LEARNING OBJECTIVE 3Describe the four financial

statements and how they are prepared.

CH 1.3: Interactive Tutorial
CH 1.3: Interactive Tutorial
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.
International Notes highlight differences between U.S. and international
accounting standards.
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.
INCOME STATEMENT
Decision Tools that are useful for business decision-making are highlighted
throughout the textbook. A summary of the Decision Tools, is provided in
each chapter.
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 $10,6
00
Expenses
Salaries and wages $5,20
expense 0
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
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).

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

SIERRA CORPORATION
Retained Earnings Statement
For the Month Ended October 31, 2017

Retained earnings, October 1 $    0

Add: Net income 2,860
 SIERRA CORPORATION
Retained Earnings Statement
For the Month Ended October 31, 2017

2,860
Less: Dividends 500
Retained earnings, October 31 $2,360
ILLUSTRATION 1-5 Sierra Corporation's retained earnings statement
By monitoring the retained earnings statement, financial statement users
can evaluate dividend payment practices. Some investors seek companies,
such as Dow Chemical, that have a history of paying high dividends. Other
investors seek companies, such as Amazon.com, that reinvest earnings to
increase the company's growth instead of paying dividends. Lenders monitor
their corporate customers' dividend payments because any money paid in
dividends reduces a company's ability to repay its debts.

DECISION TOOLS
The retained earnings statement helps users determine the company's policy
toward dividends and growth.
HELPFUL HINT
The heading of this statement identifies the company, the type of statement,
and the time period covered by the statement.
BALANCE SHEET
The balance sheet reports assets and claims to assets at a specific point in
time. Claims to assets are subdivided into two categories: claims of creditors
and claims of owners. As noted earlier, claims of creditors are
called liabilities. The owners' claim to assets is called stockholders' equity.
Illustration 1-6 shows the relationship among the categories on the balance
sheet in equation form. This equation is referred to as the basic accounting
equation.
Assets=Liabilities+Stockholders' Equity
ILLUSTRATION 1-6 Basic accounting equation
This relationship is where the name “balance sheet” comes from. Assets
must balance with the claims to assets.
As you can see from looking at Sierra's balance sheet in Illustration 1-7, the
balance sheet presents the company's financial position as of a specific date
—in this case, October 31, 2017. It lists assets first, followed by liabilities and
stockholders' equity. Stockholders' equity is comprised of two parts: (1)
common stock and (2) retained earnings. As noted earlier, common stock
results when the company sells new shares of stock; retained earnings is the
net income retained in the corporation. Sierra has common stock of $10,000
and retained earnings of $2,360, for total stockholders' equity of $12,360.

SIERRA CORPORATION
Balance Sheet
October 31, 2017

Assets
Cash $15,2
00
Accounts receivable 200
Supplies 1,000
Prepaid insurance 550
Equipment, net   
4,960
Total assets $21,9
10
Liabilities and Stockholders' Equity
Liabilities
Notes payable $ 
5,000
Accounts payable 2,500
Unearned service revenue 800
Salaries and wages payable 1,200
Interest payable      
50
Total liabilities $ 
9,550
Stockholders' equity
Common stock 10,000
Retained earnings   
2,360
 SIERRA CORPORATION
Balance Sheet
October 31, 2017

Total stockholders' equity  

12,36
0
Total liabilities and stockholders' $21,9
equity 10
ILLUSTRATION 1-7 Sierra Corporation's balance sheet
Creditors analyze a company's balance sheet to determine the likelihood that
they will be repaid. They carefully evaluate the nature of the company's
assets and liabilities. In operating the Sierra Corporation guide service, the
balance sheet will be used to determine whether cash on hand is sufficient
for immediate cash needs. The balance sheet will also be used to evaluate
the relationship between debt and stockholders' equity to determine whether
the company has a satisfactory proportion of debt and common stock
financing.

DECISION TOOLS
The balance sheet helps users determine if the company relies on debt or
stockholders' equity to finance its assets.
ALTERNATIVE TERMINOLOGY
Liabilities are also referred to as debt.
HELPFUL HINT
The heading of a balance sheet must identify the company, the statement,
and the date.
STATEMENT OF CASH FLOWS
The primary purpose of a 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. To help investors, creditors, and others in their
analysis of a company's cash position, the statement of cash flows reports
the cash effects of a company's operating, investing,
and financing activities. In addition, the statement shows the net increase
or decrease in cash during the period, and the amount of cash at the end of
the period.
Users are interested in the statement of cash flows because they want to know what is happening
to a company's most important resource. The statement of cash flows provides answers to these
simple but important questions:
 •Where did cash come from during the period?
 •How was cash used during the period?
 •What was the change in the cash balance during the period?
The statement of cash flows for Sierra, in Illustration 1-8, shows that cash
increased $15,200 during the month. This increase resulted because
operating activities (services to clients) increased cash $5,700, and financing
activities increased cash $14,500. Investing activities used $5,000 of cash for
the purchase of equipment.

SIERRA CORPORATION
Statement of Cash Flows
For the Month Ended October 31, 2017

Cash flows from operating activities

Cash receipts from operating $11,20
activities 0 
Cash payments for operating  
activities (5,500)
Net cash provided by operating $ 
activities 5,700 
Cash flows from investing activities
Purchased office equipment  
(5,000)
Net cash used by investing (5,000
activities )
Cash flows from financing activities
Issuance of common stock 10,000
 
Issuance of note payable 5,000 
Payment of dividend    
(500)
Net cash provided by financing  
activities 14,50
0 
Net increase in cash 15,20
0 
Cash at beginning of period      
 SIERRA CORPORATION
Statement of Cash Flows
For the Month Ended October 31, 2017

0 
Cash at end of period $15,2
00
ILLUSTRATION 1-8 Sierra Corporation's statement of cash flows
PEOPLE, PLANET, AND PROFIT INSIGHT Beyond
Financial Statements

Should we expand our corporate reports

beyond the income statement, retained earnings statement, balance sheet,
and statement of cash flows? Some believe we should take into account
ecological and social performance, in addition to financial results, in
evaluating a company. The argument is that a company's responsibility lies
with anyone who is influenced by its actions. In other words, a company
should be interested in benefiting many different parties, instead of only
maximizing stockholders' interests.
A socially responsible business does not exploit or endanger any group of
individuals. It follows fair trade practices, provides safe environments for
workers, and bears responsibility for environmental damage. Granted,
measurement of these factors is difficult. How to report this information is
also controversial. But many interesting and useful efforts are underway.
Throughout this textbook, we provide additional insights into how companies
are attempting to meet the challenge of measuring and reporting their
contributions to society, as well as their financial results, to stockholders.
Why might a company's stockholders be interested in its environmental and
social performance?
 DECISION TOOLS
The statement of cash flows helps users determine if the company generates
enough cash from operations to fund its investing activities.
HELPFUL HINT
The heading of this statement identifies the company, the type of statement,
and the time period covered by the statement. Negative numbers are shown
in parentheses.
INTERRELATIONSHIPS OF STATEMENTS
Illustration 1-9 shows the financial statements of Sierra Corporation. Because the results on
some financial statements become inputs to other statements, the statements are interrelated.
These interrelationships can be seen in Sierra's financial statements, as follows.
 1.The retained earnings statement uses the results of the income
statement. Sierra reported net income of $2,860 for the period. Net
income is added to the beginning amount of retained earnings to
determine ending retained earnings.
 2.The balance sheet and retained earnings statement are also
interrelated. Sierra reports the ending amount of $2,360 on the retained
earnings statement as the retained earnings amount on the balance
sheet.
 3.Finally, the statement of cash flows relates to information on the
balance sheet. The statement of cash flows shows how the Cash account
changed during the period. It shows the amount of cash at the beginning
of the period, the sources and uses of cash during the period, and the
$15,200 of cash at the end of the period. The ending amount of cash
shown on the statement of cash flows must agree with the amount of
cash on the balance sheet.
ILLUSTRATION 1-9 Sierra Corporation's financial statements
Study these interrelationships carefully. To prepare financial statements,
you must understand the sequence in which these amounts are
determined and how each statement impacts the next.
DO IT!3aFinancial Statements
CSU Corporation began operations on January 1, 2017. The following
information is available for CSU on December 31, 2017:
Accounts 1,800 Retained ? Supplies 200
receivable earnings expense
Accounts 2,000 Equipment 16,00 Cash 1,40
payable 0 0
Rent expense 9,000 Insurance 1,000 Dividends 600
expense
Notes payable 5,000 Service 17,00
revenue 0
Common stock 10,00 Supplies 4,000
0
Prepare an income statement, a retained earnings statement, and a balance
sheet.
Action Plan
 ✓Report the revenues and expenses for a period of time in an income
statement.
 ✓Show the amounts and causes (net income and dividends) of changes
in retained earnings during the period in the retained earnings statement.
 ✓Present the assets and claims to those assets (liabilities and equity)
at a specific point in time in the balance sheet.
SOLUTION
CSU CORPORATION
Income Statement
For the Year Ended December 31, 2017

Revenues
Service revenue $17,000
Expenses
Rent expense $9,000
Insurance expense 1,000
Supplies expense 200
 CSU CORPORATION
Income Statement
For the Year Ended December 31, 2017

Revenues
Total expenses 10,200
Net income $ 6,800
CSU CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 2017

Retained earnings, January 1 $    

0
Add: Net income 6,800
6,800
Less: Dividends 600
Retained earnings, December 31 $6,20
0
CSU CORPORATION
Balance Sheet
December 31, 2017

Assets
Cash $ 
1,400
Accounts receivable 1,800
Supplies 4,000
Equipment 16,00
0
Total assets $23,2
00
Liabilities and Stockholders' Equity
Liabilities
Notes payable $ 
 CSU CORPORATION
Balance Sheet
December 31, 2017

5,000
Accounts payable 2,000
Total liabilities $ 
7,000
Stockholders' equity
Common stock 10,00
0
Retained earnings 6,200
Total stockholders' equity 16,20
0
Total liabilities and stockholders' $23,2
equity 00
Related exercise material: BE1-5, BE1-6, BE1-7, BE1-8, BE1-9, BE1-10, DO IT!
1-3a, E1-4, E1-5, E1-6, E1-7, E1-8, E1-9, E1-10, E1-11, and E1-14.
HELPFUL HINT
Note that final sums are double-underlined.
HELPFUL HINT
The arrows in this illustration show interrelationships of the four financial
statements.
HELPFUL HINT
Negative amounts are presented in parentheses.
OTHER ELEMENTS OF AN ANNUAL REPORT
Publicly traded U.S. companies must provide shareholders with an annual
report. The annual report always includes the financial statements
introduced in this chapter. The annual report also includes other important
information such as a management discussion and analysis section, notes to
the financial statements, and an independent auditor's report. No analysis of
a company's financial situation and performance is complete without a
review of these items.
Management Discussion and Analysis
The management discussion and analysis (MD&A) section presents
management's views on the company's ability to pay near-term
obligations, its ability to fund operations and expansion, and its
results of operations. Management must highlight favorable or
unfavorable trends and identify significant events and uncertainties that
affect these three factors. This discussion obviously involves a number of
subjective estimates and opinions. A brief excerpt from the MD&A section
of Columbia Sportswear's annual report, which addresses its liquidity
requirements, is presented in Illustration 1-10.

COLUMBIA SPORTSWEAR COMPANY

Management's Discussion and Analysis of
Seasonality and Variability of Business

Our operations are affected by seasonal trends typical in the outdoor

apparel and footwear industry and have historically resulted in higher sales
and profits in the third and fourth calendar quarters. This pattern has
resulted primarily from the timing of shipments of fall season products to
wholesale customers in the third and fourth quarters and proportionally
higher sales in our direct-to-consumer operations in the fourth quarter,
combined with an expense base that is spread more evenly throughout the
year. We believe that our liquidity requirements for at least the next 12
months will be adequately covered by existing cash, cash provided by
operations and existing short-term borrowing arrangements.
ILLUSTRATION 1-10 Columbia Sportswear's management discussion and
analysis
Notes to the Financial Statements
Explanatory notes and supporting schedules accompany every set of
financial statements and are an integral part of the statements. The notes to
the financial statements clarify the financial statements and provide
additional detail. Information in the notes does not have to be quantifiable
(numeric). Examples of notes are descriptions of the significant accounting
policies and methods used in preparing the statements, explanations of
uncertainties and contingencies, and various statistics and details too
voluminous to be included in the statements. The notes are essential to
understanding a company's operating performance and financial position.
Illustration 1-11 is an excerpt from the notes to Columbia Sportswear's
financial statements. It describes the methods that the company uses to
account for revenues.

COLUMBIA SPORTSWEAR COMPANY

Notes to Financial Statements
Revenue Recognition

We record wholesale, distributor, e-commerce and licensed product

revenues when title passes and the risks and rewards of ownership have
passed to the customer. Title generally passes upon shipment to, or upon
 COLUMBIA SPORTSWEAR COMPANY
Notes to Financial Statements
Revenue Recognition

receipt by, the customer depending on the terms of sale with the customer.
Retail store revenues are recorded at the time of sale.
ILLUSTRATION 1-11 Notes to Columbia Sportswear's financial statements
Auditor's Report
An auditor's report is prepared by an independent outside auditor. It states
the auditor's opinion as to the fairness of the presentation of the financial
position and results of operations and their conformance with generally
accepted accounting principles.
An auditor is an accounting professional who conducts an independent
examination of a company's financial statements. Only accountants who
meet certain criteria and thereby attain the designation certified public
accountant (CPA) may perform audits. If the auditor is satisfied that the
financial statements provide a fair representation of the company's financial
position and results of operations in accordance with generally accepted
accounting principles, then the auditor expresses an unqualified opinion. If
the auditor expresses anything other than an unqualified opinion, then
readers should only use the financial statements with caution. That is,
without an unqualified opinion, we cannot have complete confidence that the
financial statements give an accurate picture of the company's financial
health. For example, recently Blockbuster, Inc.'s auditor stated that its
financial situation raised “substantial doubt about the Company's ability to
continue as a going concern.”
Illustration 1-12 is an excerpt from the auditor's report from Columbia
Sportswear's 2014 annual report. Columbia received an unqualified opinion
from its auditor, Deloitte & Touche.

COLUMBIA SPORTSWEAR COMPANY

Excerpt from Auditor's Report

In our opinion, such consolidated financial statements present fairly, in all

material respects, the financial position of Columbia Sportswear Company
and subsidiaries as of December 31, 2014 and 2013, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 2014, in conformity with accounting principles
generally accepted in the United States of America. Also, in our opinion,
such financial statement schedules, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly, in all
 COLUMBIA SPORTSWEAR COMPANY
Excerpt from Auditor's Report

material respects, the information set forth therein.

ILLUSTRATION 1-12 Excerpt from auditor's report on Columbia
Sportswear's financial statements
DO IT!3bComponents of Annual Reports
State whether each of the following items is most closely associated with the
management discussion and analysis (MD&A), the notes to the financial
statements, or the auditor's report.
 1.Descriptions of significant accounting policies.
 2.Unqualified opinion.
 3.Explanations of uncertainties and contingencies.
 4.Description of ability to fund operations and expansion.
 5.Description of results of operations.
 6.Certified public accountant (CPA).
Action Plan
 ✓Realize that financial statements provide information about a
company's performance and financial position.
 ✓Be familiar with the other elements of the annual report in order to
gain a fuller understanding of a company.
SOLUTION
 1.Descriptions of significant accounting policies: Notes.
 2.Unqualified opinion: Auditor's report.
 3.Explanations of uncertainties and contingencies: Notes.
 4.Description of ability to fund operations and expansion: MD&A.
 5.Description of results of operations: MD&A.
 6.Certified public accountant (CPA): Auditor's report.
Related exercise material: BE1-11, DO IT! 1-3b, and E1-17.
USING DECISION TOOLSVF CORPORATION
There is a good chance that you may have never heard of VF Corporation.
There is also a very good chance that you are wearing one of VF's products
right now. VF owns North Face, Lee, Vans, Nautica, Wrangler, Timberland, and
numerous other brands. VF is a direct competitor to Columbia Sportswear.
Suppose that you are considering investing in shares of VF's common stock.
INSTRUCTIONS
Answer these questions related to your decision whether to invest.
(a)
What financial statements should you evaluate?
(b)
What should these financial statements tell you?
 (c)
Do you care if the financial statements have been audited? Explain.
(d)
Appendix B at the end of this textbook contains financial statements for
Columbia, and Appendix C contains those for VF. You can make many
comparisons between Columbia and VF in terms of their respective results
from operations and financial position. Compare their respective total assets,
total revenues, and net cash provided by operating activities.
SOLUTION
 (a)Before you invest, you should evaluate the income statement,
retained earnings statement, balance sheet, and statement of cash flows.
 (b)You would probably be most interested in the income statement
because it tells about past performance and thus gives an indication of
future performance. The retained earnings statement provides a record of
the company's dividend history. The balance sheet reveals the relationship
between assets and liabilities. The statement of cash flows reveals where
the company is getting and spending its cash. This is especially important
for a company that wants to grow.
 (c)You would want audited financial statements. These statements
indicate that a CPA (certified public accountant) has examined and
expressed an opinion that the statements present fairly the financial
position and results of operations of the company. Investors and creditors
should not make decisions without studying audited financial statements.
 (d)Many interesting comparisons can be made between the two
companies (all numbers are in thousands). Columbia is smaller, with total
assets of $1,792,209 versus $9,980,140 for VF, and it has lower revenue—
$2,100,590 versus $12,282,161 for VF. In addition, Columbia's net cash
provided by operating activities of $185,783 is less than VF's $1,697,629.
However, while useful, these basic measures are not enough to determine
whether one company is a better investment than the other. In later
chapters, you will learn tools that will allow you to compare the relative
profitability and financial health of these and other companies.
Using Decision Tools comprehensive exercises ask you to apply business
information and the decision tools presented in the chapter. Most of these
exercises are based on the companies highlighted in the Feature Story.
Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.