CHAPTER 1
Introduction to Financial Statements
Learning Objectives
1. Identify the forms of business organization and the uses of accounting information.
2. Explain the three principal types of business activity.
3. Describe the four financial statements and how they are prepared.
*4. Explain the career opportunities in accounting.
ANSWERS TO QUESTIONS
1. The three basic forms of business organizations are (1) sole proprietorship, (2) partnership, and
(3) corporation.
LO 1 BT: K Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA BC: Governance Perspective
2. Advantages of a corporation are limited liability (stockholders not being personally liable for cor-
porate debts), easy transferability of ownership, and ease of raising funds. Disadvantages of a
corporation are increased taxation and government regulations.
LO 1 BT: K Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA BC: Governance Perspective
3. Proprietorships and partnerships receive favorable tax treatment compared to corporations and are
easier to form than corporations. They are also owner controlled. Disadvantages of proprietorships
and partnerships are unlimited liability (proprietors/partners are personally liable for all debts) and
difficulty in obtaining financing compared to corporations.
LO 1 BT: K Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA BC: Governance Perspective
4. Yes. Companies can choose one of the hybrid business forms, limited liability corporations
(LLCs) or subchapter S corporations, which combine the tax advantages of partnerships with the
limited liability of corporations.
LO 1 BT: K Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA BC: Governance Perspective
5. Yes. A person cannot earn a living, spend money, buy on credit, make an investment, or pay
taxes without receiving, using, or dispensing financial information. Accounting provides financial
information to interested users through the preparation and distribution of financial statements.
LO 1 BT: C Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
6. Internal users are managers who plan, organize, and run a business. To assist management,
accounting provides timely internal reports. Examples include financial comparisons of operating
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, alternatives, projections of income from new sales campaigns, forecasts of cash needs for the
next year, and financial statements.
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7. External users are those outside the business who have either a present or potential direct
financial interest (investors and creditors) or an indirect financial interest (taxing authorities, regu-
latory agencies, labor unions, customers, and economic planners).
LO 1 BT: C Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
8. The four most common types of data analytics and the basic question each addresses are:
Descriptive (What happened?), Diagnostic (Why did it happen?), Predictive (What is likely to
happen?), and Prescriptive (What should we do about it?).
LO 1 BT: K Difficulty: E TOT: 2 min. AACSB: nowledge AICPA AC: Measurement Analysis and Interpretation
Questions Chapter 1 (Continued)
9. The three types of business activities are financing activities, investing activities, and operating
activities. Financing activities include borrowing money and selling shares of stock. Investing
activities include the purchase and sale of property, plant, and equipment. Operating activities
include selling goods, performing services, and purchasing inventory.
LO 2 BT: C Difficulty: M TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
10. (a) Income statement. (d) Balance sheet.
(b) Balance sheet. (e) Balance sheet.
(c) Income statement. (f) Balance sheet.
LO 3 BT: K Difficulty: M TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
11. When a company pays dividends, it reduces the amount of assets available to pay creditors.
Therefore, banks and other creditors monitor dividend payments to ensure they do not put a
company’s ability to make debt payments at risk.
LO 3 BT: C Difficulty: M TOT: 2 min. AACSB: Knowledge AICPA AC: Measurement Anallysis and Interpretation
12. Yes. Net income does appear on the income statement—it is the result of subtracting expenses
from revenues. In addition, net income appears in the retained earnings statement—it is shown as
an addition to the beginning-of-period retained earnings. Indirectly, the net income of a company
is also included in the balance sheet. It is included in the retained earnings account which appears
in the stockholders’ equity section of the balance sheet.
LO 3 BT: C Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
13. The primary purpose of the statement of cash flows is to provide financial information about the
cash receipts and cash payments of a business for a specific period of time.
LO 3 BT: K Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
2 Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only)
,14. The three categories of the statement of cash flows are operating activities, investing activities,
and financing activities. The categories were chosen because they represent the three principal
types of business activities.
LO 3 BT: C Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
15. Retained earnings is the net income retained in a corporation. Retained earnings is increased by
net income and is decreased by dividends and a net loss.
LO 3 BT: C Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
16. The basic accounting equation is Assets = Liabilities + Stockholders’ Equity.
LO 3 BT: K Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
17. (a) Assets are resources owned by a business. Liabilities are amounts owed to creditors. Put more
simply, liabilities are existing debts and obligations. Stockholders’ equity is the ownership claim
on net assets.
(b) The items that affect stockholders’ equity are issuance of common stock and the
components of retained earnings (dividends, revenues, and expenses).
LO 3 BT: K Difficulty: E TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
18. The liabilities are (b) Accounts payable and (g) Salaries and wages payable.
LO 3 BT: C Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
19. (a) Net income from the income statement is reported as an increase to retained earnings on
the retained earnings statement.
(b) The ending amount on the retained earnings statement is reported as the retained earnings
amount on the balance sheet.
(c) The ending amount on the statement of cash flows is reported as the cash amount on the
balance sheet.
LO 3 BT: C Difficulty: M TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
20. The purpose of the management discussion and analysis section is to provide management’s
views on its ability to pay short-term obligations, its ability to fund operations and expansion, and
its results of operations. The MD&A section is a required part of the annual report.
LO 3 BT: K Difficulty: E TOT: 1 min. AACSB: Knowledge AICPA AC: Reporting
21. An unqualified opinion shows that, in the opinion of an independent auditor, the financial state-
ments have been presented fairly, in conformity with generally accepted accounting principles.
This gives investors more confidence that they can rely on the figures reported in the financial
statements.
LO 3 BT: C Difficulty: E TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only) 3
,22. Information included in the notes to the financial statements clarifies information presented in the
financial statements and includes descriptions of accounting policies, explanations of uncertain-
ties and contingencies, and statistics and details too voluminous to be reported in the financial
statements.
LO 3 BT: K Difficulty: E TOT: 1 min. AACSB: None AICPA FC: Reporting
23. Using dollar amounts, Apple’s accounting equation (in millions) is:
Assets Liabilities Stockholders’ Equity
= +
$323,,888 $258,549 $65,339
LO 3 BT: AP Difficulty: E TOT: 2 min. AACSB: Analytic AICPA AC: Reporting
Questions Chapter 1 (Continued)
24. A critical audit matter is an audit issue that was material in size and that involved challenging,
subjective, or complex auditor judgement.
LO 3 BT: K Difficulty: E TOT: 2 min. AACSB: Knowledge AICPA AC: Research
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 1.1
(a) P Shared control, tax advantages, increased skills and resources.
(b) SP Simple to set up and maintains control with owner.
(c) C Easier to transfer ownership and raise funds, no personal liability.
LO 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: Knowledge AICPA BC: Governance Perspective
BRIEF EXERCISE 1.2
(a) 4 Investors in common stock
(b) 3 Marketing managers
(c) 2 Creditors
(d) 5 Chief Financial Officer
(e) 1 Internal Revenue Service
LO 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: Knowledge AICPA AC: Measurement Analysis and
Interpretation
4 Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only)
,BRIEF EXERCISE 1.3
O (a) Cash received from customers.
F (b) Cash paid to stockholders (dividends).
F (c) Cash received from issuing new common stock.
O (d) Cash paid to suppliers.
I (e) Cash paid to purchase a new office building.
LO 2 BT: K Difficulty: Easy TOT: 2 min. AACSB: Knowledge AICPA AC: Measurement Analysis and
Interpretation & Reporting
BRIEF EXERCISE 1.4
E (a) Advertising expense
R (b) Service revenue
E (c) Insurance expense
E (d) Salaries and wages expense
D (e) Cash distributed to stockholders.
R (f) Rent revenue
E (g) Utilities expense
NSE (h) Cash purchase of equipment
C (i) Cash received from investors.
LO 3 BT: C Difficulty: Easy TOT: 3 min. AACSB: Knowledge AICPA AC: Measurement Analysis and
Interpretation & Reporting
BRIEF EXERCISE 1.5
KAROL COMPANY
Balance Sheet
December 31, 2025
Assets
Cash ................................................................................. $22,000
Accounts receivable ....................................................... 71,000
Total assets ..................................................................... $93,000
Liabilities and Stockholders‘ Equity
Liabilities
Accounts payable ................................................... $65,000
Stockholders‘ equity
Common stock ........................................................ $18,000
Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only) 5
, Retained earnings ................................................... 10,000
Total stockholders‘ equity .............................................. 28,000
Total liabilities and stockholders‘ equity...................... $93,000
LO 3 BT: AP Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA AC: Reporting
BRIEF EXERCISE 1.6
IS (a) Income tax expense
BS (b) Inventory
BS (c) Accounts payable
BS (d) Retained earnings
BS (e) Equipment
IS (f) Sales revenue
IS (g) Cost of goods sold
BS (h) Common stock
BS (i) Accounts receivable
IS (j) Interest expense
LO 3 BT: K Difficulty: Easy TOT: 3 min. AACSB: Knowledge AICPA AC: Reporting
BRIEF EXERCISE 1.7
IS (a) Revenue during the period.
BS (b) Supplies on hand at the end of the year.
SCF (c) Cash received from issuing new bonds during the period.
BS (d) Total debts outstanding at the end of the period.
LO 3 BT: K Difficulty: Easy TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
BRIEF EXERCISE 1.8
(a) $90,000 + $230,000 = $320,000 (Total assets)
(Liabilities + Stockholders‘ equity = Assets)
($90,000 + $230,000 = $320,000)
(b) $170,000 – $80,000 = $90,000 (Total liabilities)
(Assets – Stockholders‘ equity = Liabilities)
($170,000 – $80,000 = $90,000)
(c) $800,000 – 0.25($800,000) = $600,000 (Stockholders‘ equity)
(Assets – (0.25 × Assets) = Stockholders‘ equity)
6 Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only)
, [$800,000 – (0.25 × $800,000) = $600,000]
LO 3 BT: AP Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA: AC: Measurement Analysis and
Interpretation
BRIEF EXERCISE 1.9
(a) ($800,000 + $150,000) – ($500,000 – $80,000) = $530,000
(Stockholders‘ equity)
[(Assets ± Change in assets) – (Liabilities ± Change in liabilities) = Stockholders‘ equity]
[($800,000 + $150,000) – ($500,000 – $80,000) = $530,000]
(b) ($500,000 + $100,000) + [($800,000 – $500,000) – $70,000] = $830,000
(Assets)
[(Liabilities ± Change in liabilities) + (Stockholders‘ equity ± Change in stockholders‘
equity) = Assets]
[($500,000 + $100,000) + [($800,000 – $500,000) – $70,000] = $830,000]
(c) ($800,000 – $80,000) – [($800,000 – $500,000) + $110,000] = $310,000
(Liabilities)
[(Assets ± Change in assets) – (Stockholders‘ equity ± Change in stockholders‘
equity) = Liabilities]
[($800,000 – $80,000) – [($800,000 – $500,000) + $110,000] = $310,000]
LO 3 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA AC: Measurement Analysis and
Interpretation
BRIEF EXERCISE 1.10
A (a) Accounts receivable
L (b) Salaries and wages payable
A (c) Equipment
A (d) Supplies
SE (e) Common stock
L (f) Notes payable
LO 3 BT: K Difficulty: Easy TOT: 3 min. AACSB: Knowledge AICPA AC: Reporting
BRIEF EXERCISE 1.11
(d) All of these are required.
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,LO 3 BT: K Difficulty: Easy TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
SOLUTIONS TO DO IT! EXERCISES
DO IT! 1.1a
(a) Easier to transfer ownership: corporation
(b) Easier to raise funds: corporation
(c) More owner control: sole proprietorship
(d) Tax advantages: sole proprietorship and partnership
(e) No personal legal liability: corporation
LO 1 BT: C Difficulty: Easy TOT: 2 min. AACSB: Kowledge AICPA BC: Governance Perspective
DO IT! 1.1b
_3_ (a) Accounting
_5_ (b) Internal users of financial information
_2_ (c) Element of Sarbanes-Oxley Act
_1_ (d) External users of financial information
_4_ (e) Steps in solving an ethical dilemma
LO 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
DO IT! 1.2
(a) Issuance of ownership shares is classified as common stock.
(b) Land purchased is classified as an asset.
(c) Amounts owed to suppliers are classified as liabilities.
(d) Bonds payable are classified as liabilities.
(e) Amount recorded from selling a product is classified as revenue.
(f) Cost of advertising is classified as expense.
LO 2 BT: K Difficulty: Easy TOT: 2 min. AACSB: Knowledge AICPA AC: Reporting
8 Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only)
,DO IT! 1.3a
GRAY CORPORATION
Income Statement
For the Year Ended December 31, 2025
Revenues
Service revenue ............................................. $25,000
Expenses
Rent expense ................................................. $10,000
Advertising expense ..................................... 4,000
Supplies expense .......................................... 1,700
Total expenses ................................... 15,700
Net income ............................................................ $ 9,300
[Serv. rev.– Tot. expenses = Net inc. or (loss)]
[$25,000 – ($10,000 + $4,000 + $1,700) = $9,300]
GRAY CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 2025
Retained earnings, January 1 .................................. $ –0–
Add: Net income ...................................................... 9,300
9,300
Less: Dividends ........................................................ 2,500
Retained earnings, December 31 ............................. $6,800
(Beg. ret. earn. + Net inc. – Div.= End. ret. earn.)
($0 + $9,300 – $2,500 = $6,800)
GRAY CORPORATION
Balance Sheet
December 31, 2025
Assets
Cash ............................................................................ $ 3,100
Accounts receivable .................................................. 2,000
Supplies ...................................................................... 1,900
Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only) 9
, Equipment ..................................................................
26,800
Total assets ................................................................ $33,800
Liabilities and Stockholders‘ Equity
Liabilities
Notes payable ..................................................... $ 7,000
Account payable ................................................ 5,000
Total liabilities ......................................... $12,000
Stockholders‘ equity
Common stock ................................................... 15,000
Retained earnings .............................................. 6,800
Total stockholders‘ equity ..................... 21,800
Total liabilities and stockholders‘ equity................ $33,800
(Assets = Liabl. + SE)
[($3,100 + $2,000 + $1,900 + $26,800) = (($7,000 + $5,000) + ($15,000 + $6,800))]
LO 3 BT: AP Difficulty: Hard TOT: 10 min. AACSB: Analytic AICPA AC: Reporting
DO IT! 1.3b
(a) Description of ability to pay near-term obligations: MD&A
(b) Unqualified opinion: auditor‘s report
(c) Details concerning liabilities, too voluminous to be included in the
statements: notes to the financial statements
(d) Description of favorable and unfavorable trends: MD&A
(e) Certified Public Accountant (CPA): auditor‘s report
(f) Descriptions of significant accounting policies: notes to the financial
statements
LO 3 BT: K Difficulty: Easy TOT: 3 min. AACSB: Knowledge AICPA AC: Reporting
SOLUTIONS TO EXERCISES
EXERCISE 1.1
(a) 8. Auditor‘s opinion
(b) 1. Corporation
(c) 6. Common stock
(d) 7. Accounts payable
(e) 3. Accounts receivable
(f) 2. Creditor
(g) 9. Hybrid form of organization
10 Copyright © John Wiley & Sons, Inc. Solutions Manual (For Instructor Use Only)
