHINE REPAIR SHOP

BALANCE SHEET
JULY 31, 2007
Assets Liabilities and Owners’ Equity
Cash $ 400
Rent deposit 1,000
Accounts receivable 2,500
Tools 7,500
Equipment 4,200
Total assets $15,600 Owners’ equity $15,600*
*Owners’ contributions:
$300 + $1,000 + $7,500 + $4,200 $13,000
Owners’ equity, end of first month $15,600
ALTERNATE PROBLEMS
LO 1 PROBLEM 1-1A WHAT TO DO WITH A MILLION DOLLARS
Obviously, there is no single, correct answer to this problem. Students should start by
considering their personal circumstances and preference for risk. They should also con-
sider their liquidity requirements. From this point, it is appropriate to consider sources of
information.
Students should provide specific justification for their chosen investments. The “bot -
tom line” is that students should justify their selections using financial information from
as many sources as is cost effective and relate their choices to their preference or aver-
sion to risk.
Following are guidelines to be used:
Options
Issues Stock Bonds Bank deposit
Risk High Medium Low
Information Market price Market price Interest rate

needed Dividends Interest rate
Maturity date
Information Annual reports Same as for Bank

sources Investor news- the stock advertising
letters Newspaper
Newspapers, articles
business
periodicals
Additional Earnings Alternative Penalties for

information forecasts rates withdrawal
needed Brokerage fees Brokerage fees
LO 1 PROBLEM 1-2A USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS
Information Manager Stockholders Franchisor

1. a. b. a.
2. a. b. a.
3. a. b. b.
4. a. c. b.
5. a. b. b.
LO 2 PROBLEM 1-3A BALANCE SHEET
VICTOR CORPORATION
BALANCE SHEET
JULY 31, 2007
Butter and cheese Capital stock 25,000
inventory 12,100 Retained earnings 26,300
Computerized mixers 25,800
Office equipment 12,000
Buildings 35,000
Tools 5,800 Total liabilities and
Items not shown on a balance sheet and where they would appear:
Delivery expense—income statement

Salary and wage expense—income statement
Sales revenue—income statement
LO 2 PROBLEM 1-4A CORRECTED BALANCE SHEET
1. ISLAND ENTERPRISES
BALANCE SHEET
DECEMBER 31, 2007
Supplies 12,200 Retained earnings 97,850*
Building and
equipment 177,300 Total liabilities and
*$113,850 – $16,000

SUBJECT: Corrected balance sheet
Attached please find the original balance sheet your assistant prepared, along with a
corrected version of that same statement. The differences can be explained as fol-
lows:
1. The balance sheet is always as of a certain date, in this case, December 31,
2007, rather than a period of time, such as a year.
2. Accounts payable should be classified as a liability.
3. Cash dividends paid do not belong on the balance sheet; this amount should ap-
pear instead on the statement of retained earnings for the year.
4. Accounts receivable should be classified as an asset.
5. Net income for 2007 does not belong on the balance sheet; this amount should
appear instead on the statement of retained earnings for the year.
6. Supplies should be classified as an asset.
7. Retained earnings should appear with capital stock as a component of stockhold-
ers’ equity on the balance sheet. Since this is the first year of operations, the re-
tained earnings balance comprises the net income for the year less the cash divi-
dends paid.
8. Totals were added as necessary to provide summary information.
LO 2 PROBLEM 1-5A INCOME STATEMENT, STATEMENT OF RETAINED EARNINGS,

AND BALANCE SHEET
1. STERNS AUDIO BOOK RENTAL CORP.

INCOME STATEMENT
Rental revenue $125,900
Expenses:
Advertising expense $14,500
Rent—buildings 60,000
Salaries and wages 17,900
Water, gas, and electricity 3,600 96,000
Net income $ 29,900

Deduct: Dividends 12,000

BALANCE SHEET
DECEMBER 31, 2007
Accounts receivable 300 Notes payable 10,000
Audio tape inventory 70,000 Capital stock 50,000
Display fixtures 45,000 Retained earnings 53,290
4. On the basis of these statements alone, Sterns would appear to be a good candi-
date for an investment. It is operating at a profit and is paying dividends. It is control-
ling its costs and has a profit margin (net income divided by rental revenue) of nearly
24%. Before one makes an investment in Sterns stock, it would be useful to see the
statement of cash flows. Information about the current market price of the stock, the
competitors, the general outlook for the industry, the age of the various long-term as-
sets, and the due date of the note payable would also be useful before one makes
an investment. The financial statements of earlier periods would be helpful for pur -
poses of making comparisons.
LO 2 PROBLEM 1-6A INCOME STATEMENT AND BALANCE SHEET
1. FORT WORTH CORPORATION

INCOME STATEMENT
FOR THE MONTH ENDED JANUARY 31, 2007
Cleaning revenue $45,900
Expenses:
Rent $3,600
Net income $33,900
2. FORT WORTH CORPORATION

BALANCE SHEET
JANUARY 31, 2007
Equipment 62,000 Retained earnings 28,400*
*Beginning retained earnings + net income – dividends
$0 + $33,900 – $5,500
3. To fully assess Fort Worth’s long-term viability, you would need the following infor-
mation about the $30,000 note payable:
 When is it due?
 What is the interest rate?
 Is interest paid periodically or only at maturity?
 Have any assets been offered as collateral for the loan?
LO 2 PROBLEM 1-7A CORRECTED FINANCIAL STATEMENTS
1. HEIDI’S BAKERY INC.

INCOME STATEMENT
Revenues:
Pastry cash sales $23,700
Pastry credit sales 22,100 $45,800
Expenses:
Utilities $ 9,500
Net income $18,100


BALANCE SHEET
DECEMBER 31, 2007
Building and equipment 60,000 Capital stock 30,000
Land 50,000 Retained earnings 52,400
PROBLEM 1-7A (Concluded)

SUBJECT: Corrected income statement
Attached please find the original income statement you prepared, along with a cor-
rected version of that same statement. Fortunately, your disappointment with the
2007 net income is not warranted, as you will see from my revised statement. The
difference between the net loss on the original income statement of $900 and the re-
vised net income of $18,100, or $19,000, can be explained as follows:
1. Accounts receivable of $15,500 does not belong on the income statement; in-
stead, services provided on account of $22,100 should be shown on the state-
ment; the difference is $6,600.
2. Dividends are not an expense and thus they do not belong on the income state -
ment: $5,600.
3. Accounts payable is a liability and appears on a balance sheet: $6,800.
These corrections result in increased income of $19,000. Also note that notes
payable should be reported on the balance sheet as a liability, not as an offset to
building and equipment. Please let me know if I can be of any further assistance in
interpreting the results of our operations for 2007.
LO 2 PROBLEM 1-8A STATEMENT OF RETAINED EARNINGS FOR BRUNSWICK COR-

PORATION
1. BRUNSWICK CORPORATION
Beginning balance, December 31, 2003 $1,202,000,000
Add: 2004 net income 269,800,000
Ending balance, December 31, 2004 $1,413,700,000
2. The statement of stockholders’ equity would include all changes in stockholders’

equity such as issuances and retirements of stock in addition to the information nor -
mally provided in a retained earnings statement.
LO 5 PROBLEM 1-9A ROLE OF THE ACCOUNTANT IN VARIOUS ORGANIZATIONS
1. Financial accountant
2. Tax accountant
3. Financial accountant
4. Not an accounting position
5. Managerial accountant
6. Managerial accountant
8. Auditor
11. Financial accountant, accountant for not-for-profit organization
12. Auditor
LO 1 PROBLEM 1-10A INFORMATION NEEDS AND SETTING ACCOUNTING

STANDARDS
The Financial Accounting Standards Board would have been targeting external users
with this standard. Because these users would not otherwise have access to information
about the separate operating areas of a diversified company, this standard required
such disclosure. Most groups of external users would be interested in how much of the
business is concentrated in one segment, and thus subject to market fluctuations.
ALTERNATE MULTI-CONCEPT PROBLEM
LO 2,3 PROBLEM 1-11A PRIMARY ASSUMPTIONS MADE IN PREPARING FINANCIAL

STATEMENTS
Assumptions violated:
1. Economic entity—Should have separated her personal affairs from those for the
business.
2. Cost principle—Should have recorded the molds and paint at their market value
($7,500).
PROBLEM 1-11A (Concluded)
3. Matching principle—Even though this principle has not yet been introduced in the
first chapter, it can be pointed out that a portion of the cost of the long-term assets
should be recognized as depreciation expense. Because no useful lives are given in
the problem, depreciation is ignored in the solution that follows. It can also be
pointed out that the owner violated the revenue recognition principle by recognizing
the entire $1,400 of revenue when only one-half of the total received had been
earned at the end of the first month.
MILLIE’S CERAMIC STUDIO

INCOME STATEMENT
Revenues:
Classes $ 700
Greenware sales 3,000 $3,700
Expenses:
Rent $ 300
Supplies 600*
Cost of greenware 1,000 1,900
Net income $1,800
*Assumes the owner brought $600 of supplies from home and used all of them
during the month of July.
MILLIE’S CERAMIC STUDIO

BALANCE SHEET
JULY 31, 2007
Assets Liabilities and Owners’ Equity
Cash $ 4,400 Unearned revenue $ 700
Deposit 1,000 Owners’ equity 16,600**
Molds and paint 6,900*
Kiln 5,000 Total liabilities and
Total assets $17,300 owners’ equity $17,300
*Assumes that the $600 of supplies used during the month were part of the $7,500
of molds and paint brought from home.
**Owners’ contributions:
$300 + $1,000 + $7,500 + $5,000 + $1,000 $14,800
Owners’ equity, end of first month $16,600
DECISION CASES
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 1,2 DECISION CASE 1-1 AN ANNUAL REPORT AS READY REFERENCE
1. Earnings per share is reported at the bottom of the consolidated statement of

income. Information about dividends paid to stockholders would appear on the con-
solidated statement of cash flows. The amount reinvested in the company is equal to
net income less dividends and would appear on the consolidated statement of
changes in shareholders’ (stockholders’) equity.
2. The historical financial statements can provide some information that would be use -
ful in predicting future earnings. However, a potential investor would want to look at
other sections of the annual report to find out how the management of the company
feels about future prospects for the company. For example, the Message to Share-
holders would be helpful in this regard.
3. Information about the company’s current liquid assets, such as cash and accounts
receivable, can be found on the consolidated balance sheet. The balance sheet will
also provide bankers and other creditors with information about existing debts of the
company. The statement of cash flows is also useful in learning about a company’s
operating, financing, and investing activities over the past year.
4. The amount of current taxes owed by Finish Line at the end of the year is reported
on its consolidated balance sheet as a current liability, most likely as part of “Other li-
abilities and accrued expenses.”
5. Information about the company’s retirement plan is found in the notes to the consoli -
dated financial statements. Specifically, Note 6 titled “Retirement Plan” explains the
nature of the plan and how contributions are made to it.
LO 2 DECISION CASE 1-2 READING AND INTERPRETING FINISH LINE’S

FINANCIAL STATEMENTS
1. 2006 Net income: $60,533,000

2. Assets = Liabilities + Stockholders’ Equity
$627,816,000 = $199,274,000 + $428,542,000
DECISION CASE 1-2 (Concluded)
3. Beginning balance, February 26, 2005 $263,971,000
Add: 2006 net income 60,533,000
Ending balance, February 25, 2006 $319,656,000
LO 2,4 DECISION CASE 1-3 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:
FINISH LINE AND FOOT LOCKER
1. Finish Line reported net sales for 2006 of $1,306,045,000. This amount represented
an increase from the sales reported in the prior year. Foot Locker reported sales in
2005 of $5,653,000,000, which also represented an increase from the amount re-
ported in the prior year.
2. In 2006, Finish Line reported net income of $60,533,000, a decrease from the net in-
come in 2005. Foot Locker’s net income in 2005 was $264,000,000, which was also
a decrease from the prior year’s amount.
3. Finish Line’s total assets at the end of 2006 amounted to $627,816,000. Merchan-
dise inventories, net were the largest asset category on the company’s balance
sheet. Foot Locker reported total assets at the end of 2005 of $3,312,000,000 and
the largest of its assets was its merchandise inventories.
4. The statement of cash flows for both companies indicate that they both paid their
stockholders dividends during the year.
5. The auditors’ reports for the two companies contain the same basic information
about how the audits were conducted and the findings from the audits. Because the
companies have different year-ends, the various dates in the reports differ, but the
information presented to the board of directors and the shareholders is the same.
MAKING FINANCIAL DECISIONS
LO 1 DECISION CASE 1-4 AN INVESTMENT OPPORTUNITY
All investments require a trade-off between risk and return. A college education may
have intrinsic value, but it is risky in that it does not assure anyone of a job upon gradu-
ation. However, the return may be worth the risk involved in committing one’s life sav-
ings to a college education if the degree allows one the opportunity to make a start on a
career. Certainly, the offer to commit your savings to your high school friend’s art gallery
involves a significant amount of risk. The friend’s prediction that you will be able to sell
the artwork for 10 times the cost of your investment is subject to considerable uncer-
tainty. Both investments, in a college education and in an art gallery, require an assess-
ment of the risks and returns.
The profit split between you and your friend if you decide to open the art gallery is a
matter of negotiation. You will certainly want a significant share of the profits for the risk
you are taking in investing your savings. However, other factors must be considered as
well, such as the amount of time each of you will spend in running the business.
LO 2 DECISION CASE 1-5 PREPARATION OF PROJECTED STATEMENTS FOR A NEW

BUSINESS
1. REMOTE DVD WORLD INC.

PROJECTED INCOME STATEMENT
FOR THE FIRST MONTH
Revenues:
Daily rentals ($3 × 800) $2,400
Monthly memberships ($25 × 200) 5,000 $7,400
Expenses:
Wages ($5 per hour × 15 hours × 4 weeks
× 4 employees) $1,200
Rent 1,000 2,200
Net income $5,200
2. REMOTE DVD WORLD INC.

PROJECTED BALANCE SHEET
END OF FIRST MONTH
Cash $ 200* Notes payable $10,000
DVDs 20,000 Retained earnings 5,200
*$10,000 + $10,000 – $20,000 + 800($3) – $1,200 – $1,000
3. On the surface, the decision to invest in the business appears to be an easy one.
With net income of $5,200 per month, it seems as if the $10,000 loan from the bank
could be repaid in two months (of course, interest would have to be paid also). How-
ever, net income is not always the same as cash flow from operations. In this case,
the ability to generate $5,200 in cash flow each month depends on whether the
$5,000 in monthly memberships can be collected each month (the assumption is
that the first month’s memberships will not be collected until the second month). A
second concern is whether the company will be able to attain and then sustain the
projected sales forecasts of 800 rentals per month and 200 monthly memberships.
Will the demand for rentals and memberships increase, decrease, or stay relatively
stable in the future? A third issue concerns the useful life of the DVDs. A sizable
investment of $20,000 has been made in the initial inventory of DVDs. How long will
it be before more DVDs will need to be purchased to keep customers returning to
the store? Also, will the company be able to rent space in the area for $1,000 per
month in the future? What is the possibility that the rent will be increased? Finally, is
it likely that someone else will open a rental store in the area? What effect would this
have on sales?
ETHICAL DECISION MAKING
LO 1,2,4 DECISION CASE 1-6 IDENTIFICATION OF ERRORS IN FINANCIAL STATE-

MENTS AND PREPARATION OF REVISED STATEMENTS
1. Errors made in preparing the financial statements:

a. The recognition of the 2008 season ticket sales as revenue in 2007. Because
Lakeside has not provided these fans with any service yet (the games), the sale
of the 2008 season tickets does not result in revenue in 2007.
b. The recognition of $100,000 in advertising revenue. The contract with the adver-
tisers required Lakeside to average 2,000 fans per game. Because it averaged
only 1,500, the revenue should not be recorded.
DECISION CASE 1-6 (Continued)
c. The treatment of the player contracts. The $5,000 paid to the parent club for
each of the 25 players on the roster is an expense, not an asset. Also, the
amount owed to the parent club is not an element of stockholders’ equity but in -
stead is a liability, since this amount is due by February 1, 2008.
d. The recognition of the value of the controller’s personal residence as an asset.
Under the economic entity assumption, the personal affairs of the owner of a
business should not be intermingled with those of the company. The controller’s
personal residence is not an asset of the business.
2. LAKESIDE SLAMMERS INC.

INCOME STATEMENT
Revenues:
Single-game ticket revenue $420,000
Concessions revenue 280,000 $ 700,000
Expenses:
Cost of concessions sold $110,000
Player contracts 125,000
Salaries—players 225,000
Salaries and wages—staff 150,000
Rent 210,000 820,000
Net loss $(120,000)
LAKESIDE SLAMMERS INC.

Beginning balance, January 1, 2007 $ 0
Deduct: Net loss (120,000)
Deduct: Cash dividends (40,000)
Ending balance, December 31, 2007 $(160,000)
LAKESIDE SLAMMERS INC.

BALANCE SHEET
DECEMBER 31, 2007
Equipment 50,000 Due to parent club 125,000
Capital stock 40,000
Retained earnings
(deficit) (160,000)
Total assets $55,000 stockholders’ equity $ 55,000
DECISION CASE 1-6 (Continued)
3. The original financial statements grossly overstate the income of the company and
its assets.
The information regarding season ticket revenue does not provide reliable infor-
mation to the outsider. Reliable information represents what it claims to represent.
The $140,000 recognized by the initial preparer of the financial statements is actu -
ally revenue for the following year. It should not be recognized as revenue in the cur-
rent year.
The $100,000 of advertising revenue that was recognized on the initial income
statement does not represent the economic reality of the transaction. Revenue must
be collectible to be recognized. Since the company knows that the revenue is not
likely to be collected, it should not be recognized. (The economic reality of this trans -
action must reflect the future cash flows.)
Because you are aware of these errors, it is your responsibility to share the revi-
sions with the other owners as well as the bank. It appears that the controller has
made a deliberate attempt to overstate the assets and income of the business for
the express purpose of obtaining an extension of the loan. Both the other owners
and the banker rely on the statements in making decisions, and it is your responsibil-
ity to inform them of any major deficiencies in the statements.
4. a. The owners of the company may benefit in the short term, because the bank may
be more likely to give them a loan based on the original financial statements. All
outsiders are harmed, because the financial information they receive does not
represent the economic activity of the firm.
b. The owners of the company will benefit because outsiders will evaluate the com-
pany more favorably based on the original financial statements than the revised
statements (e.g., bankers will give loans at lower interest rates, the stock valua-
tions will be higher). The bankers will be harmed if they are not aware of the cor-
rect financial statement numbers, because they will assess the risk of the firm
based on the incorrect numbers and will use a lower interest rate on the debt
than they would if the risk more accurately reflected the future cash flow. Stock-
holders who currently own shares of stock may not make the correct decisions
about holding the stock. Potential stockholders may make the wrong decision
about purchasing the stock.
c. The company may lack the resources to pay the claims of the creditors (the
notes payable and the liability to the parent club). The dividend payment probably
violated the corporate charter for the company (most companies would not be
permitted to pay dividends without positive stockholders’ equity).
d. The interests of the shareholders are in conflict with the interests of the creditors
of the company. The shareholders appear to want to withdraw cash from the
company. The creditors would prefer that the company keep its cash to pay
debts.
e. As one of the owners/managers of the company, it is your responsibility to make

sure that the company follows the accounting rules. Company management is re-
sponsible for the accuracy of the financial statements.
f. The information in the original set of financial statements is not relevant (the rev-
enue numbers are not useful for predicting future revenue numbers, since they
include both earned and unearned revenue), reliable (the season-ticket and ad-
vertising revenue are not reliable, they do not represent revenue as claimed),
does not accurately represent what it claims to represent, and it is not unbiased
(revenue is too high, expenses are too low, assets are overstated and stockhold-
ers’ equity is overstated). The original financial statements are clearly presented
in a way that is biased toward the owners.
LO 4,5 DECISION CASE 1-7 RESPONSIBILITY FOR FINANCIAL STATEMENTS AND THE
ROLE OF THE AUDITOR
1. Preparation of the financial statements in a company’s annual report is the responsi-

bility of that company.
2. The financial statements are audited by an independent public accounting firm.
3. Independence is critical to the integrity of the audit of a company’s financial state-
ments. A company’s financial statements are relied on by stockholders, bankers, an-
alysts, and others when they make various decisions. The public accountant has a
responsibility to these various users to ensure that management is fairly presenting
the information in the financial statements. The users must feel assured that the
statements have been audited by someone that is independent of those who actually
prepared the statements.
4. In the past, auditors have performed a variety of services for their clients. These
have included preparation of tax returns, tax planning, and various management
consulting services. Concerns over auditor independence have caused the federal
government to place restrictions on the nonaudit services that auditors can provide
to their clients. Whether or not in any particular instance the provision of other ser-
vices to an audit client might affect the firm’s independence, the public’s perception
of the lack of independence is also an issue.
REAL WORLD PRACTICE 1.1
Yes, it is logical that “Cost of Sales” would increase if “Net Sales” increased because
the former represents all of the costs incurred to buy the inventory that was sold during
the same period. Net Sales increased from the prior year by ($1,306,045 –
$1,166,767)/$1,166,767, or 11.9%. Cost of Sales increased by ($894,724 – $798,033)/
$798,033, or 12.1%.
REAL WORLD PRACTICE 1.2
The auditors’ report for Finish Line is dated May 4, 2006, which is just over two months
after the end of the year. Companies differ in terms of the length of time they take to re -
lease their annual reports. Two months is a reasonable period of time after year-end to
release the financial statements and the auditors’ report. The time required to complete
the year-end audit is primarily responsible for the gap between a company’s year-end
and the release of its financial statements.

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CHAPTER 1

2. Explain the purpose of each of the financial statements 2 5 Easy

3. Identify and explain the primary assumptions made in 10 10 Mod

4. Explain the critical role that ethics play in providing useful

5. Describe the various roles of accountants in organizations. 11 5 Easy

*Exercise, problem, or case covers two or more learning outcomes

2. Explain the purpose of each of the financial statements 3 30 Easy

3. Identify and explain the primary assumptions made in 11* 45 Diff

4. Explain the critical role that ethics play in providing useful

5. Describe the various roles of accountants in organizations. 9 15 Easy

*Exercise, problem, or case covers two or more learning outcomes

2. Explain the purpose of each of the financial statements 1* 25 Mod

3. Identify and explain the primary assumptions made in

4. Explain the critical role that ethics play in providing useful

5. Describe the various roles of accountants in organizations. 7* 20 Mod

*Exercise, problem, or case covers two or more learning outcomes

1. Accounting is a communication process. Its purpose is to provide economic informa-

7. A balance sheet should be dated as of a particular day. It is a statement of financial

LO 1 EXERCISE 1-1 USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS

LO 2 EXERCISE 1-2 THE ACCOUNTING EQUATION

LO 2 EXERCISE 1-3 THE ACCOUNTING EQUATION

LO 2 EXERCISE 1-4 THE ACCOUNTING EQUATION

LO 2 EXERCISE 1-5 CHANGES IN STOCKHOLDERS’ EQUITY

LO 2 EXERCISE 1-6 THE ACCOUNTING EQUATION

(In thousands of dollars)

A = L + CS + (Beg. RE + Income – Div.)

LO 2 EXERCISE 1-7 CLASSIFICATION OF FINANCIAL STATEMENT ITEMS

Appears on the Classified as

LO 2 EXERCISE 1-8 NET INCOME (OR LOSS) AND RETAINED EARNINGS

1. Revenue – Expenses = Net Income

LO 2 EXERCISE 1-9 STATEMENT OF RETAINED EARNINGS

LO 3 EXERCISE 1-10 ACCOUNTING PRINCIPLES AND ASSUMPTIONS

1. Going concern (also economic entity)

LO 5 EXERCISE 1-11 ORGANIZATIONS AND ACCOUNTING

1. Securities and Exchange Commission

LO 1,2 EXERCISE 1-12 USERS OF ACCOUNTING INFORMATION AND THE FINANCIAL

USER FINANCIAL STATEMENT

LO 2,3 EXERCISE 1-13 FINISH LINE’S LAND

LO 1,5 EXERCISE 1-14 ROLES OF ACCOUNTANTS

 Accounting is much more than “bean counting” or bookkeeping. What separates

LO 1 PROBLEM 1-1 YOU WON THE LOTTERY

Following are guidelines to be used:

Information Market price Market price Interest rate

Information Annual reports Same as for Bank

Additional Earnings Alternative Penalties for

LO 1 PROBLEM 1-2 USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS

Information Management Stockholders Banker

LO 2 PROBLEM 1-3 BALANCE SHEET

LO 2 PROBLEM 1-4 CORRECTED BALANCE SHEET

1. AVON CONSULTING INC.

2. Memorandum to the company president:

LO 2 PROBLEM 1-5 INCOME STATEMENT, STATEMENT OF RETAINED EARNINGS,

1. MAPLE PARK THEATRES CORP.

2. MAPLE PARK THEATRES CORP.

3. MAPLE PARK THEATRES CORP.

PROBLEM 1-5 (Concluded)

LO 2 PROBLEM 1-6 INCOME STATEMENT AND BALANCE SHEET

1. GREEN BAY CORPORATION

2. GREEN BAY CORPORATION