1.Accounting is a system for identifying, measuring, recording, and communicating financial

1.Accounting is a system for identifying, measuring, recording, and communicating financial information about an organization’s activities to permit informed decisions by users of the information. Bookkeeping is the process—made up of mechanical “steps”—of recording transactions and maintaining accounting records. While bookkeeping is part of accounting, accounting is viewed as the complete information system that communicates the economic activities of a company to interested parties. Accounting is often referred to as the “language of business” because it communicates information about economic activities of a company that help people make decisions.

2.Accounting information is demanded or needed by decision-makers both inside and outside the business to provide information about business activities and finances so that informed decisions can be made. Five groups that create the demand for accounting information and their uses of accounting information are described below.(1) Managers need accounting information to plan and make decisions about the business (e.g., predicting the consequences of their actions and deciding on which actions to take) and to control its operations (e.g., evaluating the effectiveness of their past decisions).(2) Employees use accounting information about their employer to aid in planning their careers (e.g., judging the future prospects of the company).(3) Investors (owners) need accounting information about a business to evaluate the future prospects of a business and to decide where to invest their money.(4) Creditors (lenders) need accounting information to decide whether or not to lend money or extend credit to a business.(5) Governments need accounting information about businesses to determine taxes owed by businesses, to implement a variety of regulatory objectives, and to make national economic policy decisions.

3.An accounting entity is a company that has an identity separate from that of its owners and managers and for which accounting records are kept. There are three main forms that accounting entities take: a sole proprietorship, a partnership, and a corporation.

4.A sole proprietorship is a business entity owned by one person. A partnership is a business entity owned jointly by two or more individuals. Proprietorships and partnerships are not legally separate from the personal affairs of the owners. That is, the owners are responsible for the debts of the business. A corporation is a separate legal entity formed by one or more persons called stockholder(s). A corporation is legally separate from the affairs of its owners, which limits the stockholders’ legal responsibility for the debt of the business to the amount that the stockholders invested in the business. Corporate shareholders generally pay more taxes than owners of sole proprietorships or partnerships. Although the combined number of sole proprietorships and partnerships greatly outnumber the number of corporations, the majority of business in the United States is conducted by corporations.1

ACCOUNTING AND THE

FINANCIAL STATEMENTS

DISCUSSION QUESTIONS

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CHAPTER 1 Accounting and the Financial Statements 5.The three main types of business activities are financing activities, investing activities, and operating activities. Financing activities involve obtaining the funds necessary to begin and operate a business. These funds come from either issuing stock or borrowing money. Investing activities involve buying and selling assets that enable a corporation to operate. Operating activities are the normal business activities that a company engages in as it conducts its business. These activities involve selling products or services, purchasing inventory, collecting amounts due from customers, and paying suppliers.

6.Assets are the economic resources or future economic benefits obtained or controlled by a business. Liabilities are the creditors’ claims on the resources of a business. Stockholders’ equity is the ownership claim on the resources of a business. Stockholders’ equity is considered a residual interest in the assets of a business that remain after deducting the business’s liabilities. All three items appear on the balance sheet, forming the following equation: Assets = Liabilities + Stockholders’ Equity 7.Revenues are the increases in assets (resources) that result from the sale of products or services.Expenses are the costs of assets (resources) used, or the liabilities created, in the operation of the business. If revenues are greater than expenses, a corporation has earned net income. If expenses are greater than revenues, a corporation has incurred a net loss.

8.The four primary financial statements are:

(1) Balance sheet: a presentation of information about a company’s economic resources (assets) and the claims against those resources by creditors and owners (liabilities and stockholders’ equity) at a specific point in time

(2) Income statement: a report on how well a company has performed—

the profitability of a company—over a period of time (3) Retained earnings statement: a report on how much of the company’s income was retained in the business and how much was distributed to owners over a period of time (4) Statement of cash flows: a report on the changes in a company’s cash during a period of time. The statement of cash flows provides information about the company’s cash inflows (sources) and outflows (uses) from operating, investing, and financing activities.

9.There are many questions that can be answered based on each of the financial statements:

(1) Balance sheet:

• What is the total amount of assets (economic resources) of a corporation? What is

the total amount of liabilities (claims against the resources) for a corporation?

• How much equity do the owners of the corporation have in its assets?
• Is the corporation able to pay its debts as they become due?

(2) Income statement:

• How much revenue was earned last month? Last quarter? Last year?
• What was the total amount of expenses incurred to earn that revenue?
• How much better off is the corporation at the end of the year than it was at the

beginning of the year?

• Was the corporation profitable, and what are the prospects for the corporation’s

future profitability?

• What are the prospects for the future growth of the corporation?

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CHAPTER 1 Accounting and the Financial Statements

(3) Retained earnings statement:

• How much income was distributed in dividends by the corporation?
• What amount of equity in the business has been generated internally?

(4) Statement of cash flows:

• How much cash was taken in or paid out as a result of operations?
• How much cash was invested in new equipment?
• How much cash was used to pay off business debt?

10.Point-in-time measurement means as of a particular date. The balance sheet is a point-in-time measurement. The period-of-time description applies to what has happened over a time interval.The income statement is a period-of-time measurement that explains the business activities between balance sheet dates. The statement of cash flows and the statement of retained earnings are also period-of-time measurements.

11.The fundamental accounting equation is:

Assets = Liabilities + Stockholders’ Equity The equation is significant because it means that the balance sheet must always balance. This implies that what a company owns (its resources) must always be equal to the claims of its creditors (liabilities) and investors (stockholders’ equity).

12.Each financial statement includes a heading that is comprised of (a) the name of the company, (b) the title of the financial statement, and (c) the time period covered—either a point-in-time measurement (an exact date) or a period-of-time description (e.g., a year ended in a specific date).

13.Current assets are cash and other assets that are reasonably expected to be converted to cash within 1 year or the operating cycle, whichever is longer. Current liabilities are obligations that will be satisfied within 1 year or the operating cycle, whichever is longer.Since current assets are presented separately from other assets, statement users can see if the firm is likely to have enough resources available to meet its current liabilities as they come due. If current assets were presented among other assets, such a determination would be difficult.Current liabilities are separated from long-term liabilities because current liabilities will require asset outflows (or replacement with another liability) much sooner than will long-term liabilities. If all liabilities were presented together, financial statement users would have difficulty determining the assets (economic resources) required in the near future to satisfy the current liabilities.

14.Current assets are generally listed on the balance sheet in order of liquidity or nearness to cash, whereas current liabilities are usually listed in the order in which they will be paid.

15.The two main components of equity are contributed capital and retained earnings. Contributed capital is increased by investments of new capital in a company by its owners (the issue of common stock to stockholders). Retained earnings is the accumulated net income of a company that has not been distributed to owners. Retained earnings is increased by net income and decreased by net losses and dividends.

16.Net Income = Total Revenues – Total Expenses 1-3 © 2018 Cengage Learning ® . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 / 4

CHAPTER 1 Accounting and the Financial Statements 17.The single-step income statement format takes into account only two categories: total revenues and total expenses. Total expenses are subtracted from total revenues in a single step to arrive at net income. The multiple-step income statement format contains three important subtotals: gross margin (gross profit), income from operations, and net income. Gross margin is the difference between net sales and cost of sales (or cost of goods sold). Income from operations is the difference between gross margin and operating expenses. Net income is the difference between income from operations and any nonoperating revenues and expenses.

18.A retained earnings statement summarizes and explains the changes in retained earnings during an accounting period. Retained earnings is the income earned by the company but not paid to the owners in the form of dividends. The retained earnings statement starts with the balance in retained earnings at the beginning of the period. To this balance, add net income (or subtract the net loss) obtained from the income statement. Next, subtract any dividends the company declared during the period. The total is the retained earnings at the end of the period that is reported on the balance sheet.

19.The statement of cash flows classifies cash flows into three categories: (1) cash flows from operating activities, (2) cash flows from investing activities, and (3) cash flows from financing activities. Cash flows from operating activities are the cash flows related to the normal operations of the business in earning income, and include cash sales and collections of accounts receivable minus cash paid for goods, services, wages, salaries, and interest. Cash flows from investing activities are cash flows related to the acquisition or sale of investments and long-term assets, including cash received from the sales of property, plant, and equipment; investments; and other long-lived assets minus the cash spent to purchase long-term assets. The cash flows from investing activities by a healthy, growing business will usually represent an excess of expenditures over receipts. Cash flows from financing activities are the cash flows related to obtaining the capital of the company, including the cash contributed by owners and borrowed from creditors minus amounts paid as dividends and repayments of liabilities. A business can finance its growth either internally with cash generated by operations or externally with cash from owners and creditors.

20.The retained earnings statement describes the changes in retained earnings, a balance sheet account, that occur between two balance sheet dates. One of the major sources of change in retained earnings is the net income (or net loss) for the year, which is determined on the income statement. The other major source of change in retained earnings is dividends, which are not considered a part of income.

21.Other than the financial statements, users will find notes to the financial statements, management’s discussion and analysis of the condition of the company, and the auditor’s report in the annual report of a company. The notes to the financial statements are an integral part of the financial statements that clarify and expand upon the information in the financial statements.Management’s discussion and analysis provides a discussion and explanation of various items reported in the financial statements. Additionally, management uses this opportunity to highlight favorable and unfavorable trends and significant risks facing the company. The auditor’s report expresses the opinion of the auditor as to whether the financial statements fairly present the financial position and results of operations of the company.1-4 © 2018 Cengage Learning ® . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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