Here are incomplete financial statements for donavan, inc. calculate the missing amounts.

Introduction to Financial Statements

 CHAPTER PREVIEW 

The Chapter Preview describes the purpose of the chapter and highlights major topics.

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 Chapter Outline presents the chapter's topics and subtopics, as well as practice opportunities.

Knowing the Numbers

The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business.

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.

Knowing the numbers is sometimes even a matter of corporate survival. Consider the story of Columbia Sportswear Company, headquartered in Portland, Oregon. Gert Boyle's family fled Nazi Germany when she was 13 years old and then purchased a small hat company in Oregon, Columbia Hat Company. In 1971, Gert's husband, who was then running the company, died suddenly of a heart attack. The company was in the midst of an aggressive expansion, which had taken its sales above $1 million for the first time but which had also left the company financially stressed. Gert took over the small, struggling company with help from her son Tim, who was then a senior at the University of Oregon. Somehow, they kept the company afloat. Today, Columbia has more than 4,000 employees and annual sales in excess of $1 billion. Its brands include Columbia, Mountain Hardwear, Sorel, and Montrail. Gert still heads up the Board of Directors, and Tim is the company's President and CEO.

Columbia doesn't just focus on financial success. The company is very committed to corporate, social, and environmental responsibility. For example, several of its factories have participated in a project to increase health awareness of female factory workers in developing countries. Columbia was also a founding member of the Sustainable Apparel Coalition, which is a group that strives to reduce the environmental and social impact of the apparel industry. In addition, it monitors all of the independent factories that produce its products to ensure that they comply with the company's Standards of Manufacturing Practices. These standards address issues including forced labor, child labor, harassment, wages and benefits, health and safety, and the environment.

Employers such as Columbia Sportswear 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.

LEARNING OBJECTIVE 1

Identify the forms of business organization and the uses of accounting information.

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.

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.

SOLE PROPRIETORSHIP 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.

PARTNERSHIP 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.

CORPORATION 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 become stockholders 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.

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.

ALTERNATIVE TERMINOLOGY

Stockholders are sometimes called shareholders.

Alternative Terminology notes present synonymous terms that you may come across in practice.

USERS AND USES OF FINANCIAL INFORMATION

The purpose of financial information is to provide inputs for decision‐making. 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.

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 in Illustration 1-1.

ILLUSTRATION 1-1 Questions that internal users ask

Accounting Across the Organization boxes show applications of accounting information in various business functions.

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.

 ACCOUNTING ACROSS THE ORGANIZATION 

Clif Bar & Company

Owning a Piece of the Bar

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®. One of Clif Bar & 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. 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 basic accounting knowledge, employees are more aware of the financial impact of their actions, which leads to better decisions.

What are the benefits to the company and to the employees of making the financial statements available to all employees? (Go to WileyPLUSfor this answer and additional questions.)

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 energy‐trading 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 the following.

General management: Managers of Ford Motors, Massachusetts General Hospital, California State University–Fullerton, a McDonald'sfranchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions.

Marketing: Marketing specialists 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? (Go to WileyPLUS for this answer and additional questions.)

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.” 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 both the independence of the outside auditors who review the accuracy of corporate financial statements and the oversight role of boards of directors.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

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 marginal Ethics Notes highlight ethics situations and issues in actual business settings. (3) Many of the People, 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 each chapter, an Ethics Case simulates 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 

Dewey & LeBoeuf LLP

I Felt the Pressure—Would You?

“I felt the pressure.” That's what some of the employees of the now‐defunct law firm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former finance director and former chief financial officer (CFO) of the firm. Here are some of their comments:

· “I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”

· “I intentionally gave the auditors incorrect information in the course of the audit.”

What happened here is that a small group of lower‐level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e‐mails with one another in which they referred to their financial manipulations as accounting tricks, cooking the books, and fake income.

Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014).

Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to WileyPLUS for this answer and additional questions.)

Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers to the critical thinking questions are available in WileyPLUS and at www.wiley.com/college/weygandt . Additional questions are offered in WileyPLUS .

DO IT! 1

Business Organization Forms

DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.

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.

1. Easier to raise funds.

2. Simple to establish.

3. No personal legal liability.

4. Tax advantages.

5. Easier to transfer ownership.

Action Plan

✓ Know which organizational form best matches the business type, size, and preferences of the owner(s).

SOLUTION

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 DO IT! 1-1.

LEARNING OBJECTIVE 2

Explain the three principal types of business activity.

All businesses are involved in three types of activity—financing, investing, and operating. For example, Gert Boyle's parents, the founders of Columbia Sportswear, obtained cash through financing to start and grow their business. Some of this financing came from personal savings, and some likely came from outside sources like banks. The family then invested the cash in equipment to run the business, such as sewing equipment and delivery vehicles. Once this equipment was in place, they could begin the operating activities of making and selling clothing.

The accounting information system keeps track of the results of each of the various business activities—financing, investing, and operating. Let's look at each type of business activity in more detail.

FINANCING ACTIVITIES

It takes money to make money. The two primary sources of outside funds for corporations are borrowing money (debt financing) and issuing (selling) shares of stock in exchange for cash (equity financing).

Columbia Sportswear may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom Columbia owes money are its creditors. Amounts owed to creditors—in the form of debt and other obligations—are called liabilities . Specific names are given to different types of liabilities, depending on their source. Columbia may have a note payable to a bank for the money borrowed to purchase delivery trucks. Debt securities sold to investors that must be repaid at a particular date some years in the future are bonds payable.

Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase.

The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a payment schedule (e.g., payment at the end of three months). As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may legally force the company to sell property to pay its debts. In the case of financial difficulty, creditor claims must be paid before stockholders' claims.

Stockholders, on the other hand, have no claim to corporate cash until the claims of creditors are satisfied. Suppose you buy a company's stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company's creditors are paid amounts currently due. However, many corporations make payments to stockholders on a regular basis as long as there is sufficient cash to cover required payments to creditors. These cash payments to stockholders are called dividends .

INVESTING ACTIVITIES

Once the company has raised cash through financing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. A growing company purchases many resources, such as computers, delivery trucks, furniture, and buildings. Resources owned by a business are called assets . Different types of assets are given different names. For example, Columbia Sportswear's sewing equipment is a type of asset referred to as property, plant, and equipment.

Cash is one of the more important assets owned by Columbia or any other business. If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations. Investments are another example of an investing activity.

ALTERNATIVE TERMINOLOGY

Property, plant, and equipment is sometimes called fixed assets.

OPERATING ACTIVITIES

Once a business has the assets it needs to get started, it begins operations. Columbia Sportswear is in the business of selling outdoor clothing and footwear. It sells TurboDown jackets, Millenium snowboard pants, Sorel® snow boots, Bugaboots™, rainwear, and anything else you might need to protect you from the elements. We call amounts earned on the sale of these products revenues. Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business. For example, Columbia records revenue when it sells a footwear product.

Revenues arise from different sources and are identified by various names depending on the nature of the business. For instance, Columbia's primary source of revenue is the sale of sportswear. However, it also generates interest revenue on debt securities held as investments. Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue.

The company purchases its longer‐lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operating activities. For example, supplies are assets used in day‐to‐day operations. Goods available for future sales to customers are assets called inventory. Also, if Columbia sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future. This right to receive money in the future is called an account receivable.

Before Columbia can sell a single Sorel® boot, it must purchase wool, rubber, leather, metal lace loops, laces, and other materials. It then must process, wrap, and ship the finished product. It also incurs costs like salaries, rents, and utilities. All of these costs, referred to as expenses, are necessary to produce and sell the product. In accounting language, expenses are the cost of assets consumed or services used in the process of generating revenues.

Expenses take many forms and are identified by various names depending on the type of asset consumed or service used. For example, Columbia keeps track of these types of expenses: cost of goods sold (such as the cost of materials), selling expenses (such as the cost of salespersons' salaries), marketing expenses (such as the cost of advertising), administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corporate office), interest expense (amounts of interest paid on various debts), and income taxes(corporate taxes paid to the government).

Columbia may also have liabilities arising from these expenses. For example, it may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable. Additionally, Columbia may have interest payable on the outstanding amounts owed to the bank. It may also have wages payable to its employees and sales taxes payable, property taxes payable, and income taxes payable to the government.

Columbia compares the revenues of a period with the expenses of that period to determine whether it earned a profit. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.

DO IT! 2

Business Activities

Classify each item as an asset, liability, common stock, revenue, or expense.

1. Cost of renting property.

2. Truck purchased.

3. Notes payable.

4. Issuance of ownership shares.

5. Amount earned from performing service.

6. Amounts owed to suppliers.

Action Plan

✓ Classify each item based on its economic characteristics. Proper classification of items is critical if accounting is to provide useful information.

SOLUTION

1. Cost of renting property: Expense.

2. Truck purchased: Asset.

3. Notes payable: Liabilities.

4. Issuance of ownership shares: Common stock.

5. Amount earned from performing service: Revenue.

6. Amounts owed to suppliers: Liabilities.

 Related exercise material: BE1-3, DO IT! 1-2, and E1-3.

LEARNING OBJECTIVE 3

Describe the four financial statements and how they are prepared.

Assets, liabilities, expenses, and revenues are of interest to users of accounting information. This information is arranged in the format of four different financial statements, which form the backbone of financial accounting:

· To show how successfully your business performed during a period of time, you report its revenues and expenses in an income statement.

· To indicate how much of previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth, you present a retained earnings statement.

· To present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities), you prepare a balance sheet.

· To show where your business obtained cash during a period of time and how that cash was used, you present a statement of cash flows.

To introduce you to these statements, we have prepared the financial statements for your outdoor guide service, Sierra Corporation, after your first month of operations. To summarize, you officially started your business in Truckee, California, on October 1, 2017. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe outdoor day trips, such as rafting, snowshoeing, and hiking, as well as multi‐day backcountry experiences. To minimize your initial investment, at this point the company has limited outdoor equipment for customer use. Instead, your customers either bring their own equipment or rent equipment through local outfitters. The financial statements for Sierra's first month of business are provided in the following pages.

INTERNATIONAL NOTE

The primary types of financial statements required by International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same. Neither IFRS nor GAAP is very specific regarding format requirements for the primary financial statements. However, in practice, some format differences do exist in presentations commonly employed by IFRS companies as compared to GAAP companies.

International Notes highlight differences between U.S. and international accounting standards.

INCOME STATEMENT

Decision Tools that are useful for business decision‐making are highlighted throughout the textbook. A summary of the Decision Tools, such as the one on page 21, is provided in each chapter.

DECISION TOOLS

The income statement helps users determine if the company's operations are profitable.

The income statement reports a company's revenues and expenses and resulting net income or loss for a period of time. To indicate that its income statement reports the results of operations for a specific period of time, Sierra dates the income statement “For the Month Ended October 31, 2017.” The income statement lists the company's revenues followed by its expenses. Finally, Sierra determines the net income (or net loss) by deducting expenses from revenues. Sierra Corporation's income statement is shown in Illustration 1-4. Congratulations, you are already showing a profit!

SIERRA CORPORATION Income Statement For the Month Ended October 31, 2017

Revenues

  Service revenue

$10,600

Expenses

  Salaries and wages expense

$5,200

  Rent expense

900

  Supplies expense

1,500

  Depreciation expense

40

  Interest expense

50

  Insurance expense

    50

    Total expenses

  7,740

Net income

$ 2,860

ILLUSTRATION 1-4 Sierra Corporation's income statement

▼ HELPFUL HINT

The financial statement heading identifies the company, the type of statement, and the time period covered. Sometimes, another line indicates the unit of measure, e.g., “in thousands” or “in millions.”

Why are financial statement users interested in net income? Investors are interested in a company's past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company's future performance. If investors believe that Sierra will be successful in the future and that this will result in a higher stock price, they will buy its stock. Creditors also use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn't think it would be repaid, it wouldn't loan the money. Therefore, prior to making the loan the bank loan officer uses the income statement as a source of information to predict whether the company will be profitable enough to repay its loan. Thus, reporting a strong profit will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing.

Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (see Illustration 1-7), nor does it regard as a business expense the $500 of dividends paid (see Illustration 1-5).

ETHICS NOTE

When companies find errors in previously released income statements, they restate those numbers. Perhaps because of the increased scrutiny shortly after Sarbanes‐Oxley was implemented, companies filed a record 1,195 restatements.

RETAINED EARNINGS STATEMENT

If Sierra is profitable, at the end of each period it must decide what portion of profits to pay to shareholders in dividends. In theory, it could pay all of its current‐period profits, but few companies do this. Why? Because they want to retain part of the profits to allow for further expansion. High‐growth companies, such as Google and Facebook, often pay no dividends. Retained earnings is the net income retained in the corporation.

The retained earnings statement shows the amounts and causes of changes in retained earnings for a specific time period. The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the first line of the statement. Then, the company adds net income and deducts dividends to determine the retained earnings at the end of the period. If a company has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1-5 presents Sierra Corporation's retained earnings statement.