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Principles of
Accounting
ELEVENTH EDITION
Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A.
DePaul University
Marian Powers, Ph.D.
Northwestern University
Susan V. Crosson, M.S. Accounting, C.P.A
Santa Fe College
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Principles of Accounting, Eleventh Edition © 2011, 2008 South-Western, Cengage Learning
Belverd Needles, Marian Powers,
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Library of Congress Control Number: 2009941180
Student Edition ISBN 10: 1-4390-3774-4
Student Edition ISBN 13: 978-1-4390-3774-4
Instructors Edition ISBN 10: 0-538-75528-8
Instructors Edition ISBN 13: 978-0-538-75528-3
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Loose-leaf Edition ISBN 13: 978-0-538-75519-1
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1 2 3 4 5 6 7 13 12 11 10 09
BRIEF CONTENTS
1 Uses of Accounting Information and the Financial Statements 2
2 Analyzing Business Transactions 48
3 Measuring Business Income 98
4 Completing the Accounting Cycle 142
5 Financial Reporting and Analysis 180
SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 226
6 The Operating Cycle and Merchandising Operations 266
SUPPLEMENT TO CHAPTER 6 Special-Purpose Journals 302
7 Internal Control 318
8 Inventories 350
9 Cash and Receivables 390
10 Current Liabilities and Fair Value Accounting 430
11 Long-Term Assets 472
12 Contributed Capital 518
13 Long-Term Liabilities 562
14 The Corporate Income Statement and the Statement
of Stockholders’ Equity 614
15 The Statement of Cash Flows 656
16 Financial Performance Measurement 706
17 Partnerships 754
18 The Changing Business Environment:
A Manager’s Perspective 794
19 Cost Concepts and Cost Allocation 836
iii
iv
Brief Contents
20 Costing Systems: Job Order Costing 882
21 Costing Systems: Process Costing 920
22 Value-Based Systems: ABM and Lean 958
23 Cost Behavior Analysis 988
24 The Budgeting Process 1040
25 Performance Management and Evaluation 1092 |
26 Standard Costing and Variance Analysis 1136
27 Short-Run Decision Analysis 1184
28 Capital Investment Analysis 1224
APPENDIX A Accounting for investments 1262
APPENDIX B Present Value Tables 1276
CONTENTS
Preface xvii
About the Authors xxxvii
CHAPTER 1 Uses of Accounting Information and the Financial Statements 2
DECISION POINT (cid:2) A USER’S FOCUS KEEP-FIT CENTER 3 Financial Position and the Accounting
Equation 17
Accounting as an Information System 4
Business Goals, Activities, and Performance Assets 18
Measures 4 Liabilities 18
Financial and Management Accounting 7 Owner’s Equity 18
Processing Accounting Information 7 Financial Statements 19
Ethical Financial Reporting 8 Income Statement 19
Decision Makers: The Users of Accounting Statement of Owner’s Equity 20
Information 10 The Balance Sheet 20
Management 10 Statement of Cash Flows 21
Users with a Direct Financial Interest 11 Relationships Among the Financial Statements 21
Users with an Indirect Financial Interest 12 Generally Accepted Accounting Principles 24
Governmental and Not-for-Profit Organizations 12 GAAP and the Independent CPA’s Report 25
Accounting Measurement 13 Organizations That Issue Accounting Standards 26
Business Transactions 14 Other Organizations That Influence GAAP 26
Money Measure 14 Professional Conduct 27
Separate Entity 15 Corporate Governance 27
The Forms of Business Organization 15 (cid:2) KEEP-FIT CENTER: REVIEW PROBLEM 28
Characteristics of Corporations, Sole Proprietorships, STOP & REVIEW 31
and Partnerships 15
CHAPTER ASSIGNMENTS 33
CHAPTER 2 Analyzing Business Transactions 48
DECISION POINT (cid:2) A USER’S FOCUS PAWS AND HOOFS Business Transaction Analysis 58
CLINIC 49 Owner’s Investment to Form the Business 58
Measurement Issues 50 Economic Event That Is Not a Business
Recognition 50 Transaction 59
Valuation 51 Prepayment of Expenses in Cash 59
Classification 53 Purchase of an Asset on Credit 59
Ethics and Measurement Issues 53 Purchase of an Asset Partly in Cash and Partly
on Credit 60
Double-Entry System 54
Payment of a Liability 60
Accounts 54
Revenue in Cash 61
The T Account 54
Revenue on Credit 61
The T Account Illustrated 55
Revenue Collected in Advance 61
Rules of Double-Entry Accounting 55
Collection on Account 62
Normal Balance 56
Expense Paid in Cash 62
Owner’s Equity Accounts 56
v
vi
Contents
Expense to Be Paid Later 63 Recording and Posting Transactions 70
Withdrawals 63 Chart of Accounts 70
Summary of Transactions 65 General Journal 70
The Trial Balance 65 General Ledger 72
Preparation and Use of a Trial Balance 65 Some Notes on Presentation 73
Finding Trial Balance Errors 67 (cid:2) PAWS AND HOOFS CLINIC: REVIEW PROBLEM 75
Cash Flows and the Timing STOP & REVIEW 79
of Transactions 68 CHAPTER ASSIGNMENTS 81
CHAPTER 3 Measuring Business Income 98
DECISION POINT (cid:2) A USER’S FOCUS RELIABLE Type 2 Adjustment: Recognizing Unrecorded,
ANSWERING SERVICE 99 Incurred Expenses (Accrued Expenses) 111
Profitability Measurement: Issues and Type 3 Adjustment: Allocating Recorded, Unearned
Ethics 100 Revenues (Deferred Revenues) 113
Net Income 100 Type 4 Adjustment: Recognizing Unrecorded,
Earned Revenues (Accrued Revenues) 114
Income Measurement Assumptions 101
A Note About Journal Entries 115
Ethics and the Matching Rule 102
Using the Adjusted Trial Balance to Prepare
Accrual Accounting 104
Financial Statements 116
Recognizing Revenues 104
Cash Flows from Accrual-Based
Recognizing Expenses 105
Information 119
Adjusting the Accounts 105
(cid:2) RELIABLE ANSWERING SERVICE: REVIEW
Adjustments and Ethics 106
PROBLEM 121
The Adjustment Process 107 STOP & REVIEW 125
Type 1 Adjustment: Allocating Recorded Costs
CHAPTER ASSIGNMENTS 127
(Deferred Expenses) 107
CHAPTER 4 Completing the Accounting Cycle 142
DECISION POINT (cid:2) A USER’S FOCUS WESTWOOD The Accounts After Posting 148
MOVERS 143 The Post-Closing Trial Balance 150
From Transactions to Financial
Reversing Entries: An Optional First
Statements 144 Step 152
The Accounting Cycle 144
The Work Sheet: An Accountant’s Tool 154
Closing Entries 144
Preparing the Work Sheet 154
Preparing Closing Entries 147 |
Using the Work Sheet 157
Step 1: Closing the Credit Balances 147 (cid:2) WESTWOOD MOVERS: REVIEW PROBLEM 158
Step 2: Closing the Debit Balances 147
STOP & REVIEW 160
Step 3: Closing the Income Summary Account
CHAPTER ASSIGNMENTS 162
Balance 147
Step 4: Closing the Withdrawals Account
Balance 147
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Contents
CHAPTER 5 Financial Reporting and Analysis 180
DECISION POINT (cid:2) A USER’S FOCUS FUN-FOR-FEET Classified Balance Sheet 190
COMPANY 181 Assets 190
Foundations of Financial Reporting 182 Liabilities 192
Objective of Financial Reporting 182 Owner’s Equity 193
Qualitative Characteristics of Accounting Dell’s Balance Sheets 194
Information 182
Forms of the Income Statement 196
Accounting Conventions 184
Multistep Income Statement 196
Ethical Financial Reporting 184
Dell’s Income Statements 199
Accounting Conventions for Preparing
Single-Step Income Statement 200
Financial Statements 185
Using Classified Financial Statements 201
Consistency 185
Evaluation of Liquidity 201
Full Disclosure (Transparency) 186
Evaluation of Profitability 202
Materiality 187
(cid:2) FUN-FOR-FEET COMPANY: REVIEW PROBLEM 208
Conservatism 187
STOP & REVIEW 210
Cost-Benefit 188
CHAPTER ASSIGNMENTS 212
SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 226
The Components of an Annual Report 226 Financial Statements 228
Letter to the Stockholders 227 Notes to the Financial Statements 233
Financial Highlights 227 Reports of Management’s Responsibilities 234
Description of the Company 227 Reports of Certified Public Accountants 234
Management’s Discussion and Analysis 227
CHAPTER 6 The Operating Cycle and Merchandising Operations 266
DECISION POINT (cid:2) A USER’S FOCUS FONG Perpetual Inventory System 275
COMPANY 267 Purchases of Merchandise 275
Managing Merchandising Businesses 268 Sales of Merchandise 277
Operating Cycle 268
Periodic Inventory System 281
Choice of Inventory System 270
Purchases of Merchandise 282
Foreign Business Transactions 270
Sales of Merchandise 284
Terms of Sale 272 (cid:2) FONG COMPANY: REVIEW PROBLEM 286
Sales and Purchases Discounts 272
STOP & REVIEW 289
Transportation Costs 273
CHAPTER ASSIGNMENTS 290
Terms of Debit and Credit Card Sales 274
SUPPLEMENT TO CHAPTER 6 Special-Purpose Journals 302
Sales Journal 302 Cash Receipts Journal 308
Purchases Journal 306 Cash Payments Journal 311
viii
Contents
CHAPTER 7 Internal Control 318
DECISION POINT (cid:2) A USER’S FOCUS FISHER’S Internal Control over Merchandising
GRILL 319 Transactions 325
Management Issues Related to Internal Internal Control and Management Goals 325
Control 320 Control of Cash 326
The Need for Internal Controls 320 Control of Cash Receipts 326
Management’s Responsibility for Internal Control of Purchases and Cash Disbursements 327
Control 321
Petty Cash Funds 332
Independent Accountant’s Audit of Internal
Establishing the Petty Cash Fund 332
Control 322
Making Disbursements from the Petty Cash
Internal Control: Components, Activities,
Fund 333
and Limitations 322
Reimbursing the Petty Cash Fund 333
Components of Internal Control 322
(cid:2) FISHER’S GRILL: REVIEW PROBLEM 335
Control Activities 323
STOP & REVIEW 337
Limitations of Internal Control 324
CHAPTER ASSIGNMENTS 338
CHAPTER 8 Inventories 350
DECISION POINT (cid:2) A USER’S FOCUS SNUGS First-In, First-Out (FIFO) Method 362
COMPANY 351 Last-In, First-Out (LIFO) Method 363
Managing Inventories 352 Summary of Inventory Costing Methods 364
Inventory Decisions 352 Impact of Inventory Decisions 365
Evaluating the Level of Inventory 353
Effects on the Financial Statements 365
Effects of Inventory Misstatements on Income
Effects on Income Taxes 365
Measurement 355
Effects on Cash Flows 367
Inventory Cost and Valuation 358
Inventory Cost Under the Perpetual
Goods Flows and Cost Flows 358
Inventory System 367
Lower-of-Cost-or-Market (LCM) Rule 359
Valuing Inventory by Estimation 370
Disclosure of Inventory Methods 360
Retail Method 370
Inventory Cost Under the Periodic
Gross Profit Method 371
Inventory System 361
(cid:2) SNUGS COMPANY: REVIEW PROBLEM 373
Specific Identification Method 361
STOP & REVIEW 376
Average-Cost Method 362 |
CHAPTER ASSIGNMENTS 378
CHAPTER 9 Cash and Receivables 390
DECISION POINT (cid:2) A USER’S FOCUS PENTE COMPUTER Financing Receivables 396
COMPANY 391 Ethics and Estimates in Accounting for
Management Issues Related to Cash Receivables 398
and Receivables 392 Cash Equivalents and Cash Control 399
Cash Management 392 Cash Equivalents 399
Accounts Receivable and Credit Policies 393 Fair Value of Cash and Cash Equivalents 399
Evaluating the Level of Accounts Receivable 394 Cash Control Methods 400
ix
Contents
Bank Reconciliations 401 Duration of a Note 413
Uncollectible Accounts 403 Interest and Interest Rate 413
The Allowance Method 404 Maturity Value 414
Disclosure of Uncollectible Accounts 404 Accrued Interest 414
Estimating Uncollectible Accounts Expense 405 Dishonored Note 414
Writing Off Uncollectible Accounts 409 (cid:2) PENTE COMPUTER COMPANY: REVIEW PROBLEM 415
Notes Receivable 411 STOP & REVIEW 417
Maturity Date 412 CHAPTER ASSIGNMENTS 419
CHAPTER 10 Current Liabilities and Fair Value Accounting 430
DECISION POINT (cid:2) A USER’S FOCUS MEGGIE’S FITNESS Valuation Approaches to Fair Value
CENTER 431 Accounting 448
Management Issues Related to Current Interest and the Time Value of Money 448
Liabilities 432 Calculating Present Value 449
Managing Liquidity and Cash Flows 432
Applications Using Present Value 453
Evaluating Accounts Payable 432
Valuing an Asset 453
Reporting Liabilities 434
Deferred Payment 454
Common Types of Current Liabilities 436 Other Applications 455
Definitely Determinable Liabilities 436 (cid:2) MEGGIE’S FITNESS CENTER: REVIEW PROBLEM 456
Estimated Liabilities 443
STOP & REVIEW 458
Contingent Liabilities and CHAPTER ASSIGNMENTS 460
Commitments 447
CHAPTER 11 Long-Term Assets 472
DECISION POINT (cid:2) A USER’S FOCUS CAMPUS Disposal of Depreciable Assets 490
CLEANERS 473 Discarded Plant Assets 491
Management Issues Related to Long-Term
Plant Assets Sold for Cash 491
Assets 474
Exchanges of Plant Assets 493
Acquiring Long-Term Assets 476
Natural Resources 494
Financing Long-Term Assets 477
Depletion 494
Applying the Matching Rule 478
Depreciation of Related Plant Assets 495
Acquisition Cost of Property, Plant, and
Development and Exploration Costs in the Oil and
Equipment 479
Gas Industry 495
General Approach to Acquisition Costs 480
Intangible Assets 497
Specific Applications 480
Research and Development Costs 500
Depreciation 483
Computer Software Costs 500
Factors in Computing Depreciation 484
Goodwill 500
Methods of Computing Depreciation 484 (cid:2) CAMPUS CLEANERS: REVIEW PROBLEM 502
Special Issues in Depreciation 488
STOP & REVIEW 505
CHAPTER ASSIGNMENTS 507
x
Contents
CHAPTER 12 Contributed Capital 518
DECISION POINT (cid:2) A USER’S FOCUS GAMMON, INC. 519 Preference as to Assets 532
Management Issues Related to Contributed Convertible Preferred Stock 532
Capital 520 Callable Preferred Stock 533
The Corporate Form of Business 520 Issuance of Common Stock 534
Advantages and Disadvantages of Par Value Stock 535
Incorporation 521
No-Par Stock 536
Equity Financing 522
Issuance of Stock for Noncash Assets 537
Dividend Policies 524
Accounting for Treasury Stock 539
Using Return on Equity to Measure
Purchase of Treasury Stock 539
Performance 526
Sale of Treasury Stock 540
Stock Options as Compensation 527
Retirement of Treasury Stock 542
Cash Flow Information 527
(cid:2) GAMMON, INC.: REVIEW PROBLEM 544
Components of Stockholders’ Equity 528
STOP & REVIEW 547
Preferred Stock 531
CHAPTER ASSIGNMENTS 549
Preference as to Dividends 531
CHAPTER 13 Long-Term Liabilities 562
DECISION POINT (cid:2) A USER’S FOCUS WILSON Case 1: Market Rate Above Face Rate 579
MANUFACTURING COMPANY 563 Case 2: Market Rate Below Face Rate 580
Management Issues Related to Issuing Long-
Amortization of Bond Discounts
Term Debt 564 and Premiums 581
Deciding to Issue Long-Term Debt 564
Amortizing a Bond Discount 581
Evaluating Long-Term Debt 565
Amortizing a Bond Premium 586
Types of Long-Term Debt 566
Retirement of Bonds 590
Cash Flow Information 572
Calling Bonds 590
The Nature of Bonds 573
Converting Bonds 591
Bond Issue: Prices and Interest Rates 573 Other Bonds Payable Issues 592 |
Characteristics of Bonds 574
Sale of Bonds Between Interest Dates 592
Accounting for the Issuance of Bonds 575 Year-End Accrual of Bond Interest Expense 593
Bonds Issued at Face Value 575 (cid:2) WILSON MANUFACTURING COMPANY:
Bonds Issued at a Discount 576 REVIEW PROBLEM 596
Bonds Issued at a Premium 577 STOP & REVIEW 599
Bond Issue Costs 578 CHAPTER ASSIGNMENTS 602
Using Present Value to Value a Bond 579
T he Corporate Income Statement and the Statement
CHAPTER 14
of Stockholders’ Equity 614
DECISION POINT (cid:2) A USER’S FOCUS KOWALSKI, Gains and Losses 619
INC. 615 Write-Downs and Restructurings 619
Performance Measurement: Quality of Nonoperating Items 620
Earnings Issues 616
Income Taxes 621
The Effect of Accounting Estimates and
Deferred Income Taxes 622
Methods 617
xi
Contents
Net of Taxes 623 Retained Earnings 629
Earnings per Share 625 Stock Dividends and Stock Splits 630
Basic Earnings per Share 626 Stock Dividends 630
Diluted Earnings per Share 626 Stock Splits 633
Comprehensive Income and the Statement Book Value 635
of Stockholders’ Equity 627 (cid:2) KOWALSKI, INC.: REVIEW PROBLEM 637
Comprehensive Income 627 STOP & REVIEW 640
The Statement of Stockholders’ Equity 629 CHAPTER ASSIGNMENTS 642
CHAPTER 15 The Statement of Cash Flows 656
DECISION POINT (cid:2) A USER’S FOCUS LOPATA Operating Activities 668
CORPORATION 657 Depreciation 670
Overview of the Statement
Gains and Losses 671
of Cash Flows 658
Changes in Current Assets 671
Purposes of the Statement of Cash Flows 658
Changes in Current Liabilities 672
Uses of the Statement of Cash Flows 658
Schedule of Cash Flows from Operating
Classification of Cash Flows 658 Activities 673
Required Disclosure of Noncash Investing Investing Activities 674
and Financing Transactions 660
Investments 675
Format of the Statement of Cash Flows 660
Plant Assets 675
Ethical Considerations and the Statement
Financing Activities 678
of Cash Flows 662
Bonds Payable 678
Analyzing Cash Flows 663
Common Stock 678
Can a Company Have Too Much Cash? 663
Retained Earnings 679
Cash-Generating Efficiency 663
Treasury Stock 681
Asking the Right Questions About the Statement
of Cash Flows 665 (cid:2) LOPATA CORPORATION: REVIEW PROBLEM 682
Free Cash Flow 665 STOP & REVIEW 686
CHAPTER ASSIGNMENTS 688
CHAPTER 16 Financial Performance Measurement 706
DECISION POINT (cid:2) A USER’S FOCUS WASHINGTON Trend Analysis 718
INVESTMENTS 707 Vertical Analysis 718
Foundations of Financial Performance Ratio Analysis 721
Measurement 708
Comprehensive Illustration of Ratio
Financial Performance Measurement: Management’s
Analysis 722
Objectives 708
Evaluating Liquidity 723
Financial Performance Measurement:
Evaluating Profitability 723
Creditors’ and Investors’ Objectives 708
Evaluating Long-Term Solvency 726
Standards of Comparison 709
Evaluating the Adequacy of Cash Flows 727
Sources of Information 711
Evaluating Market Strength 729
Executive Compensation 712
(cid:2) WASHINGTON INVESTMENTS: REVIEW PROBLEM 731
Tools and Techniques of Financial
Analysis 715 STOP & REVIEW 735
Horizontal Analysis 715 CHAPTER ASSIGNMENTS 737
xii
Contents
CHAPTER 17 Partnerships 754
DECISION POINT (cid:2) A USER’S FOCUS HOLDER Dissolution of a Partnership 767
AND WILLIAMS PARTNERSHIP 755 Admission of a New Partner 767
Partnership Characteristics 756 Withdrawal of a Partner 770
Characteristics of Partnerships 756 Death of a Partner 772
Advantages and Disadvantages of Partnerships 757
Liquidation of a Partnership 772
Limited Partnerships and Joint Ventures 757
Gain on Sale of Assets 773
Accounting for Partners’ Equity 759 Loss on Sale of Assets 775
Distribution of Partnership Income (cid:2) HOLDER AND WILLIAMS PARTNERSHIP:
and Losses 761 REVIEW PROBLEM 778
Stated Ratios 761 STOP & REVIEW 781
Capital Balance Ratios 762 CHAPTER ASSIGNMENTS 783
Salaries, Interest, and Stated Ratios 763
CHAPTER 18 The Changing Business Environment: A Manager’s Perspective 794
DECISION POINT (cid:2) A MANAGER’S FOCUS GOOD Achieving Continuous Improvement 809
FOODS STORE 795 Performance Measures: A Key to Achieving
The Role of Management Accounting 796 Organizational Objectives 811 |
Management Accounting and Financial Accounting: Using Performance Measures in the Management
A Comparison 796 Process 811
Management Accounting and the Management The Balanced Scorecard 812
Process 797
Benchmarking 814
Value Chain Analysis 803
Standards of Ethical Conduct 814
Primary Processes and Support Services 803
(cid:2) GOOD FOODS STORE: REVIEW PROBLEM 816
Advantages of Value Chain Analysis 805
STOP & REVIEW 819
Managers and Value Chain Analysis 805
CHAPTER ASSIGNMENTS 821
Continuous Improvement 807
Cookie Company (Continuing Case) 835
Management Tools for Continuous
Improvement 807
CHAPTER 19 Cost Concepts and Cost Allocation 836
DECISION POINT (cid:2) A MANAGER’S FOCUS THE CHOICE Statement of Cost of Goods Manufactured 844
CANDY COMPANY 837 Cost of Goods Sold and a Manufacturer’s Income
Cost Information 838 Statement 845
Managers’ Use of Cost Information 838 Inventory Accounts in Manufacturing
Cost Information and Organizations 838 Organizations 846
Cost Classifications and Their Uses 838 Document Flows and Cost Flows Through
the Inventory Accounts 846
Cost Traceability 839
The Manufacturing Cost Flow 847
Cost Behavior 840
Elements of Product Costs 850
Value-Adding Versus Nonvalue-Adding Costs 840
Cost Classifications for Financial Reporting 841 Prime Costs and Conversion Costs 851
Computing Product Unit Cost 852
Financial Statements and the Reporting
of Costs 842 Product Cost Measurement Methods 852
Income Statement and Accounting for Computing Service Unit Cost 854
Inventories 842
xiii
Contents
Cost Allocation 855 (cid:2) THE CHOICE CANDY COMPANY:
Allocating the Costs of Overhead 855 REVIEW PROBLEM 861
STOP & REVIEW 863
Allocating Overhead: The Traditional
Approach 857 CHAPTER ASSIGNMENTS 866
Allocating Overhead: The ABC Approach 859 Cookie Company (Continuing Case) 880
Costing Systems: Job Order Costing 882
CHAPTER 20
DECISION POINT (cid:2) A MANAGER’S FOCUS AUGUSTA Completed Units 891
CUSTOM GOLF CARTS, INC. 883 Sold Units 891
Product Unit Cost Information and the Reconciliation of Overhead Costs 892
Management Process 884
A Job Order Cost Card and the Computation
Planning 884
of Unit Cost 893
Performing 884
A Manufacturer’s Job Order Cost Card and the
Evaluating 884 Computation of Unit Cost 893
Communicating 884 Job Order Costing in a Service Organization 894
Product Costing Systems 885 (cid:2) AUGUSTA CUSTOM GOLF CARTS, INC.:
Job Order Costing in a Manufacturing REVIEW PROBLEM 897
Company 887 STOP & REVIEW 899
Materials 888 CHAPTER ASSIGNMENTS 901
Labor 890 Cookie Company (Continuing Case) 919
Overhead 890
Costing Systems: Process Costing 920
CHAPTER 21
DECISION POINT (cid:2) A MANAGER’S FOCUS MILK PRODUCTS Accounting for Costs 931
COMPANY 921 Assigning Costs 931
The Process Costing System 922 Process Costing for Two or More Production
Patterns of Product Flows and Cost Flow Departments 933
Methods 923 Preparing a Process Cost Report Using the
Cost Flows Through the Work in Process Inventory Average Costing Method 935
Accounts 924 Accounting for Units 935
Computing Equivalent Production 925 Accounting for Costs 937
Equivalent Production for Direct Materials 926 Assigning Costs 937
Equivalent Production for Conversion Costs 927 (cid:2) MILK PRODUCTS COMPANY: REVIEW PROBLEM 940
Summary of Equivalent Production 927 STOP & REVIEW 943
Preparing a Process Cost Report Using the CHAPTER ASSIGNMENTS 945
FIFO Costing Method 928 Cookie Company (Continuing Case) 957
Accounting for Units 928
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Contents
Value-Based Systems: ABM and Lean 958
CHAPTER 22
DECISION POINT (cid:2) A MANAGER’S FOCUS BEAN BAG The New Operating Environment and Lean
CONVERTIBLES, INC. 959 Operations 968
Value-Based Systems and Management 960 Just-in-Time (JIT) 968
Value Chains and Supply Chains 961 Continuous Improvement of the Work
Process Value Analysis 962 Environment 970
Value-Adding and Non-Value-Adding Accounting for Product Costs in a JIT Operating
Activities 963 Environment 970
Value-Based Systems 963 Backflush Costing 972
Activity-Based Management 963 Comparison of ABM and Lean 976
Managing Lean Operations 964 (cid:2) BEAN BAG CONVERTIBLES, INC.: REVIEW PROBLEM 977 |
Activity-Based Costing 964 STOP & REVIEW 980
The Cost Hierarchy and the Bill of CHAPTER ASSIGNMENTS 982
Activities 965 Cookie Company (Continuing Case) 997
Cost Behavior Analysis 998
CHAPTER 23
DECISION POINT (cid:2) A MANAGER’S FOCUS MY MEDIA Cost-Volume-Profit Analysis 1010
PLACE 999 Breakeven Analysis 1012
Cost Behavior and Management 1000
Using an Equation to Determine the Breakeven
The Behavior of Costs 1001 Point 1013
Mixed Costs and the Contribution Margin The Breakeven Point for Multiple Products 1014
Income Statement 1006 Using C-V-P Analysis to Plan Future Sales,
The Engineering Method 1006 Costs, and Profits 1017
The Scatter Diagram Method 1006 Applying C-V-P to Target Profits 1017
The High-Low Method 1007 (cid:2) MY MEDIA PLACE: REVIEW PROBLEM 1020
Statistical Methods 1009 STOP & REVIEW 1023
Contribution Margin Income Statements 1009 CHAPTER ASSIGNMENTS 1025
Cookie Company (Continuing Case) 1038
The Budgeting Process 1040
CHAPTER 24
DECISION POINT (cid:2) A MANAGER’S FOCUS FRAMECRAFT The Overhead Budget 1053
COMPANY 1041 The Selling and Administrative Expense
The Budgeting Process 1042 Budget 1054
Advantages of Budgeting 1042 The Cost of Goods Manufactured Budget 1055
Budgeting and Goals 1043 Financial Budgets 1057
Budgeting Basics 1043 The Budgeted Income Statement 1057
The Master Budget 1045 The Capital Expenditures Budget 1058
Preparation of a Master Budget 1045 The Cash Budget 1058
Budget Procedures 1048 The Budgeted Balance Sheet 1061
Operating Budgets 1049 (cid:2) FRAMECRAFT COMPANY: REVIEW PROBLEM 1063
The Sales Budget 1049 STOP & REVIEW 1066
The Production Budget 1050 CHAPTER ASSIGNMENTS 1068
The Direct Materials Purchases Budget 1051 Cookie Company (Continuing Case) 1091
The Direct Labor Budget 1053
xv
Contents
Performance Management and Evaluation 1092
CHAPTER 25
DECISION POINT (cid:2) A MANAGER’S FOCUS WINTER Performance Evaluation of Investment
WONDERLAND RESORT 1093 Centers 1105
Performance Measurement 1094 Return on Investment 1105
What to Measure, How to Measure 1094 Residual Income 1107
Other Measurement Issues 1094 Economic Value Added 1108
Organizational Goals and the Balanced The Importance of Multiple Performance
Scorecard 1095 Measures 1110
The Balanced Scorecard and Management 1095 Performance Incentives and Goals 1111
Responsibility Accounting 1097 Linking Goals, Performance Objectives, Measures,
Types of Responsibility Centers 1098 and Performance Targets 1111
Organizational Structure and Performance Performance-Based Pay 1112
Management 1100 The Coordination of Goals 1112
Performance Evaluation of Cost Centers and (cid:2) WINTER WONDERLAND RESORT:
Profit Centers 1102 REVIEW PROBLEM 1115
Evaluating Cost Center Performance Using Flexible STOP & REVIEW 1118
Budgeting 1102 CHAPTER ASSIGNMENTS 1120
Evaluating Profit Center Performance Using Cookie Company (Continuing Case) 1135
Variable Costing 1103
Standard Costing and Variance Analysis 1136
CHAPTER 26
DECISION POINT (cid:2) A MANAGER’S FOCUS ICU, INC. 1137 Computing and Analyzing Direct Labor
Standard Costing 1138 Variances 1150
Standard Costs and Managers 1138 Computing Direct Labor Variances 1150
Computing Standard Costs 1139 Analyzing and Correcting Direct Labor
Variances 1152
Standard Direct Materials Cost 1139
Computing and Analyzing Overhead
Standard Direct Labor Cost 1139
Variances 1154
Standard Overhead Cost 1140
Using a Flexible Budget to Analyze Overhead
Total Standard Unit Cost 1141
Variances 1154
Variance Analysis 1142
Computing Overhead Variances 1154
The Role of Flexible Budgets in Variance
Analyzing and Correcting Overhead Variances 1159
Analysis 1142
Using Cost Variances to Evaluate Managers’
Using Variance Analysis to Control Costs 1145
Performance 1161
Computing and Analyzing Direct Materials
(cid:2) ICU, INC.: REVIEW PROBLEM 1163
Variances 1147
STOP & REVIEW 1168
Computing Direct Materials Variances 1147
CHAPTER ASSIGNMENTS 1170
Analyzing and Correcting Direct Materials
Cookie Company (Continuing Case) 1183
Variances 1149
Short-Run Decision Analysis 1184
CHAPTER 27
DECISION POINT (cid:2) A MANAGER’S FOCUS HOME STATE Incremental Analysis for Short-Run Decisions 1186 |
BANK 1185 Incremental Analysis for Outsourcing
Short-Run Decision Analysis and the Decisions 1189
Management Process 1186
xvi
Contents
Incremental Analysis for Special Order Incremental Analysis for Sell or Process-
Decisions 1191 Further Decisions 1199
Incremental Analysis for Segment (cid:2) HOME STATE BANK: REVIEW PROBLEM 1202
Profitability Decisions 1194 STOP & REVIEW 1205
Incremental Analysis for Sales Mix CHAPTER ASSIGNMENTS 1207
Decisions 1196 Cookie Company (Continuing Case) 1223
Capital Investment Analysis 1224
CHAPTER 28
DECISION POINT (cid:2) A MANAGER’S FOCUS The Time Value of Money 1234
NEIGHBORHOOD COMMUNICATIONS 1225 Interest 1234
The Capital Investment Process 1226
Present Value 1235
Capital Investment Analysis 1226 Present Value of a Single Sum Due in the
Capital Investment Analysis in the Management Future 1236
Process 1227 Present Value of an Ordinary Annuity 1236
The Minimum Rate of Return on Investment 1229
The Net Present Value Method 1238
Cost of Capital 1229
Advantages of the Net Present Value Method 1238
Other Measures for Determining Minimum Rate of
The Net Present Value Method Illustrated 1238
Return 1230
Other Methods of Capital Investment
Ranking Capital Investment Proposals 1230
Analysis 1241
Measures Used in Capital Investment
The Payback Period Method 1241
Analysis 1231
The Accounting Rate-of-Return Method 1242
Expected Benefits from a Capital Investment 1231
(cid:2) NEIGHBORHOOD COMMUNICATIONS:
Equal Versus Unequal Cash Flows 1232
REVIEW PROBLEM 1244
Carrying Value of Assets 1232
STOP & REVIEW 1246
Depreciation Expense and Income Taxes 1232
CHAPTER ASSIGNMENTS 1248
Disposal or Residual Values 1233
Cookie Company (Continuing Case) 1260
APPENDIX A Accounting for Investments 1262
Management Issues Related to Investments 1262
Trading Securities 1264
Available-for-Sale Securities 1267
Long-Term Investments in Equity Securities 1267
Investments in Debt Securities 1271
Long-Term Investments in Bonds 1272
STOP & REVIEW 1273
APPENDIX B Present Value Tables 1276
Endnotes 1280
Company Index 1284
Subject Index 1285
PREFACE
Accounting
This revision of Principles of Accounting is based on an understanding of the
in Motion! nature, culture, and motivations of today’s undergraduate students and on exten-
sive feedback from many instructors who use our book. These substantial changes
meet the needs of these students, who not only face a business world increasingly
complicated by ethical issues, globalization, and technology but who also have
more demands on their time. To assist them to meet these challenges, the authors
carefully show them how the effects of business transactions, which are the result
of business decisions, are recorded in a way that will be reflected on the finan-
cial statements. Instructors will find that building on the text’s historically strong
pedagogy, the authors have strengthened transaction analysis and its link to the
accounting cycle.
Updated Content, Strengthened Transaction Analysis
Organization
Maintaining a solid foundation in double-entry accounting, we increased the
and Pedagogy number of in-text journal entries and have used T accounts linked to these
journal-entry illustrations throughout the financial accounting chapters. In
Chapter 2, “Analyzing Business Transactions,” for example, we clarified the rela-
tionship of transaction analysis to the accounting cycle. In Chapter 6, “The Oper-
ating Cycle and Merchandising Accounting,” we include transaction illustrations
for all transactions mentioned in the chapter. At the same time, we reduced exces-
sive detail, shortened headings, simplified explanations, and increased readability
in an effort to reduce the length of each chapter.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH WAGES EXPENSE
Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 26 4,800
10 2,800 6 13,320
19 1,400 9 2,600
22 5,000 26 4,800
Entry in Journal Form:
Dr. Cr.
July 26 Wages Expense 4,800
Cash 4,800
Content and Organization: Partnerships,
Special-Purpose Journals, and Investments
Based on user input, Chapter 17 introduces a new topic of partnerships to the |
text. To make room for this, the investments chapter is now located in Appendix A
with ample assignment material to provide greater flexibility of coverage.
xvii
xviii
Preface
Also based on user desires, we have inserted a supplement on special-purpose
journals with assignment material after Chapter 6.
Strong Pedagogical System
Principles of Accounting originated the pedagogical system of Integrated Learn-
ing Objectives. The system supports both learning and teaching by providing
flexibility in support of the instructor’s teaching of first-year accounting. The
chapter review and all assignments identify the applicable learning objective(s) for
easy reference.
Each learning objective refers to a specific content area, usually either con-
ceptual content or procedural techniques, in short and easily understandable seg-
ments. Each segment is followed by a “Stop and Apply” section that illustrates
and solves a short exercise related to the learning objective.
STOP & APPLY
Match the letter of each item below with the numbers of the related items:
a. An inventory cost ____ 3. Application of the LCM rule
b. An assumption used in the valuation of ____ 4. Goods flow
inventory ____ 5. Transportation charge for mer-
c. Full disclosure convention chandise shipped FOB shipping
d. Conservatism convention point
e. Consistency convention ____ 6. Cost flow
f. Not an inventory cost or assumed flow ____ 7. Choosing a method and sticking
with it
____ 1. Cost of consigned goods
____ 8. Transportation charge for mer-
____ 2. A note to the financial statements
chandise shipped FOB destination
explaining inventory policies
SOLUTION
1. f; 2. c; 3. d; 4. b; 5. a; 6. f; 7. e; 8. f
To make the text more visually appealing and readable, it is divided into
student-friendly sections with brief bulleted lists, new art, photographs, and end-
of-section review material.
Cash Flows To avoid financial distress, a company must be able to pay its bills on time. Because
and the Timing the timing of cash flows is critical to maintaining adequate liquidity to pay bills,
managers and other users of financial information must understand the difference
of Transactions
between transactions that generate immediate cash and those that do not. Con-
sider the transactions of Miller Design Studio shown in Figure 2-3. Most of them
LO5 Show how the timing involve either an inflow or outflow of cash.
of transactions affects cash As you can see in Figure 2-3, Miller’s Cash account has more transactions
flows and liquidity. than any of its other accounts. Look at the transactions of July 10, 15, and 22:
(cid:2) July 10: Miller received a cash payment of $2,800.
(cid:2) July 15: The firm billed a customer $9,600 for a service it had already per-
formed.
(cid:2) July 22: The firm received a partial payment of $5,000 from the customer,
but it had not received the remaining $4,600 by the end of the month.
Because Miller incurred expenses in providing this service, it must pay careful
attention to its cash flows and liquidity.
One way Miller can manage its expenditures is to rely on its creditors to give
it time to pay. Compare the transactions of July 3, 5, and 9 in Figure 2-3.
xix
Preface
Further, to reduce distractions, the margins of the text include only Study
Study Note Notes, which alert students to common misunderstandings of concepts and tech-
niques; key ratio and cash flow icons, which highlight discussions of profitability
After Step 1 has been completed,
and liquidity; and accounting equations. Icons and equations appear in the finan-
the Income Summary account
cial chapters (Chapters 1–17).
reflects the account balance of
the Design Revenue account
before it was closed.
Enhanced Real- IFRS, Fair Value, and Other Updates
World Examples
International Financial Reporting Standards and fair value have been integrated
Demonstrate throughout the book where accounting standards have changed and also in the
Business Focus features where applicable. All current events, statistics, and tables
Accounting
have been updated with the latest data.
in Motion
FOCUS ON BUSINESS PRACTICE |
IFRS: The Arrival of International Financial Reporting Standards in the United States
Over the next few years, international financial and Exchange Commission (SEC) recently voted to
reporting standards (IFRS) will become much more allow foreign registrants in the United States. This
important in the United States and globally. The is a major development because in the past, the
International Accounting Standards Board (IASB) SEC required foreign registrants to explain how the
has been working with the Financial Accounting standards used in their statements differed from
Standards Board (FASB) and similar boards in other U.S. standards. This change affects approximately 10
nations to achieve identical or nearly identical stan- percent of all public U.S. companies. In addition, the
dards worldwide. IFRS are now required in many SEC may in the near future allow U.S. companies to
parts of the world, including Europe. The Securities- use IFRS.11
Use of Small, Diverse Companies
Each chapter begins with a Decision Point, a real-world scenario about a small
company that challenges students to see the connection between accounting
information and management decisions.
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How can Pente Computer
PENTE COMPUTER COMPANY Company manage its cash
needs?
(cid:2) How can the company
Pente Computer Company sells computer products for cash
reduce the level of
or on credit. The company’s peak sales occur in August and
uncollectible accounts and
September, when students are shopping for computers increase the likelihood that
and computer-related supplies, and during the pre-holiday accounts receivable will be
season in November and D ecember. It is now January, and paid on time?
Andre Pente, the company’s owner, has been reviewing the (cid:2) How can the company
company’s performance over the past two years. He has evaluate the effectiveness
determined that in those years, approximately 1.5 p ercent of its credit policies and
of net sales have been uncollectible, and he is concerned the level of its accounts
receivable?
that this year, the company may not have enough cash to
cover operations before sales begin to increase again in
late summer. In this chapter, we discuss concepts and tech-
niques that would help Pente manage his cash and accounts
receivable so that the company maintains its liquidity.
xx
Preface
These company examples come full circle at the end of the chapter by linking
directly to the Review Problem. Smaller, diverse company examples illustrate
accounting concepts and encourage students to apply what they have learned.
(cid:2) PENTE COMPUTER COMPANY: REVIEW PROBLEM
In this chapter’s Decision Point, we posed the following questions:
• How can Pente Computer Company manage its cash needs?
• How can the company reduce the level of uncollectible accounts and
increase the likelihood that accounts receivable will be paid on time?
• How can the company evaluate the effectiveness of its credit policies and
the level of its accounts receivable?
During the months when sales are at their peak, Pente Computer Company may
have excess cash available that it can invest in a way that earns a return but still
permits ready access to cash. At other times, it may have to arrange for short-term
borrowing. To ensure that it can borrow funds when it needs to, the company
must maintain good relations with its bank.
Use of Well-Known Public Companies
This textbook also offers examples from highly recognizable public companies,
such as CVS Caremark, Southwest Airlines, Dell Computer, and Netflix, to relate
basic accounting concepts and techniques to the real world. Chapter 5, “Finan-
cial Reporting and Analysis,” helps students interpret financial information.
The latest available data is used in exhibits to incorporate the most recent FASB
pronouncements. The authors illustrate current practices in financial reporting by
referring to data from Accounting Trends and Techniques (AICPA) and integrate
international topics wherever appropriate.
Consolidated means that data from all CVS Caremark Corporation CVS’s fiscal year ends on the Saturday |
companies owned by CVS are combined. Consolidated Statements of Operations closest to December 31.
Fiscal Year Ended
Dec. 31, 2008 Dec. 29, 2007 Dec. 30, 2006
(In millions, except per share amounts) (52 weeks) (52 weeks) (53 weeks)
Net revenues $87,471.9 $76,329.5 $43,821.4
Cost of revenues 69,181.5 60,221.8 32,079.2
Gross profit 18,290.4 16,107.7 11,742.2
Total operating expenses 12,244.2 11,314.4 9,300.6
Operating profit1 6,046.2 4,793.3 2,441.6
Interest expense, net2 509.5 434.6 215.8
Earnings before income tax provision 5,536.7 4,358.7 2,225.8
Loss from discontinued operations, (132) — —
net of income tax benefit of $82.4
Income tax provision 2,192.6 1,721.7 856.9v
Net earnings3 3,212.1 2,637.0 1,368.9
Preference dividends, net of income tax benefit4 14.1 14.2 13.9
Net earnings available to common shareholders $ 3,198.0 $ 2,622.8 $ 1,355.0
BASIC EARNINGS PER COMMON SHARE:5
Net earnings $ 2.23 $ 1.97 $ 1.65
Weighted average common shares outstanding 1,433.5 1,328.2 820.6
DILUTED EARNINGS PER COMMON SHARE:
Net earnings $ 2.18 $ 1.92 $ 1.60
Weighted average common shares outstanding 1,469.1 1,371.8 853.2
xxi
Preface
Revised and Expanded Assignments
Assignments have been carefully scrutinized for direct relevancy to the learning
objectives in the chapters. Names and numbers for all Short Exercises, Exercises,
and Problems have been changed except those used on videos. We have reversed
the alternate and main problems from the previous edition. Most importantly,
alternative problems have been expanded so that there are ample problems for
any course.
All of the cases have been updated as appropriate and the number of cases in
each chapter has been reduced in response to user preferences. The variety of cases
in each chapter depends on their relevance to the chapter topics, but throughout
the text there are cases involving conceptual understanding, ethical dilemmas,
interpreting financial reports, group activities, business communication, and the
Internet. Annual report cases based on CVS Caremark and Southwest Airlines
can be found at the end of the chapter.
Specific Chapter Changes
The following chapter-specific changes have been made in this edition of
Principles of Accounting:
Chapter 1: Uses of Accounting Information and the Financial Statements
• Discussion of performance measures revised using CVS and General Motors
as examples of how these measures relate to profitability and liquidity
• Discussion of the statement of cash flows revised to relate the statement to
business activities and goals
• Updated and enhanced coverage of the roles of the Financial Account-
ing Standards Board (FASB) and the International Accounting Standards
Board (IASB)
• New Focus on Business Practice box on SEC’s decision to let foreign com-
panies registered in the United States use international financial reporting
standards (IFRS)
• New study note on the role of the Public Company Accounting Oversight
Board (PCAOB)
Chapter 2: Analyzing Business Transactions
• Learning Objective (LO) 3 revised to clarify and emphasize the role of
T accounts, journal form, and their relationship to the general ledger
• New example of recognition violation
• Section on valuation revised to address fair value and IFRS
• New Focus on Business Practice box on fair value accounting in an interna-
tional marketplace
• Cash flow discussion edited for clearer delineation of the sequence of transactions
Chapter 3: Measuring Business Income
• New example of earnings management focusing on Dell Computer
• New Focus on Business Practice box describing the FASB’s rules for revenue
recognition and the one broad principle (IFRS) that the IASB uses
Chapter 4: Completing the Accounting Cycle
• In-text examples focusing on Miller Design Studio simplified by using fewer
accounts, thus clarifying the process of preparing closing entries and the
worksheet
xxii
Preface
Chapter 5: Financial Reporting and Analysis
• Section on the objective of financial reporting revised to reflect FASB’s empha-
sis on the needs of capital providers and other users of financial reports |
• Coverage of qualitative characteristics simplified and shortened
• New Focus on Business Practice box on convergence of U.S. GAAP and IFRS
and their effect on accounting standards
• New Focus on Business Practice box on how convergence of U.S. GAAP and
IFRS can make financial analysis more difficult
• New Focus on Business Practice box on the use of ratios (performance mea-
sures) in executive compensation
Chapter 6: The Operating Cycle and Merchandising Transactions
• Discussion of the operating cycle revised for greater clarity
• T accounts and journal entries used to illustrate accounting for merchandis-
ing transactions under both the perpetual and periodic inventory systems
• Updated Focus on Business Practice box on the increased use of credit and
debit cards
• Clearer differentiation between the cost of goods available for sale and the
cost of goods sold in LO4
• New supplement on Special-Purpose Journals
Chapter 7: Internal Control
• New Focus on Business Practice box on the effectiveness of the Sarbanes-
Oxley Act in preventing fraud
• New Focus on Business Practice box on methods of preventing shoplifting
• Material reformatted to clarify discussion of documents used in an internal
control plan for purchases and cash disbursements
Chapter 8: Inventories
• Discussion of disclosure of inventory methods shortened for greater clarity
• New Focus on Business Practice box on the lower-of-cost-or-market rule
• New Focus on Business Practice box on the use of LIFO inside and outside
the United States
• New Focus on Business Practice box on how IFRS and U.S. standards define
fair value
Chapter 9: Cash and Receivables
• Concept of fair value introduced at various points throughout the chapter
• Revised Focus on Business Practice box on estimating cash collections
• New coverage of subprime loans
Chapter 10: Current Liabilities and Fair Value Accounting
• Chapter revised to include coverage of fair value accounting
• Discussion and assignments related to future value deleted to emphasize pres-
ent value and fair value, which are more directly related to this course
• New study note on the disclosure of the fair value of short-term debt
Chapter 11: Long-Term Assets
• Coverage of tax laws revised to address the Economic Stimulus Act of 2008
• Coverage of intangible assets revised to reflect current standards
• Revised Focus on Business Practice box on customer lists
xxiii
Preface
Chapter 12: Contributed Capital
• Revised Focus on Business Practice box on politics and accounting for stock
options
• Section on cash flow information added to LO1
• Updated Focus on Business Practice box on share buybacks
Chapter 13: Long-Term Liabilities
• Bonds interest rates changed so that they are more realistic and less compli-
cated than in previous edition
• Updated discussion of accounting for defined pension plans
• New Focus on Business Practice box on post-retirement liabilities
• Section on cash flow information added to LO1
Chapter 14: The Corporate Income Statement and the Statement of Stock-
holders’ Equity
• Nonoperating items, which were covered in LO3 in previous edition, now
discussed in LO1
• New Focus on Business Practice box on looking beyond the bottom line
• Revised Focus on Business Practice box on pro-forma earnings
Chapter 15: The Statement of Cash Flows
• Clarification of required disclosure of noncash investing and financing activi-
ties in LO1
• Sections on the risks of having too much cash and on interpreting the state-
ment of cash flows added to LO2
• New Focus on Business Practice box on the IASB’s support of the direct method
Chapter 16: Financial Performance Measurement
• Updated Focus on Business Practice box on pro-forma earnings
• Revised Focus on Business Practice box on performance measurement
Chapter 17: Partnerships
• New chapter added in response to users’ requests
Chapter 18: The Changing Business Environment: A Manager’s Perspective
• Updated definition of management accounting
• Lean production introduced as a key term
• Sections on total quality management and activity based management revised |
• Updated Focus on Business Practice box on how to blow the whistle on fraud
Chapter 19: Cost Concepts and Cost Allocation
• Discussions of costs in LO2 in previous edition incorporated in LO1
• Section on document and cost flows through the inventory accounts in new
LO3 revised
• Introduction to methods of product cost measurement added and section on
computing service unit cost shortened in new LO4
• LO7 and LO8 streamlined and incorporated in new LO5
Chapter 20: Costing Systems: Job Order Costing
• Chapter 20 in previous edition separated into two chapters, with new C hapter 20
focusing on job order costing and new Chapter 21 focusing on process costing
• Operations costing system introduced as a key concept
xxiv
Preface
• Discussions of manufacturer’s job order cost card, computation of unit cost,
and job order costing in a service organization included in new LO4
• New Focus on Business Practice box on the use of project costing
Chapter 21: Costing Systems: Process Costing
• New chapter (part of Chapter 20 in previous edition)
Chapter 22: Value-Based Systems: ABM and Lean
• LO1 and LO2 in last edition combined and revised
• Section on process value analysis included in LO1
• New listing of ABC’s disadvantages in LO2
• New focus on lean operations in LO3
Chapter 23: Cost Behavior Analysis
• LO1 and LO2 in last edition combined and revised
• Discussions of variable, fixed, and mixed costs and discussions of step costs
and linear relationships included in LO1
• Discussion of contribution margin income statement included in LO2
• LO5 revised to clarify concepts
Chapter 24: The Budgeting Process
• Section on advantages of budgeting and three key terms—static budget, con-
tinuous budget, and zero-based budgeting—added to revised LO1
Chapter 25: Performance Management and Evaluation
• LO1 and LO2 in last edition combined and revised
Chapter 26: Standard Costing and Variance Analysis
• LO1 and LO2 in last edition combined and revised
Chapter 27: Short-Run Decision Analysis
• Chapter revised to focus on short-run decisions and incremental analysis; cap-
ital investment analysis and time value of money now covered in Chapter 28
Chapter 28: Capital Investment Analysis
• New chapter
Online Solutions
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xxv
Preface
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(cid:2) Instructor’s Companion Website: The instructor website contains a vari-
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xxvi
Preface
with information based on problems from the textbook and practice sets.
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puterized accounting systems firsthand. Also, the program is enhanced
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(cid:2) Personalized study plans, which include a variety of multimedia assets (from
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(cid:2) Assessment options, including the full test bank and algorithmic variations
(cid:2) Reporting capability based on AACSB, AICPA, and IMA competencies and
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(cid:2) Course Management tools, including grade book
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general ledger packages more closely than other educational packages. Problems
that can be used with Klooster/Allen are highlighted by an icon.
xxvii
Preface
Working Papers (Printed): A set of preformatted pages allow students to more
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www.cengage.com/accounting/needles
Acknowledgements
A successful textbook is a collaborative effort. We are grateful to the many pro-
fessors, other professional colleagues, and students who have taught and studied
from our book, and we thank all of them for their constructive comments. In the
space available, we cannot possibly mention everyone who has been helpful, but
we do want to recognize those who made special contributions to our efforts in
preparing the eleventh edition of Principles of Accounting.
We wish to express deep appreciation to colleagues at DePaul University, who
have been extremely supportive and encouraging.
Very important to the quality of this book are our proofreaders, Margaret
Kearney and Cathy Larson, to whom we give special thanks. We also appreci-
ate the support of our Supervising Development Editor, Katie Yanos; Execu-
tive Editor, Sharon Oblinger; Senior Marketing Manager, Kristen Hurd; and
Content Project Manager, Darrell Frye.
Others who have had a major impact on this book through their reviews,
suggestions, and participation in surveys, interviews, and focus groups are listed
below. We cannot begin to say how grateful we are for the feedback from the
many instructors who have generously shared their responses and teaching experi-
ences with us.
Daneen Adams, Santa Fe College
Sidney Askew, Borough of Manhattan Community College
Nancy Atwater, College of St. Scholastica
Algis Backaitis, Wayne County Community College
Abdul Baten, Northern Virginia Community College
Robert Beebe, Morrisville State College
Teri Bernstein, Santa Monica College
Martin Bertisch, York College
Tes Bireda, Hillsborough Community College
James Bryant, Catonsville Community College
Earl Butler, Broward Community College
Lloyd Carroll, Borough of Manhattan Community College
Stanley Carroll, New York City College of Technology
Roy Carson, Anne Arundel Community College
Janet Caruso, Nassau Community College
Sandra Cereola, Winthrop University
James J. Chimenti, Jamestown Community College
xxviii
Preface
Carolyn Christesen, SUNY Westchester Community College
Stan Chu, Borough of Manhattan Community College
Jay Cohen, Oakton Community College
Sandra Cohen, Columbia College
Scott Collins, The Pennsylvania State University
Joan Cook, Milwaukee Area Tech College—Downtown
Barry Cooper, Borough of Manhattan Community College
Michael Cornick, Winthrop University
Robert Davis, Canisius College
Ron Deaton, Grays Harbor College
Jim Delisa, Highline Community College
Tim Dempsey, DeVry College of Technology
Vern Disney, University of South Carolina Sumter |
Eileen Eichler, Farmingdale State College
Mary Ewanechko, Monroe Community College
Cliff Frederickson, Grays Harbor College
John Gabelman, Columbus State Community College
Lucille Genduso, Kaplan University
Nashwa George, Berkeley
Rom Gilbert, Santa Fe College
Janet Grange, Chicago State University
Tom Grant, Kutztown
Tim Griffin, Hillsborough Community College—Ybor City Campus
Sara Harris, Arapahoe Community College
Lori Hatchell, Aims Community College
Roger Hehman, Raymond Walters College/University of Cincinnati
Sueann Hely, West Kentucky Community & Technical College
Many Hernandez, Borough of Manhattan Community College
Michele Hill, Schoolcraft College
Cindy Hinz, Jamestown Community College
Jackie Holloway, National Park Community College
Phillip Imel, Southwest Virginia Community College
Jeff Jackson, San Jacinto College
Irene Joanette-Gallio, Western Nevada Community College
Vicki Jobst, Benedictine University
Doug Johnson, Southwest Community College
Jeff Kahn, Woodbury University
John Karayan, Woodbury University
Miriam Keller-Perkins, University of California-Berkeley
Randy Kidd, Longview Community College
David Knight, Borough of Manhattan Community College
Emil Koren, Saint Leo University
Bill Lasher, Jamestown Business College
Jennifer LeSure, Ivy Tech State College
Archish Maharaja, Point Park University
Harvey Man, Borough of Manhattan Community College
Robert Maxwell, College Of The Canyons
Stuart McCrary, Northwestern University
Noel McKeon, Florida Community College—Jacksonville
Terri Meta, Seminole Community College
Roger Moore, Arkansas State University—Beebe
Carol Murphy, Quinsigamond Community College
Carl Muzio, Saint John’s University
Mary Beth Nelson, North Shore Community College
xxix
Preface
Andreas Nicolaou, Bowling Green State University
Patricia Diane Nipper, Southside Virginia Community College
Tim Nygaard, Madisonville Community College
Susan L. Pallas, Southeast Community College
Clarence Perkins, Bronx Community College
Janet Pitera, Broome Community College
Eric Platt, Saint John’s University
Shirley Powell, Arkansas State University—Beebe
LaVonda Ramey, Schoolcraft College
Michelle Randall, Schoolcraft College
Eric Rothenburg, Kingsborough Community College
Rosemarie Ruiz, York College—CUNY
Michael Schaefer, Blinn College
Sarah Shepard, West Hills College Coalinga
Linda Sherman, Walla Walla Community College
Deborah Stephenson, Winston-Salem State University
Ira Stolzenberg, SUNY—Old Westbury
David Swarts, Clinton Community College
Linda Tarrago, Hillsborough Community College—Main Campus
Thomas Thompson, Savannah Technical College
Peter Vander Weyst, Edmonds Community College Lynnwood
Dale Walker, Arkansas State University—Beebe
Doris Warmflash, Westchester Community College
Wanda Watson, San Jacinto College—Central
Andy Williams, Edmonds Community College—Lynnwood
Josh Wolfson, Borough of Manhattan Community College
Paul Woodward, Santa Fe College
Allen Wright, Hillsborough Community College—Main Campus
Jian Zhou, SUNY at Binghamton
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ABOUT THE AUTHORS
Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A.
DePaul University
Belverd Needles is an internationally recognized expert in accounting education.
He has published in leading journals and is the author or editor of more than
20 books and monographs. His current research relates to international finan-
cial reporting, performance measurement, and corporate governance of high-
performance companies in the United States, Europe, India, and Australia. His
textbooks are used throughout the world and have received many awards, includ-
ing the 2008 McGuffey Award from the Text and Academic Authors Associa-
tion. Dr. Needles was named Educator of the Year by the American Institute
of CPAs, Accountant of the Year for Education by the national honorary soci-
ety Beta Alpha Psi, and Outstanding International Accounting Educator by the
American Accounting Association. Among the numerous other awards he has
received are the Excellence in Teaching Award from DePaul University and the
Illinois CPA Society’s Outstanding Educator Award and Life-Time Achievement |
Award. Active in many academic and professional organizations, he has served as
the U.S. representative on several international accounting committees, includ-
ing the Education Committee of the International Federation of Accountants
(IFAC). He is currently vice president of education of the American Accounting
Association.
Marian Powers, Ph.D.
Northwestern University
Internationally recognized as a dynamic teacher in executive education, Marian
Powers specializes in teaching managers how to read and understand financial
reports, including the impact that international financial reporting standards
have on their companies. More than 1,000 executives per year from countries
throughout the world, including France, the Czech Republic, Australia, India,
China, and Brazil, attend her classes. She has taught at the Kellogg’s Allen Cen-
ter for Executive Education at Northwestern University since 1987 and at the
Center for Corporate Financial Leadership since 2002. Dr. Powers’s research
on international financial reporting, performance measurement, and corporate
governance has been published in leading journals, among them The Accounting
Review; The International Journal of Accounting; Issues in Accounting Education;
The Journal of Accountancy; The Journal of Business, Finance and Accounting;
and Financial Management. She has also coauthored three interactive multime-
dia software products: Fingraph Financial Analyst™ (financial analysis software);
Financial Analysis and Decision Making, a goal-based learning simulation focused
on interpreting financial reports; and Introduction to Financial Accounting, a
goal-based simulation that uses the Financial Consequences Model to introduce
financial accounting and financial statements to those unfamiliar with account-
ing. Dr. Powers is a member of the American Accounting Association, European
Accounting Association, International Association of Accounting Education and
Research, and Illinois CPA Society. She currently serves on the board of directors
of the Illinois CPA Society and the board of the CPA Endowment Fund of Illi-
nois. She has served as vice president of Programs and secretary of the Educational
Foundation.
xxxi
xxxii
About the Authors
Susan V. Crosson,
Santa Fe College
Susan V. Crosson is the accounting program coordinator and a professor of
accounting at Santa Fe College, Gainesville, FL. Susan has also enjoyed teach-
ing at the University of Florida, Washington University in St. Louis, Univer-
sity of Oklahoma, Johnson County Community College in Kansas, and Kansas
City Kansas Community College. She is known for her innovative application
of pedagogical strategies online and in the classroom. She is a recipient of the
Outstanding Educator Award from the American Accounting Association’s
Two Year College Section, an Institute of Management Accountants’ Fac-
ulty Development Grant to blend technology into the classroom, the Florida
Association of Community Colleges Professor of the Year Award for Instruc-
tional Excellence, and the University of Oklahoma’s Halliburton Education
Award for Excellence. Susan is active in many academic and professional
organizations. She served in the American Institute of CPA Pre- certification
Education Executive Committee and is on the Florida Institute of CPAs
Relations with Accounting Educators committee and the Florida Association
of Accounting Educators Steering Committee. She has served as the Ameri-
can Accounting Association’s Vice President for Sections and Regions and as
a council member-at-large, chairperson of the Membership Committee, and
was chairperson of the Two-Year Accounting Section. Previously she served
as chairperson of the Florida Institute of CPAs Accounting Careers and Edu-
cation Committee and was chair of the Florida Institute of CPAs Relations
with Accounting Educators Committee. Susan was on the American Institute
of CPAs’ Core Competencies Best Practices Task Force also. Susan co-authors
accounting textbooks for Cengage Learning: Principles of Accounting and
Financial and Managerial Accounting, and Managerial Accounting with Bel |
Needles and Marian Powers. Susan holds a BBA in Economics and Account-
ing from Southern Methodist University and a MS in Accounting from
Texas Tech University.
Principles of
Accounting
ELEVENTH EDITION
C H A P T E R
Uses of Accounting
1
Information and the
Financial Statements
Today, more people than ever before recognize the impor-
Making a
Statement tance of accounting information and the profound effect that
unethical and misleading financial reports can have on a business,
INCOME STATEMENT
its owners, its employees, its lenders, and the financial markets. In
Revenues
this chapter, we discuss the importance of ethical financial report-
– Expenses
ing, the uses and users of accounting information, and the financial
= Net Income
statements that accountants prepare. We end the chapter with a
discussion of generally accepted accounting principles.
STATEMENT OF
OWNER’S EQUITY
Beginning Balance
LEARNING OBJECTIVES
+ Net Income
– Withdrawals
LO1 Define accounting and describe its role in making informed
= Ending Balance decisions, identify business goals and activities, and explain
the importance of ethics in accounting. (pp. 4–10)
BALANCE SHEET
Assets Liabilities LO2 Identify the users of accounting information. (pp. 10–13)
LO3 Explain the importance of business transactions, money
Owner’s
Equity measure, and separate entity. (pp. 13–15)
A = L + OE
LO4 Identify the three basic forms of business organization.
(pp. 15–16)
STATEMENT OF CASH FLOWS
Operating activities LO5 Define financial position, and state the accounting
+ Investing activities
+ Financing activities equation. (pp. 17–19)
= Change in Cash
+ Beginning Balance LO6 Identify the four basic financial statements. (pp. 19–23)
= Ending Cash Balance
LO7 Explain how generally accepted accounting principles (GAAP)
and international financial reporting standards (IFRS) relate to
Financial statements
financial statements and the independent CPA’s report, and
measure how well a
identify the organizations that influence GAAP. (pp. 24–27)
business is run.
2
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Is Keep-Fit Center meeting its
goal of profitability?
KEEP-FIT CENTER
(cid:2) As owner of Keep-Fit Center,
what financial knowledge does
On January 1, 2010, Lilian Jackson, an experienced fitness coach, Lilian Jackson need to measure
started a business called Keep-Fit Center, which offers classes and progress toward the company’s
goals?
private instruction in aerobics, yoga, and Pilates. By December 31,
2010, the center had generated fees of $375,500, and its clients were (cid:2) In deciding whether to make
giving it high marks for excellent service. Lilian is therefore now con- a loan to Keep-Fit Center,
what financial knowledge
sidering expanding the business. To do so, she would need a bank
would a bank need to evaluate
loan, and to qualify for one, both she and the bank would have to use
the company’s financial
various financial measures to determine the business’s profitability
performance?
and liquidity (i.e., its ability to repay the loan).
Whether a business is small like Keep-Fit Center or large like CVS,
the same financial measures are used to evaluate it. In this chapter,
as you learn more about accounting and the business environment,
you will become familiar with these financial measures and be able
to answer questions such as those on the right.
33
4 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Accounting as Accounting is an information system that measures, processes, and communicates
an Information financial information about an economic entity.1 An economic entity is a unit that
exists independently, such as a business, a hospital, or a governmental body. Although
System
the central focus of this book is on business entities, we include other economic units
at appropriate points in the text and end-of-chapter assignments.
LO1 Define accounting and Accountants focus on the needs of decision makers who use financial informa-
describe its role in making tion, whether those decision makers are inside or outside a business or other economic |
informed decisions, identify entity. Accountants provide a vital service by supplying the information decision mak-
business goals and activities, and ers need to make “reasoned choices among alternative uses of scarce resources in the
explain the importance of ethics conduct of business and economic activities.”2 As shown in Figure 1-1, accounting is
in accounting. a link between business activities and decision makers.
1. Accounting measures business activities by recording data about them for
future use.
2. The data are stored until needed and then processed to become useful
information.
3. The information is communicated through reports to decision makers.
In other words, data about business activities are the input to the accounting
system, and useful information for decision makers is the output.
Business Goals, Activities,
and Performance Measures
A business is an economic unit that aims to sell goods and services to customers
at prices that will provide an adequate return to its owners. The list that follows
contains the names of some well-known businesses and the principal goods or
services that they sell.
BUSINESS ACTIVITIES DECISION MAKERS
Actions
Data
Information
ACCOUNTING
MEASUREMENT PROCESSING COMMUNICATION
SALES INVOICE
$5,200
A
F
AUNN
AICNANI
TROPER
L
L
FIGURE 1-1
Accounting as an Information System
Purchase
Order
Accounting as an Information System 5
FIGURE 1-2 BUSINESS GOALS BUSINESS ACTIVITIES
Business Goals
and Activities
FIRST BANK
PROFITABILITY FINANCING OPERATING
TITLE
DEED
LIQUIDITY INVESTING
Wal-Mart Corp. Comprehensive discount store
Reebok International Ltd. Athletic footwear and clothing
Best Buy Co. Consumer electronics, personal computers
Wendy’s International Inc. Food service
Starbucks Corp. Coffee
Southwest Airlines Co. Passenger airline
Despite their differences, these businesses have similar goals and engage in
similar activities, as shown in Figure 1-2.
The two major goals of all businesses are profitability and liquidity.
Study Note
(cid:2) Profitability is the ability to earn enough income to attract and hold invest-
Users of accounting information ment capital.
focus on a company’s
(cid:2) Liquidity is the ability to have enough cash to pay debts when they are due.
profitability and liquidity. Thus,
more than one measure of For example, Toyota may meet the goal of profitability by selling many cars
performance is of interest to
at a price that earns a profit, but if its customers do not pay for their cars quickly
them. For example, lenders are
enough to enable Toyota to pay its suppliers and employees, the company may
concerned primarily with cash
fail to meet the goal of liquidity. If a company is to survive and be successful, it
flow, and owners are concerned
must meet both goals.
with earnings and withdrawals.
All businesses, including Lilian Jackson’s Keep-Fit Center, pursue their goals
by engaging in operating, investing, and financing activities.
(cid:2) Operating activities include selling goods and services to customers, employ-
ing managers and workers, buying and producing goods and services, and
paying taxes.
(cid:2) Investing activities involve spending the capital a company receives in pro-
ductive ways that will help it achieve its objectives. These activities include
buying land, buildings, equipment, and other resources that are needed to
operate the business and selling them when they are no longer needed.
6 CHAPTER 1 Uses of Accounting Information and the Financial Statements
FOCUS ON BUSINESS PRACTICE
What Does CVS Have to Say About Itself?
CVS, a major drug store chain, describes the company’s progress
in meeting its major business objectives as follows:
FINANCING: OPERATING:
Obtains Funds from Sells Products and
Liquidity: “Along with our strong free cash flow generation, . . .
— Stockholders Services Through
we faced virtually none of the liquidity issues that sent — Investors More Than
— Banks and 3,500 Drugstores
shockwaves across so much of the business landscape in Other Creditors and Pharmacies
2008. CVS Caremark has a solid balance sheet and an invest- |
ment grade credit rating, and we maintain a commercial
INVESTING:
paper program currently backed by $4 billion in committed
Invests Funds in
bank facilities.” — Furniture, Fixtures
and Equipment
— Improvements
Profitability: “CVS Caremark generated record revenue and earn- to Buildings
ings, achieved industry-leading same-store sales growth, — Computer
Equipment
and continued to gain share across our businesses.”3
CVS’s main business activities are shown at the right.
(cid:2) Financing activities involve obtaining adequate funds, or capital, to begin
operations and to continue operating. These activities include obtaining capi-
tal from creditors, such as banks and suppliers, and from owners. They also
include repaying creditors and paying a return to the owners.
An important function of accounting is to provide performance measures,
which indicate whether managers are achieving their business goals and whether
the business activities are well managed. The evaluation and interpretation of
financial statements and related performance measures is called financial analy-
sis. For financial analysis to be useful, performance measures must be well aligned
with the two major goals of business—profitability and liquidity.
Profitability is commonly measured in terms of earnings or income, and cash
flows are a common measure of liquidity. In 2008, the drug and pharmacy chain
CVS projected earnings of $3.5 billion and cash flows from operating activities of
$4.5 billion in 2009. These figures indicate that CVS was achieving both profit-
ability and liquidity in difficult financial times.4 Not all companies were so fortu-
nate in 2008. For instance, General Motors reported that it would have to curtail
spending on new auto and truck models because its earnings (or profitability) and
cash flows were negative; in fact, they were the largest in the history of the U.S.
auto industry. Clearly, General Motors was not meeting either its profitability or
liquidity goals to such an extent that management had to go to the government
for a bailout in the billions of dollars. In spite of the bailout, the company was
forced to declare bankruptcy in 2009.
Although it is important to know the amounts of earnings and cash flows
in any given period and whether they are rising or falling, ratios of accounting
measures are also useful tools of financial analysis. For example, to assess Keep-
Fit Center’s profitability, it would be helpful to consider the ratio of its earnings
to total assets, and for liquidity, the ratio of its cash flows to total assets. In addi-
tion, ratios of accounting measures allow for comparisons from one period to
another and from one company to another.
Accounting as an Information System 7
FOCUS ON BUSINESS PRACTICE
Cash Bonuses Depend on Accounting Numbers!
Nearly all businesses use the amounts reported in their selecting measures that are not easily manipulated is impor-
financial statements as a basis for rewarding management. tant. Equally important is maintaining a balance of measures
Because managers act to achieve these accounting measures, that reflect the goals of profitability and liquidity.5
Financial and Management Accounting
Accounting’s role of assisting decision makers by measuring, processing, and com-
municating financial information is usually divided into the categories of manage-
ment accounting and financial accounting. Although the functions of management
accounting and financial accounting overlap, the two can be distinguished by the
principal users of the information they provide.
Management accounting provides internal decision makers, who are
charged with achieving the goals of profitability and liquidity, with information
about operating, investing, and financing activities. Managers and employees
who conduct the activities of the business need information that tells them
how they have done in the past and what they can expect in the future. For
example, The Gap, a retail clothing business, needs an operating report on
each outlet that tells how much was sold at that outlet and what costs were |
incurred, and it needs a budget for each outlet that projects the sales and costs
for the next year.
Financial accounting generates reports and communicates them to exter-
nal decision makers so they can evaluate how well the business has achieved its
goals. These reports are called financial statements. CVS, whose stock is traded
on the New York Stock Exchange, sends its financial statements to its owners
(called stockholders), its banks and other creditors, and government regulators.
Financial statements report directly on the goals of profitability and liquid-
ity and are used extensively both inside and outside a business to evaluate the
business’s success. It is important for every person involved with a business to
understand financial statements. They are a central feature of accounting and a
primary focus of this book.
Processing Accounting Information
It is important to distinguish accounting from the ways in which accounting
information is processed by bookkeeping, computers, and management informa-
tion systems.
Accounting includes the design of an information system that meets users’
needs, and its major goals are the analysis, interpretation, and use of information.
Bookkeeping, on the other hand, is mechanical and repetitive; it is the process of
recording financial transactions and keeping financial records. It is a small—but
important—part of accounting.
Today, computers collect, organize, and communicate vast amounts of
information with great speed. They can perform both routine bookkeeping
chores and complex calculations. Accountants were among the earliest and
most enthusiastic users of computers, and today they use computers in all
aspects of their work.
8 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Computers make it possible to create a management information system to
Study Note
organize a business’s many information needs. A management information sys-
tem (MIS) consists of the interconnected subsystems that provide the information
Computerized accounting
needed to run a business. The accounting information system is the most important
information is only as reliable
and useful as the data that go subsystem because it plays the key role of managing the flow of economic data to all
into the system. The accountant parts of a business and to interested parties outside the business.
must have a thorough under-
standing of the concepts
Ethical Financial Reporting
that underlie accounting to
ensure the data’s reliability and
Ethics is a code of conduct that applies to everyday life. It addresses the question
usefulness.
of whether actions are right or wrong. Actions—whether ethical or unethical,
right or wrong—are the product of individual decisions. Thus, when an organi-
zation acts unethically by using false advertising, cheating customers, polluting
the environment, or treating employees unfairly, it is not the organization that
is responsible—it is the members of management and other employees who have
made a conscious decision to act in this manner.
Ethics is especially important in preparing financial reports because users
of these reports must depend on the good faith of the people involved in their
preparation. Users have no other assurance that the reports are accurate and fully
disclose all relevant facts.
The intentional preparation of misleading financial statements is called fraud-
ulent financial reporting.6 It can result from the distortion of records (e.g., the
manipulation of inventory records), falsified transactions (e.g., fictitious sales),
or the misapplication of various accounting principles. There are a number of
motives for fraudulent reporting—for instance, to cover up financial weakness to
obtain a higher price when a company is sold; to meet the expectations of inves-
tors, owners, and financial analysts; or to obtain a loan. The incentive can also
be personal gain, such as additional compensation, promotion, or avoidance of
penalties for poor performance.
Whatever the motive for fraudulent financial reporting, it can have dire con- |
sequences, as the accounting scandals that erupted at Enron Corporation and
WorldCom attest. Unethical financial reporting and accounting practices at those
two major corporations caused thousands of people to lose their jobs, their invest-
ment incomes, and their pensions. They also resulted in prison sentences and
fines for the corporate executives who were involved.
FOCUS ON BUSINESS PRACTICE
How Did Accounting Develop?
Accounting is a very old discipline. Forms of it have been famous Italian mathematician, scholar, and philosopher
essential to commerce for more than 5,000 years. Account- Fra Luca Pacioli. In 1494, Pacioli published his most impor-
ing, in a version close to what we know today, gained tant work, Summa de Arithmetica, Geometrica, Proportioni et
widespread use in the 1400s, especially in Italy, where it Proportionalita, which contained a detailed description of
was instrumental in the development of shipping, trade, accounting as practiced in that age. This book became the
construction, and other forms of commerce. This system most widely read book on mathematics in Italy and firmly
of double-entry bookkeeping was documented by the established Pacioli as the “Father of Accounting.”
Accounting as an Information System 9
Unethical accounting practices at Enron
led to the collapse of the company and the
loss of thousands of jobs and pensions.
This photograph shows the former Enron
building in Houston, Texas.
Courtesy of Paul S. Wolf, 2009/Used under
license from Shutterstock.com.
In 2002, Congress passed the Sarbanes-Oxley Act to regulate financial
reporting and the accounting profession, among other things. This legislation
ordered the Securities and Exchange Commission (SEC) to draw up rules requir-
ing the chief executives and chief financial officers of all publicly traded U.S.
companies to swear that, based on their knowledge, the quarterly statements and
annual reports that their companies file with the SEC are accurate and complete.
Violation can result in criminal penalties. A company’s management expresses its
duty to ensure that financial reports are not false or misleading in the manage-
ment report that appears in the company’s annual report. For example, Target
Corporation’s management report includes the following statement:
Management is responsible for the consistency, integrity and presentation
of the information in the Annual Report.7
However, it is accountants, not management, who physically prepare and
audit financial reports. To meet the high ethical standards of the accounting pro-
fession, they must apply accounting concepts in such a way as to present a fair
view of a company’s operations and financial position and to avoid misleading
readers of their reports. Like the conduct of a company, the ethical conduct of a
profession is a collection of individual actions. As a member of a profession, each
accountant has a responsibility—not only to the profession but also to employers,
clients, and society as a whole—to ensure that any report he or she prepares or
audits provides accurate, reliable information.
The high regard that the public has historically had for the accounting profes-
sion is evidence that an overwhelming number of accountants have upheld the
ethics of the profession. Even as the Enron and WorldCom scandals were making
headlines, a Gallup Poll showed an increase of 28 percent in the accounting pro-
fession’s reputation between 2002 and 2005, placing it among the most highly
rated professions.8
Accountants and top managers are, of course, not the only people responsible
for ethical financial reporting. Managers and employees at all levels must be con-
scious of their responsibility for providing accurate financial information to the
people who rely on it.
10 CHAPTER 1 Uses of Accounting Information and the Financial Statements
STOP
& APPLY
Match the terms below with the definitions (some answers may be used more than once):
_____ 1. Management accounting a. An unethical practice
_____ 2. Liquidity b. A business goal
_____ 3. Financial accounting c. Engaged in by all businesses |
_____ 4. Investing activities d. Major function of accounting
_____ 5. Operating activities
_____ 6. Financing activities
_____ 7. Profitability
_____ 8. Fraudulent financial reporting
SOLUTION
1. d; 2. b; 3. d; 4. c; 5. c; 6. c; 7. b; 8. a
Decision Makers:
As shown in Figure 1-3, the people who use accounting information to make
The Users of decisions fall into three categories:
Accounting 1. Those who manage a business
Information 2. Those outside a business enterprise who have a direct financial interest in the
business
LO2 Identify the users of
3. Those who have an indirect financial interest in a business
accounting information.
These categories apply to governmental and not-for-profit organizations as well
as to profit-oriented ventures.
Management
MManagement refers to the people who are responsible for operating a business and
Study Note
mmeeting its goals of profitability and liquidity. In a small business, management may
cconsist solely of the owners. In a large business, managers must decide what to do,
Managers are internal users of
accounting information. hhow to do it, and whether the results match their original plans. Successful managers
cconsistently make the right decisions based on timely and valid information.
FIGURE 1-3
DECISION MAKERS
The Users of Accounting Information
MANAGEMENT THOSE WITH DIRECT THOSE WITH INDIRECT
FINANCIAL INTEREST FINANCIAL INTEREST
Finance
Investment Investors Tax Authorities
Operations and Creditors Regulatory Agencies
Production Labor Unions
Marketing Customers
Human Resources Economic Planners
Information Systems
Accounting
Decision Makers: The Users of Accounting Information 11
To make good decisions, Lilian Jackson and other owners and managers need
answers to such questions as:
(cid:2) What were the company’s earnings during the past quarter?
(cid:2) Is the rate of return to the owners adequate?
(cid:2) Does the company have enough cash?
(cid:2) Which products or services are most profitable?
Because so many key decisions are based on accounting data, management is one
of the most important users of accounting information.
In its decision-making process, management performs functions that are
essential to the operation of a business. The same basic functions must be per-
formed in all businesses, and each requires accounting information on which to
base decisions. The basic management functions are:
Financing the business: obtaining funds so that a company can begin and con-
tinue operating
Investing resources: investing assets in productive ways that support a company’s
goals
Producing goods and services: managing the production of goods and services
Marketing goods and services: overseeing how goods or services are advertised,
sold, and distributed
Managing employees: overseeing the hiring, evaluation, and compensation of
employees
Providing information to decision makers: gathering data about all aspects of a
company’s operations, organizing the data into usable information, and provid-
ing reports to managers and appropriate outside parties. Accounting plays a key
role in this function.
Users with a Direct Financial Interest
Another group of decision makers who need accounting information are those with
a direct financial interest in a business. They depend on accounting to measure and
report information about how a business has performed. Most businesses periodi-
cally publish a set of general-purpose financial statements that report their success
in meeting the goals of profitability and liquidity. These statements show what has
happened in the past, and they are important indicators of what will happen in the
future. Many people outside the company carefully study these financial reports.
The two most important groups are investors (including owners) and creditors.
FOCUS ON BUSINESS PRACTICE
What Do CFOs Do?
According to a survey, the chief financial officer (CFO) is the involving international operations, and many of them are
“new business partner of the chief executive officer” (CEO). becoming CEOs of their companies. Those who do become
CFOs are increasingly required to take on responsibilities CEOs are finding that “a financial background is invaluable when |
for strategic planning, mergers and acquisitions, and tasks they’re saddled with the responsibility of making big calls.”9
12 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Investors Those such as Lilian Jackson, owner of the Keep-Fit Center, and
Study Note
CCVS’s stockholders who may invest in a business and acquire a part ownership in
The primary external users of iit are interested in its past success and its potential earnings. A thorough study of
accounting information are aa company’s financial statements helps potential investors judge the prospects for
investors and creditors. aa profitable investment. After investing, they must continually review their com-
mmitment, again by examining the company’s financial statements.
Creditors Most companies borrow money for both long- and short-term oper-
ating needs. Creditors, those who lend money or deliver goods and services before
being paid, are interested mainly in whether a company will have the cash to pay
interest charges and to repay the debt at the appropriate time. They study a com-
pany’s liquidity and cash flow as well as its profitability. Banks, finance companies,
mortgage companies, securities firms, insurance firms, suppliers, and other lenders
must analyze a company’s financial position before they make a loan.
Users with an Indirect Financial Interest
In recent years, society as a whole, through governmental and public groups,
has become one of the largest and most important users of accounting informa-
tion. Users who need accounting information to make decisions on public issues
include tax authorities, regulatory agencies, and various other groups.
Tax Authorities Government at every level is financed through the collection of
taxes. Companies and individuals pay many kinds of taxes, including federal, state,
and city income taxes; Social Security and other payroll taxes; excise taxes; and sales
taxes. Each tax requires special tax returns and often a complex set of records as well.
Proper reporting is generally a matter of law and can be very complicated. The Inter-
nal Revenue Code, for instance, contains thousands of rules governing the prepara-
tion of the accounting information used in computing federal income taxes.
Regulatory Agencies Most companies must report periodically to one or more
regulatory agencies at the federal, state, and local levels. For example, all publicly
traded corporations must report periodically to the Securities and Exchange
Commission (SEC). This body, set up by Congress to protect the public, regu-
lates the issuing, buying, and selling of stocks in the United States. Companies
listed on a stock exchange also must meet the special reporting requirements of
their exchange.
Other Groups Labor unions study the financial statements of corporations as
part of preparing for contract negotiations; a company’s income and costs often
play an important role in these negotiations. Those who advise investors and
creditors—financial analysts, brokers, underwriters, lawyers, economists, and the
financial press—also have an indirect interest in the financial performance and
prospects of a business. Consumer groups, customers, and the general public
have become more concerned about the financing and earnings of corporations
as well as the effects that corporations have on inflation, the environment, social
issues, and the quality of life. And economic planners, among them the President’s
Council of Economic Advisers and the Federal Reserve Board, use aggregated
accounting information to set and evaluate economic policies and programs.
Governmental and Not-for-Profit Organizations
More than 30 percent of the U.S. economy is generated by governmental and
not-for-profit organizations (hospitals, universities, professional organizations,
Accounting Measurement 13
and charities). The managers of these diverse entities perform the same functions
as managers of businesses, and they therefore have the same need for accounting
information and a knowledge of how to use it. Their functions include raising |
funds from investors (including owners), creditors, taxpayers, and donors and
deploying scarce resources. They must also plan how to pay for operations and to
repay creditors on a timely basis. In addition, they have an obligation to report
their financial performance to legislators, boards, and donors, as well as to deal
with tax authorities, regulators, and labor unions. Although most of the examples
in this text focus on business enterprises, the same basic principles apply to gov-
ernmental and not-for-profit organizations.
STOP
& APPLY
Match the terms below with the type of user of accounting information (some answers may be
used more than once):
_____ 1. Tax authorities a. Internal user
_____ 2. Investors b. Direct external user
_____ 3. Management c. Indirect user
_____ 4. Creditors
_____ 5. Regulatory agencies
_____ 6. Labor unions and consumer groups
SOLUTION
1. c; 2. b; 3. a; 4. b; 5. c; 6. c
Accounting
In this section, we begin the study of the measurement aspects of accounting—
Measurement that is, what accounting actually measures. To make an accounting measurement,
the accountant must answer four basic questions:
LO3 Explain the importance 1. What is measured?
of business transactions, money
2. When should the measurement be made?
measure, and separate entity.
3. What value should be placed on what is measured?
4. How should what is measured be classified?
Accountants in industry, professional associations, public accounting, govern-
ment, and academic circles debate the answers to these questions constantly,
and the answers change as new knowledge and practice require. But the basis of
today’s accounting practice rests on a number of widely accepted concepts and
conventions, which are described in this book. We begin by focusing on the first
question: What is measured? We discuss the other three questions (recognition,
valuation, and classification) in the next chapter.
Every system must define what it measures, and accounting is no exception.
Basically, financial accounting uses money to gauge the impact of business trans-
actions on separate business entities.
14 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Business Transactions
Business transactions are economic events that affect a business’s financial posi-
tion. Businesses can have hundreds or even thousands of transactions every day.
These transactions are the raw material of accounting reports.
A transaction can be an exchange of value (a purchase, sale, payment, col-
lection, or loan) between two or more parties. A transaction also can be an eco-
nomic event that has the same effect as an exchange transaction but that does not
involve an exchange. Some examples of “nonexchange” transactions are losses
from fire, flood, explosion, and theft; physical wear and tear on machinery and
equipment; and the day-by-day accumulation of interest.
To be recorded, a transaction must relate directly to a business entity. Suppose
a customer buys toothpaste from CVS but has to buy shampoo from a competing
store because CVS is out of shampoo. The transaction in which the toothpaste
was sold is entered in CVS’s records. However, the purchase of the shampoo
from the competitor is not entered in CVS’s records because even though it indi-
rectly affects CVS economically, it does not involve a direct exchange of value
between CVS and the customer.
Money Measure
All business transactions are recorded in terms of money. This concept is called
money measure. Of course, nonfinancial information may also be recorded, but
it is through the recording of monetary amounts that a business’s transactions
and activities are measured. Money is the only factor common to all business
transactions, and thus it is the only unit of measure capable of producing financial
data that can be compared.
The monetary unit a business uses depends on the country in which the busi-
Study Note
ness resides. For example, in the United States, the basic unit of money is the
dollar. In Japan, it is the yen; in Europe, the euro; and in the United Kingdom, |
The common unit of
measurement used in the the pound. In international transactions, exchange rates must be used to translate
United States for financial from one currency to another. An exchange rate is the value of one currency in
reporting purposes is the dollar. terms of another. For example, a British person purchasing goods from a U.S.
company like CVS and paying in U.S. dollars must exchange British pounds for
U.S. dollars before making payment. In effect, currencies are goods that can be
bought and sold.
Table 1-1 illustrates the exchange rates for several currencies in dollars. It
shows the exchange rate for British pounds as $1.49 per pound on a particular
date. Like the prices of many goods, currency prices change daily according to
supply and demand. For example, a year earlier, the exchange rate for British
pounds was $1.98. Although our discussion in this book focuses on dollars, some
examples and assignments involve foreign currencies.
TABLE 1-1 Price Price
Examples of Foreign Exchange Rates Country in $U.S. Country in $U.S.
Australia (dollar) 0.72 Hong Kong (dollar) 0.13
Brazil (real) 0.46 Japan (yen) 0.011
Britain (pound) 1.49 Mexico (peso) 0.07
Canada (dollar) 0.85 Russia (ruble) 0.03
Europe (euro) 1.35 Singapore (dollar) 0.68
Source: The Wall Street Journal, January 7, 2009.
The Forms of Business Organization 15
Separate Entity
For accounting purposes, a business is a separate entity, distinct not only from
Study Note
its creditors and customers but also from its owners. It should have its own set of
For accounting purposes, a financial records, and its records and reports should refer only to its own affairs.
business is always separate For example, Just Because Flowers Company should have a bank account
and distinct from its owners, separate from the account of Holly Sapp, the owner. Holly Sapp may own a
creditors, and customers. home, a car, and other property, and she may have personal debts, but these are
not the resources or debts of Just Because Flowers. Holly Sapp may own another
business, say a stationery shop. If she does, she should have a completely separate
set of records for each business.
STOP
& APPLY
Match the terms below with the type of user of accounting information:
_____ 1. R equires an exchange of value a. Business transaction
between two or more parties b. Money measure
_____ 2. R equires a separate set of records for c. Separate entity
a business
_____ 3. A n amount associated with a
business transaction
SOLUTION
1. a; 2. c; 3. b
The Forms
The three basic forms of business organization are the sole proprietorship, the part-
of Business nership, and the corporation. Accountants recognize each form as an economic unit
separate from its owners. Legally, however, only the corporation is separate from
Organization
its owners. The characteristics of corporations make them very efficient in amassing
capital, which enables them to grow extremely large. As Figure 1-4 shows, even
LO4 Identify the three basic though corporations are fewer in number than sole proprietorships and partnerships,
forms of business organization. they contribute much more to the U.S. economy in monetary terms. For example,
in 2007, Exxon Mobil generated more revenues than all but 30 of the world’s coun-
tries. Here, we point out the most important features of each form of business.
Characteristics of Corporations, Sole Proprietorships,
and Partnerships
AA sole proprietorship is a business owned by one person.* The owner takes
Study Note
aall the profits or losses of the business and is liable for all its obligations. As
A key disadvantage of a F Figure 1-4 shows, sole proprietorships represent the largest number of businesses
partnership is the unlimited iin the United States, but typically they are the smallest in size.
liability of its owners. Unlimited A partnership is like a sole proprietorship in most ways, but it has two or
liability can be avoided by mmore owners. The partners share the profits and losses of the business accord-
organizing the business as a iing to a prearranged formula. Generally, any partner can obligate the business |
corporation or, in some states,
by forming what is known as
*Accounting for a sole proprietorship is simpler than accounting for a partnership or corpora-
a limited liability partnership
tion. For that reason, we focus on the sole proprietorship in the early part of this book. At
(LLP).
critical points, however, we call attention to the essential differences between accounting for a
sole proprietorship and accounting for a partnership or corporation.
16 CHAPTER 1 Uses of Accounting Information and the Financial Statements
FIGURE 1-4
Number and Receipts of U.S. Proprietorships, Partnerships, and Corporations
NUMBER OF BUSINESSES
Proprietorships 19,710
Partnerships 2,375
Corporations 5,401
0 2 4 6 8 10 12 14 16 18 20 22 Millions
RECEIPTS OF BUSINESSES
Proprietorships $ 1,050
Partnerships 2,923
Corporations 20,690
$0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000 Billions
Source: U.S. Treasury Department, Internal Revenue Service, Statistics of Income Bulletin, Winter 2006.
to another party, and the personal resources of each partner can be called on to
pay the obligations. A partnership must be dissolved if the ownership changes, as
when a partner leaves or dies. If the business is to continue as a partnership after
this occurs, a new partnership must be formed.
Both the sole proprietorship and the partnership are convenient ways of
separating the owners’ commercial activities from their personal activities.
Legally, however, there is no economic separation between the owners and the
businesses. A corporation, on the other hand, is a business unit chartered by
the state and legally separate from its owners (the stockholders). The stockhold-
ers, whose ownership is represented by shares of stock, do not directly control
the corporation’s operations. Instead, they elect a board of directors to run the
corporation for their benefit. In exchange for their limited involvement in the
corporation’s operations, stockholders enjoy limited liability; that is, their risk
of loss is limited to the amount they paid for their shares. Thus, stockholders
are often willing to invest in risky, but potentially profitable, activities. Also,
because stockholders can sell their shares without dissolving the corporation,
the life of a corporation is unlimited and not subject to the whims or health of
a proprietor or a partner.
FOCUS ON BUSINESS PRACTICE
Are Most Corporations Big or Small Businesses?
Most people think of corporations as large national or only about 15,000 have stock that is publicly bought and
global companies whose shares of stock are held by thou- sold. The vast majority of corporations are small businesses
sands of people and institutions. Indeed, corporations can privately held by a few stockholders. Illinois alone has more
be huge and have many stockholders. However, of the than 250,000 corporations. Thus, the study of corporations
approximately 4 million corporations in the United States, is just as relevant to small businesses as it is to large ones.
Financial Position and the Accounting Equation 17
STOP
& APPLY
Match the descriptions on the left with the forms of business enterprise on the right:
_____ 1. Pays dividends _____ 5. M ost numerous but usually small in size
_____ 2. Owned by only one person _____ 6. Biggest segment of the economy
_____ 3. Multiple co-owners a. Sole proprietorship
_____ 4. M anagement appointed by board of b. Partnership
directors
c. Corporation
SOLUTION
1. c; 2. a; 3. b; 4. c; 5. a; 6. c
Financial
Financial position refers to a company’s economic resources, such as cash, inven-
Position and tory, and buildings, and the claims against those resources at a particular time.
Another term for claims is equities.
the Accounting
Every company has two types of equities: creditors’ equities, such as bank
Equation loans, and owner’s equity. The sum of these equities equals a company’s
resources:
LO5 Define financial position,
and state the accounting Economic Resources (cid:2) Creditors’ Equities (cid:3) Owner’s Equity
equation.
In accounting terminology, economic resources are called assets and creditors’ |
equities are called liabilities. So the equation can be written like this:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
This equation is known as the accounting equation. The two sides of the equa-
tion must always be equal, or “in balance,” as shown in Figure 1-5. To evalu-
ate the financial effects of business activities, it is important to understand their
effects on this equation.
FIGURE 1-5
The Accounting Equation
Owner’s
Assets Liabilities
Equity
A = L + OE
18 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Assets
Assets are the economic resources of a company that are expected to benefit
the company’s future operations. Certain kinds of assets—for example, cash and
money that customers owe to the company (called accounts receivable)—are
monetary items. Other assets—inventories (goods held for sale), land, buildings,
and equipment—are nonmonetary, physical items. Still other assets—the rights
granted by patents, trademarks, and copyrights—are nonphysical.
Liabilities
Liabilities are a business’s present obligations to pay cash, transfer assets, or
provide services to other entities in the future. Among these obligations are
amounts owed to suppliers for goods or services bought on credit (called
accounts payable), borrowed money (e.g., money owed on bank loans), sala-
ries and wages owed to employees, taxes owed to the government, and ser-
vices to be performed.
As debts, liabilities are claims recognized by law. That is, the law gives creditors
the right to force the sale of a company’s assets if the company fails to pay its debts.
Creditors have rights over owners and must be paid in full before the owners receive
anything, even if payment of the debt uses up all the assets of the business.
Owner’s Equity
Owner’s equity represents the claims by the owner of a business to the assets
of the business. Theoretically, owner’s equity is what would be left if all liabili-
ties were paid, and it is sometimes said to equal net assets. By rearranging the
accounting equation, we can define owner’s equity this way:
Owner’s Equity (cid:2) Assets (cid:4) Liabilities
Owner’s equity is affected by the owner’s investments in and withdrawals
from the business and by the business’s revenues and expenses. Owner’s invest-
ments are assets that the owner puts into the business (e.g., by transferring cash
from a personal bank account to the business’s bank account). In this case, the
assets (cash) of the business increase, and the owner’s equity in those assets also
increases. Owner’s withdrawals are assets that the owner takes out of the business
(e.g., by transferring cash from the business’s bank account to a personal bank
account). In this case, the assets of the business decrease, as does the owner’s
equity in the business.
Simply stated, revenues and expenses are the increases and decreases in
owner’s equity that result from operating a business. For example, the amount a
customer pays (or agrees to pay in the future) to CVS for a product or service is
a revenue for CVS. CVS’s assets (cash or accounts receivable) increase, as does
its stockholders’ (owner’s) equity in those assets. On the other hand, the amount
CVS must pay out (or agree to pay out) so that it can provide a product or service
is an expense. In this case, the assets (cash) decrease or the liabilities (accounts
payable) increase, and the owner’s equity decreases.
Generally, a company is successful if its revenues exceed its expenses. When
revenues exceed expenses, the difference is called net income. When expenses
exceed revenues, the difference is called net loss. It is important not to confuse
expenses and withdrawals, both of which reduce owner’s equity. In summary,
owner’s equity is the accumulated net income (revenues (cid:4) expenses) less with-
drawals over the life of the business.
Financial Statements 19
STOP
& APPLY
Johnson Company had assets of $140,000 and liabilities of $60,000 at the beginning of the year,
and assets of $200,000 and liabilities of $70,000 at the end of the year. During the year, $20,000 |
was invested in the business, and withdrawals of $24,000 were made. What amount of net income
did the company earn during the year?
Beginning of the year
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
$140,000 (cid:2) $60,000 (cid:3) $ 80,000
During year
Investment (cid:3) 20,000
Withdrawals (cid:4) 24,000
?
Net income
End of year
$200,000 (cid:2) $70,000 (cid:3) $130,000
SOLUTION
Net income (cid:2) $54,000
Start by finding the owner’s equity at the beginning of the year. (Check: $140,000 (cid:4) $60,000 (cid:2) $80,000)
Then find the owner’s equity at the end of the year. (Check: $200,000 (cid:4) $70,000 (cid:2) $130,000)
Then determine net income by calculating how the transactions during the year led to the owner’s equity amount
at the end of the year. (Check: $80,000 (cid:3) $20,000 (cid:4) $24,000 (cid:3) $54,000 (cid:2) $130,000)
Financial
Financial statements are the primary means of communicating important account-
Statements ing information about a business to those who have an interest in the business.
These statements are models of the business enterprise in that they show the
business in financial terms. As is true of all models, however, financial statements
LO6 Identify the four basic
are not perfect pictures of the real thing. Rather, they are the accountant’s best
financial statements.
effort to represent what is real. Four major financial statements are used to com-
municate accounting information about a business: the income statement, the
statement of owner’s equity, the balance sheet, and the statement of cash flows.
Study Note
Businesses use four basic
Income Statement
financial statements to
communicate financial The income statement summarizes the revenues earned and expenses incurred by
information to decision makers. a business over an accounting period (see Exhibit 1-1). Many people consider it
the most important financial report because it shows whether a business achieved
its profitability goal—that is, whether it earned an acceptable income. Exhibit 1-1
shows that Weiss Consultancy had revenues of $14,000 from consulting. From
this amount, total expenses of $5,600 were deducted (equipment rental expense
of $2,800, wages expense of $1,600, and utilities expense of $1,200) to arrive at
net income of $8,400. To show the period to which the statement applies, it is
dated “For the Month Ended December 31, 2011.”
20 CHAPTER 1 Uses of Accounting Information and the Financial Statements
EXHIBIT 1-1
Income Statement for Weiss Consultancy
Weiss Consultancy Income Statement
For the Month Ended December 31, 2011
Revenues
Consulting fees
earned $14,000
Expenses
Equipment rental expense $2,800
Wages expense 1,600
Utilities expense 1,200
Total expenses 5,600
Net income $ 8,400
Statement of Owner’s Equity
The statement of owner’s equity shows the changes in owner’s equity over an
accounting period. In Exhibit 1-2, beginning owner’s equity is zero because Weiss
Consultancy began operations in this accounting period. During the month, the
owner, James Weiss, invested $200,000 in the business, and the company earned
an income (as shown on the income statement) of $8,400. Deducted from this
amount are $2,400 of withdrawals that the owner made during the month, leav-
ing an ending balance of $206,000 of capital in the business.
The Balance Sheet
The purpose of a balance sheet is to show the financial position of a business on
Study Note a certain date, usually the end of the month or year (see Exhibit 1-3). For this rea-
son, it often is called the statement of financial position and is dated as of a specific
The date on the balance sheet is
date. The balance sheet presents a view of the business as the holder of resources,
a single date, whereas the dates
or assets, that are equal to the claims against those assets. The claims consist of the
on the other three statements
cover a period of time, such as a company’s liabilities and the owner’s equity in the company. Exhibit 1-3 shows
month, quarter, or year. that Weiss Consultancy has several categories of assets, which total $208,400.
These assets equal the total liabilities of $2,400 (accounts payable) plus the ending |
balance of owner’s equity of $206,000. Notice that the amount of the owner’s
Capital account on the balance sheet comes from the ending balance on the state-
ment of owner’s equity.
EXHIBIT 1-2
Weiss Consultancy
Statement of Owner’s Equity
for Weiss Consultancy Statement of Owner’s Equity
For the Month Ended December 31, 2011
J. Weiss, Capital, December 1, 2011 $ 0
Investment by J. Weiss 200,000
Net income for the month 8,400
Subtotal $208,400
Less withdrawals 2,400
J. Weiss, Capital, December 31, 2011 $206,000
Financial Statements 21
EXHIBIT 1-3
Balance Sheet for Weiss Consultancy
Weiss Consultancy
Balance Sheet
December 31, 2011
Assets Liabilities
Cash $ 62,400 Accounts payable $ 2,400
Accounts receivable 4,000 Total liabilities $ 2,400
Supplies 2,000
Owner’s Equity
Land 40,000
Buildings 100,000 J. Weiss, Capital 206,000
Total assets $208,400 Total liabilities and owner’s equity $208,400
Statement of Cash Flows
Whereas the income statement focuses on a company’s profitability, the state-
Study Note
ment of cash flows focuses on its liquidity (see Exhibit 1-4). Cash flows are the
inflows and outflows of cash into and out of a business. Net cash flows are the
The statement of cash flows
explains the change in cash in difference between the inflows and outflows.
terms of operating, investing, As you can see in Exhibit 1-4, the statement of cash flows is organized accord-
and financing activities over an ing to the three major business activities described earlier in the chapter.
accounting period. It provides (cid:2) Cash flows from operating activities: The first section of Exhibit 1-4 shows
valuable information that cannot
the cash produced by business operations. Weiss’s operating activities pro-
be determined in an examination
duced net cash flows of $4,800 (liquidity) compared to net income of $8,400
of the other financial statements.
(profitability). The company used cash to increase accounts receivable and
supplies. However, by borrowing funds, it increased accounts payable. This is
not a good trend, which Weiss should try to reverse in future months.
(cid:2) Cash flows from investing activities: Weiss used cash to expand by pur-
Study Note chasing land and a building.
(cid:2) Cash flows from financing activities: Weiss obtained most of its cash from
Notice the sequence in which
the owner, who then made a small cash withdrawal.
these statements are prepared:
Income statement, statement of
Overall, Weiss had a net increase in cash of $62,400, due in large part to the
owner’s equity, balance sheet,
investment by the owner. In future months, Weiss must generate more cash
and finally, the statement of
through operations.
cash flows.
The statement of cash flows is related directly to the other three financial
statements. Notice that net income comes from the income statement and that
withdrawals come from the statement of owner’s equity. The other items in the state-
ment r epresent changes in the balance sheet accounts: accounts receivable, supplies,
accounts payable, land, and buildings. Here we focus on the importance and overall
structure of the statement. Its construction and use are discussed in a later chapter.
Relationships Among the Financial Statements
Exhibit 1-5 illustrates the relationships among the four financial statements by
showing how they would appear for Weiss Consultancy. The period covered is
the month of December 2011. Notice the similarity of the headings at the top
22 CHAPTER 1 Uses of Accounting Information and the Financial Statements
of each statement. Each identifies the company and the kind of statement. The
income statement, the statement of owner’s equity, and the statement of cash
flows indicate the period to which they apply; the balance sheet gives the specific
date to which it applies. Much of this book deals with developing, using, and
interpreting more complete versions of these statements.
EXHIBIT 1-4
Statement of Cash Flows for Weiss Consultancy
Weiss Consultancy
Statement of Cash Flows
For the Month Ended December 31, 2011
Cash flows from operating activities
Net income $ 8,400 |
Adjustments to reconcile net income to net cash flows from
operating activities
(Increase) in accounts receivable ($ 4,000)
(Increase) in supplies (2,000)
Increase in accounts payable 2,400) (3,600)
Net cash flows from operating activities $ 4,800
Cash flows from investing activities
Purchase of land ($ 40,000)
Purchase of building (100,000)
Net cash flows from investing activities (140,000)
Cash flows from financing activities
Investments by owner $ 200,000
Withdrawals (2,400)
Net cash flows from financing activities 197,600
Net increase (decrease) in cash $ 62,400
Cash at beginning of month 0
Cash at end of month
$ 62,400
Note: Parentheses indicate a negative amount.
Financial Statements 23
EXHIBIT 1-5
Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows for Weiss Consultancy
Weiss Consultancy Weiss Consultancy
Statement of Cash Flows Income Statement
For the Month Ended December 31, 2011 For the Month Ended December 31, 2011
Cash flows from operating activities Revenues
Net income $ 8,400 Consulting fees $14,000
Adjustments to reconcile Expenses
net income to net cash Equipment rental expense $2,800
flows from operating Wages expense 1,600
activities Utilities expense 1,200
(Increase) in accounts ($ 4,000) Total expenses 5,600
receivable Net income $ 8,400
(Increase) in supplies (2,000)
Weiss Consultancy
Increase in accounts
Statement of Owner’s Equity
payable 2,400) (3,600)
For the Month Ended December 31, 2011
Net cash flows from
operating activities $ 4,800 J. Weiss, Capital, December 1, 2011 $ 0
Investment by J. Weiss 200,000
Cash flows from investing activities
Net income for the month 8,400
Purchase of land ($ 40,000) Subtotal $208,400
Purchase of building (100,000) Less withdrawals 2,400
Net cash flows from
J. Weiss, Capital, December 31, 2011 $206,000
investing activities (140,000)
Cash flows from financing activities
Investments
Weiss Consultancy
by owner $200,000
Balance Sheet
Withdrawals (2,400) December 31, 2011
Net cash flows from
Assets Liabilities
financing activities 197,600
Net increase (decrease) Cash $ 62,400 Accounts payable $ 2,400
in cash $ 62,400
Accounts 4,000 Total liabilities $ 2,400
Cash at beginning of receivable
month 0 Supplies 2,000
Owner’s Equity
Cash at end of month $ 62,400 Land 40,000
Buildings 100,000 J. Weiss, Capital 206,000
Total liabilities and
T otal assets $208,400 owner’s equity $208,400
24 CHAPTER 1 Uses of Accounting Information and the Financial Statements
STOP
& APPLY
Complete the following financial statements by determining the amounts that correspond to the
letters. (Assume no new investments by owners.)
Income Statement
Revenues $2,775
Expenses (a)
Net income $ (b)
Statement of Owner’s Equity
Beginning balance $7,250
Net income (c)
Less withdrawals 500
Ending balance $7,500
Balance Sheet
Total assets $ (d)
Liabilities $4,000
Owner’s equity
L. Buckman, capital (e)
Total liabilities and owner’s equity $ (f)
SOLUTION
Net income links the income statement and the statement of owner’s equity. The ending balance of owner’s equity
links the statement of owner’s equity and the balance sheet.
Thus, start with (c), which must equal $750 (check: $7,250 (cid:3) $750 (cid:4) $500 (cid:2) $7,500). Then, (b) equals (c),
or $750. Thus, (a) must equal $2,025 (check: $2,775 – $2,025 (cid:2) $750). Because (e) equals $7,500 (ending
balance from the statement of owner’s equity), (f) must equal $11,500 (check: $4,000 (cid:3) $7,500 (cid:2) $11,500). Now,
(d) equals (f), or $11,500.
Generally
To ensure that financial statements are understandable to their users, a set
Accepted of practices, called generally accepted accounting principles (GAAP), has
been developed to provide guidelines for financial accounting. “Generally
Accounting
accepted accounting principles encompass the conventions, rules, and proce-
Principles dures necessary to define accepted accounting practice at a particular time.”10
In other words, GAAP arise from wide agreement on the theory and prac-
LO7 Explain how generally tice of accounting at a particular time. These “principles” are not like the |
accepted accounting principles unchangeable laws of nature in chemistry or physics. They evolve to meet the
(GAAP) and international finan- needs of decision makers, and they change as circumstances change or as bet-
cial reporting standards (IFRS) ter methods are developed.
relate to financial statements In this book, we present accounting practice, or GAAP, as it is today,
and the independent CPA’s and we try to explain the reasons or theory on which the practice is based.
report, and identify the organiza- Both theory and practice are important to the study of accounting. H owever,
tions that influence GAAP. accounting is a discipline that is always growing, changing, and improv-
ing. Just as years of research are necessary before a new surgical method or
lifesaving drug can be introduced, it may take years for new accounting discoveries
to be implemented. As a result, you may encounter practices that seem
contradictory. In some cases, we point out new directions in accounting. Your
instructor also may mention certain weaknesses in current theory or practice.
Generally Accepted Accounting Principles 25
TABLE 1-2
Firm Home Office Some Major Clients
Large International Certified Public
Accounting Firms Deloitte & Touche New York General Motors, Procter &
Gamble
Ernst & Young New York Coca-Cola, McDonald’s
KPMG New York General Electric, Xerox
PricewaterhouseCoopers New York Exxon Mobil, IBM, Ford
GAAP and the Independent CPA’s Report
Because financial statements are prepared by management and could be falsi-
fied for personal gain, all companies that sell shares of their stock to the public
and many companies that apply for sizable loans have their financial statements
audited by an independent certified public accountant (CPA). Independent
means that the CPA is not an employee of the company being audited and has
no financial or other compromising ties with it. CPAs are licensed by all states for
the same reason that lawyers and doctors are—to protect the public by ensuring
the quality of professional service. The firms listed in Table 1-2 employ about 25
percent of all CPAs.
An audit is an examination of a company’s financial statements and the
accounting systems, controls, and records that produced them. The purpose
Study Note of the audit is to ascertain that the financial statements have been prepared in
accordance with generally accepted accounting principles. If the independent
The audit lends credibility to
CPA is satisfied that this standard has been met, his or her report contains the
a set of financial statements.
following language:
The auditor does not attest to
the absolute accuracy of the
In our opinion, the financial statements . . . present fairly, in all material
published information or to
respects . . . in conformity with generally accepted accounting principles . . .
the value of the company as
an investment. All he or she This wording emphasizes that accounting and auditing are not exact sciences.
renders is an opinion, based on Because the framework of GAAP provides room for interpretation and the
appropriate testing, about the application of GAAP necessitates the making of estimates, the auditor can render
fairness of the presentation of only an opinion about whether the financial statements present fairly or conform
the financial information. in all material respects to GAAP. The auditor’s report does not preclude minor or
immaterial errors in the financial statements. However, a favorable report from
FOCUS ON BUSINESS PRACTICE
IFRS: The Arrival of International Financial Reporting Standards in the United States
Over the next few years, international financial and Exchange Commission (SEC) recently voted to
reporting standards (IFRS) will become much more allow foreign registrants in the United States. This
important in the United States and globally. The is a major development because in the past, the
International Accounting Standards Board (IASB) SEC required foreign registrants to explain how the
has been working with the Financial Accounting standards used in their statements differed from |
Standards Board (FASB) and similar boards in other U.S. standards. This change affects approximately 10
nations to achieve identical or nearly identical stan- percent of all public U.S. companies. In addition, the
dards worldwide. IFRS are now required in many SEC may in the near future allow U.S. companies to
parts of the world, including Europe. The Securities- use IFRS.11
26 CHAPTER 1 Uses of Accounting Information and the Financial Statements
the auditor does imply that, on the whole, investors (owners) and creditors can
rely on the financial statements. Historically, auditors have enjoyed a strong repu-
tation for competence and independence. The independent audit has been an
important factor in the worldwide growth of financial markets.
Organizations That Issue Accounting Standards
Two organizations issue accounting standards that are used in the United States:
Study Note
the FASB and the IASB. The Financial Accounting Standards Board (FASB)
The FASB is the primary source is the most important body for developing rules on accounting practice. This
of GAAP, but the IASB is independent body has been designated by the Securities and Exchange Commis-
increasing in importance. sion (SEC) to issue Statements of Financial Accounting Standards.
With the growth of financial markets throughout the world, global coop-
eration in the development of accounting principles has become a priority. The
International Accounting Standards Board (IASB) has approved more than
40 international financial reporting standards (IFRS). Foreign companies
may use these standards in the United States rather than having to convert their
statements to U.S. GAAP as called for by the FASB standards.
Other Organizations That Influence GAAP
Many organizations directly or indirectly influence GAAP and so influence much
of what is in this book.
The Public Company Accounting Oversight Board (PCAOB), a governmen-
Study Note
tal body created by the Sarbanes-Oxley Act, regulates the accounting profession
The PCAOB regulates audits of and has wide powers to determine the standards that auditors must follow and to
public companies registered discipline them if they do not.
with the Securities and
The American Institute of Certified Public Accountants (AICPA), the pro-
Exchange Commission.
fessional association of certified public accountants, influences accounting prac-
tice through the activities of its senior technical committees.*
The Securities and Exchange Commission (SEC) is an agency of the federal
Study Note government that has the legal power to set and enforce accounting practices for
companies whose securities are offered for sale to the general public. As such, it
The AICPA is the primary
has enormous influence on accounting practice.
professional organization of
certified public accountants. The Governmental Accounting Standards Board (GASB), which is under the
same governing body as the FASB, issues accounting standards for state and local
governments.
U.S. tax laws that govern the assessment and collection of revenue for operat-
ing the federal government also influence accounting practice. Because a major
source of the government’s revenue is the income tax, the tax laws specify the rules
for determining taxable income. The Internal Revenue Service (IRS) interprets
and enforces these rules. In some cases, the rules conflict with good a ccounting
*In May 2005, the AICPA passed a resolution to start working with the FASB to develop
GAAP for privately held, for-profit companies, which would result in recognition, measure-
ment, and disclosure differences, where appropriate, from current GAAP for public compa-
nies. If and when this resolution is acted upon, two sets of GAAP will exist: one for private
companies and one for public companies.
Generally Accepted Accounting Principles 27
practice, but they are nonetheless an important influence on practice. Cases in
which the tax laws affect accounting practice are noted throughout this book.
Professional Conduct
The code of professional ethics of the American Institute of Certified Public |
Accountants (and adopted, with variations, by each state) governs the conduct
of CPAs. Fundamental to this code is responsibility to clients, creditors, investors
(owners), and anyone else who relies on the work of a CPA. The code requires
CPAs to act with integrity, objectivity, and independence.
(cid:2) Integrity means the accountant is honest and candid and subordinates per-
sonal gain to service and the public trust.
(cid:2) Objectivity means the accountant is impartial and intellectually honest.
(cid:2) Independence means the accountant avoids all relationships that impair or
even appear to impair his or her objectivity.
The accountant must also exercise due care in all activities, carrying out pro-
fessional responsibilities with competence and diligence. For example, an accoun-
tant must not accept a job for which he or she is not qualified, even at the risk
of losing a client to another firm, and careless work is unacceptable. These broad
principles are supported by more specific rules that public accountants must fol-
low; for instance, with certain exceptions, client information must be kept strictly
confidential. Accountants who violate the rules can be disciplined or even sus-
pended from practice.
The Institute of Management Accountants (IMA) also has a code of profes-
Study Note
sional conduct. It emphasizes that management accountants have a responsibility
The IMA is the primary to be competent in their jobs, to keep information confidential except when autho-
professional association of rized or legally required to disclose it, to maintain integrity and avoid conflicts of
management accountants. interest, and to communicate information objectively and without bias.12
Corporate Governance
The financial scandals at Enron, WorldCom, and other companies highlighted the
importance of corporate governance, which is the oversight of a corporation’s
management and ethics by its board of directors. Corporate governance is grow-
ing and is clearly in the best interests of a business. A survey of 124 corporations
in 22 countries found that 78 percent of boards of directors had established ethi-
cal standards, a fourfold increase over a 10-year period. In addition, research has
shown that, over time, companies with codes of ethics tend to have higher stock
prices than those that have not adopted such codes.13
To strengthen corporate governance, a provision of the Sarbanes-Oxley Act
requires boards of directors to establish an audit committee made up of indepen-
dent directors who have financial expertise. This provision is aimed at ensuring
that boards of directors are objective in evaluating management’s performance.
The audit committee is also responsible for engaging the corporation’s indepen-
dent auditors and reviewing their work. Another of the committee’s functions is
to ensure that adequate systems exist to safeguard the corporation’s resources and
that accounting records are reliable. In short, the audit committee is the front
line of defense against fraudulent financial reporting.
28 CHAPTER 1 Uses of Accounting Information and the Financial Statements
STOP
& APPLY
Match the common acronym with its description:
_____ 1. GAAP a. Sets U.S. accounting standards
_____ 2. IFRS b. Audits financial statements
_____ 3. CPA c. Established by the Sarbanes-Oxley Act
_____ 4. FASB d. Sets international accounting standards
_____ 5. IASB e. Established by the FASB
_____ 6. PCAOB f. Established by the IASB
_____ 7. AICPA g. Influences accounting standards through
_____ 8. SEC member CPAs
h. Receives audited financial statements of public
companies
SOLUTION
1. c; 2. f; 3. b; 4. a; 5. d; 6. c; 7. g; 8. h
(cid:2) KEEP-FIT CENTER: REVIEW PROBLEM
The Decision Point at the beginning of this chapter focused on Keep-Fit Center, an
apparently successful new company. Although the firm generated commissions from
sales of property, the owner, Lilian Jackson, had these questions:
• Is Keep-Fit Center meeting its goal of profitability?
• As owner of Keep-Fit Center, what financial knowledge does Lilian Jackson need |
to measure progress toward the company’s goals?
• In deciding whether to make a loan to Keep-Fit Center, what financial knowledge
would a bank need to evaluate the company’s financial performance?
As you’ve learned in this chapter, managers and others with an interest in a business
measure its profitability in financial terms such as net sales, net income, total assets, and
owner’s equity and liquidity in terms such as cash flows. Owners and managers report on
the progress they have made toward their financial goals in their company’s financial
statements.
Preparation and
Interpretation of
Financial Statements
LO6
Keep-Fit Center: Review Problem 29
The following financial statement accounts and amounts are from the records of Keep-Fit
Center for the year ended December 31, 2010, the company’s first year of operations:
Accounts payable $ 19,000
Accounts receivable 104,000
Cash 111,000
Equipment 47,000
Fees revenue 375,000
Investment by L. Jackson 100,000
Marketing expense 18,000
Salaries 172,000
Salaries payable 78,000
Studio and equipment rent expense 91,000
Supplies 2,000
Supplies expense 6,000
Utilities expense 11,000
Withdrawals 10,000
Required
1. Prepare an income statement, statement of owner’s equity, and balance sheet
for Keep-Fit Center. For examples, refer to Exhibit 1-5.
2. User insight: From the income statement and balance sheet, does it appear that
Keep-Fit Center is profitable? Why or why not?
Answers to 1. Preparation of financial statements
Review Problem
30 CHAPTER 1 Uses of Accounting Information and the Financial Statements
2. Keep-Fit Center is profitable. The income statement shows that it earned
$77,000 after expenses were deducted from fees revenue. Further, it may be
observed that this $77,000 of net income is very good when compared to total
assets of $264,000 and owner’s equity on the balance sheet.
Stop & Review 31
STOP
& REVIEW
LO1 Defi ne accounting and Accounting is an information system that measures, processes, and communicates
describe its role in financial information about an economic entity. It provides the information nec-
making informed deci- essary to make reasoned choices among alternative uses of scarce resources in the
sions, identify business conduct of business and economic activities. A business is an economic entity that
engages in operating, investing, and financing activities to achieve the goals of
goals and activities, and
profitability and liquidity.
explain the importance
Management accounting focuses on the preparation of information primarily
of ethics in accounting.
for internal use by management. Financial accounting is concerned with the devel-
opment and use of reports that are communicated to those outside the business as
well as to management. Ethical financial reporting is important to the well-being
of a company; fraudulent financial reports can have serious consequences for many
people.
LO2 Identify the users of Accounting plays a significant role in society by providing information to man-
accounting information. agers of all institutions and to individuals with a direct financial interest in those
institutions, including present or potential investors (owners) and creditors.
Accounting information is also important to those with an indirect financial
interest in the business—for example, tax authorities, regulatory agencies, and
economic planners.
LO3 Explain the importance To make an accounting measurement, the accountant must determine what is
of business transactions, measured, when the measurement should be made, what value should be placed on
money measure, and what is measured, and how to classify what is measured. The objects of accounting
separate entity. measurement are business transactions. Financial accounting uses money measure
to gauge the impact of these transactions on a separate business entity.
LO4 Identify the three basic The three basic forms of business organization are the sole proprietorship, the part-
forms of business nership, and the corporation. Accountants recognize each form as an economic
organization. unit separate from its owners, although legally only the corporation is separate from |
its owners. A sole proprietorship is a business owned by one person. A partnership
is like a sole proprietorship in most ways, but it has two or more owners. A corpora-
tion, on the other hand, is a business unit chartered by the state and legally separate
from its owners (the stockholders).
LO5 Defi ne fi nancial position, Financial position refers to a company’s economic resources and the claims against
and state the accounting those resources at a particular time. The accounting equation shows financial
equation. position as Assets (cid:2) Liabilities (cid:3) Owner’s Equity. Business transactions affect
financial position by decreasing or increasing assets, liabilities, and owner’s equity
in such a way that the accounting equation is always in balance.
LO6 Identify the four basic The four basic financial statements are the income statement, the statement of
fi nancial statements. owner’s equity, the balance sheet, and the statement of cash flows. They are the
primary means by which accountants communicate the financial condition and
activities of a business to those who have an interest in the business.
32 CHAPTER 1 Uses of Accounting Information and the Financial Statements
LO7 Explain how generally Acceptable accounting practice consists of the conventions, rules, and procedures
accepted accounting that make up generally accepted accounting principles at a particular time. GAAP
principles (GAAP) and are essential to the preparation and interpretation of financial statements and the
international fi nancial independent CPA’s report. Foreign companies registered in the United States
may use international financial reporting standards (IFRS).
reporting standards
Among the organizations that influence the formulation of GAAP are
(IFRS) relate to fi nancial
the Public Company Accounting Oversight Board, the Financial Accounting
statements and the inde-
Standards Board, the American Institute of Certified Public Accountants, the
pendent CPA’s report,
Securities and Exchange Commission, and the Internal Revenue Service.
and identify the orga-
All accountants are required to follow a code of professional ethics, the founda-
nizations that infl uence
tion of which is responsibility to the public. Accountants must act with integrity,
GAAP.
objectivity, and independence, and they must exercise due care in all their activities.
The board of directors is responsible for determining corporate policies and
appointing corporate officers. It is also responsible for corporate governance, the
oversight of a corporation’s management and ethics. The audit committee, which
is appointed by the board and made up of independent directors, is an important
factor in corporate governance.
REVIEW of Concepts and Terminology
The following concepts and terms Financial analysis 6 (LO1) Management 10 (LO2)
were introduced in this chapter: Financial position 17 (LO5) Management accounting 7 (LO1)
Accounting 4 (LO1) Financial statements 7 (LO1) Management information system
Accounting equation 17 (LO5) Financing activities 6 (LO1) (MIS) 8 (LO1)
American Institute of Certified Fraudulent financial reporting Money measure 14 (LO3)
Public Accountants (AICPA) 8 (LO1) Net assets 18 (LO5)
26 (LO7)
Generally accepted accounting Net income 18 (LO5)
Assets 18 (LO5) principles (GAAP) 24 (LO7) Net loss 18 (LO5)
Audit 25 (LO7) Governmental Accounting Objectivity 27 (LO1)
Audit committee 27 (LO7) Standards Board (GASB)
Operating activities 5 (LO1)
Balance sheet 20 (LO6) 26 (LO7)
Owner’s equity 18 (LO5)
Bookkeeping 7 (LO1) Income statement 19 (LO6)
Partnership 15 (LO4)
Business 4 (LO1) Independence 27 (LO7)
Performance measures 6 (LO1)
Business transactions 14 (LO3) Institute of Management
Accountants (IMA) 27 (LO7) Profitability 5 (LO1)
Cash flows 21 (LO6)
Public Company Accounting
Integrity 27 (LO7)
Certified public accountant (CPA) Oversight Board (PCAOB)
25 (LO7) Internal Revenue Service (IRS) 26 (LO7)
26 (LO7)
Corporate governance 27 (LO7) Revenues 18 (LO5)
International Accounting Standards
Corporation 16 (LO4) Board (IASB) 26 (LO7) Sarbanes-Oxley Act 9 (LO1) |
Due care 27 (LO7) Securities and Exchange Commis-
International financial reporting
Ethics 8 (LO1) standards (IFRS) sion (SEC) 12, 26 (LO2 and LO7)
Exchange rate 14 (LO3) 26 (LO7) Separate entity 15 (LO3)
Expenses 18 (LO5) Investing activities 5 (LO1) Sole proprietorship 15 (LO4)
Financial accounting 7 (LO1) Liabilities 18 (LO5) Statement of cash flows 21 (LO6)
Financial Accounting Standards Liquidity 5 (LO1) Statement of owner’s equity
Board (FASB) 26 (LO7) 20 (LO6)
Chapter Assignments 33
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
Short exercises are simple applications of chapter material for one or more learn-
ing objectives. If you need help locating the related text discussions, refer to the
LO numbers in the margin.
LO1 Accounting and Business Enterprises
SE 1. Match the terms on the left with the definitions on the right:
_____ 1. Accounting a. The process of producing account-
_____ 2. Profitability ing information for the internal
use of a company’s management.
_____ 3. Liquidity
b. Having enough cash available to
_____ 4. Financing activities
pay debts when they are due.
_____ 5. Investing activities c. Activities management engages in to
_____ 6. Operating activities obtain adequate funds for beginning
and continuing to operate a business.
_____ 7. Financial accounting
d. The process of generating and
_____ 8. Management accounting
communicating accounting infor-
_____ 9. Ethics mation in the form of financial
_____ 10. F raudulent financial statements to decision makers
reporting outside the organization.
e. Activities management engages in
to spend capital in ways that are
productive and will help a business
achieve its objectives.
f. The ability to earn enough income
to attract and hold investment
capital.
g. An information system that mea-
sures, processes, and communi-
cates financial information about
an identifiable economic entity.
h. The intentional preparation of mis-
leading financial statements.
i. Activities management engages in
to operate the business.
j. A code of conduct that addresses
whether actions are right or
wrong.
LO3 LO4 Accounting Concepts
SE 2. Indicate whether each of the following words or phrases relates most closely
to (a) a business transaction, (b) a separate entity, or (c) a money measure:
1. Partnership 4. Sole proprietorship
2. U.S. dollar 5. Sale of an asset
3. Payment of an expense
34 CHAPTER 1 Uses of Accounting Information and the Financial Statements
LO4 Forms of Business Organization
SE 3. Match the descriptions on the left with the forms of business organization
on the right:
_____ 1. Most numerous a. Sole proprietorship
b. Partnership
_____ 2. Commands most revenues
c. Corporation
_____ 3. Has two or more co-owners
_____ 4. Has stockholders
_____ 5. Is owned by only one person
_____ 6. Has a board of directors
LO5 The Accounting Equation
SE 4. Determine the amount missing from each accounting equation below.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
1. ? $50,000 $ 70,000
2. $156,000 $84,000 ?
3. $292,000 ? $192,000
LO5 The Accounting Equation
SE 5. Use the accounting equation to answer each question below.
1. The assets of Aaron Company are $240,000, and the liabilities are $90,000.
What is the amount of the owner’s equity?
2. The liabilities of Oak Company equal one-fifth of the total assets. The own-
er’s equity is $40,000. What is the amount of the liabilities?
LO5 The Accounting Equation
SE 6. U se the accounting equation to answer each question below.
1. At the beginning of the year, Fazio Company’s assets were $45,000, and its own-
er’s equity was $25,000. During the year, assets increased by $30,000 and liabili-
ties increased by $5,000. What was the owner’s equity at the end of the year?
2. At the beginning of the year, Gal Company had liabilities of $50,000 and
owner’s equity of $96,000. If assets increased by $40,000 and liabilities
decreased by $30,000, what was the owner’s equity at the end of the year?
LO5 The Accounting Equation and Net Income
SE 7. Carlton Company had assets of $280,000 and liabilities of $120,000 at the |
beginning of the year, and assets of $400,000 and liabilities of $140,000 at the
end of the year. During the year, the owner invested an additional $40,000 in
the business, and the company made withdrawals of $48,000. What amount of
net income did the company earn during the year?
LO6 Preparation and Completion of a Balance Sheet
SE 8. Use the following accounts and balances to prepare a balance sheet with the
accounts in proper order for Global Company at June 30, 2010, using Exhibit 1-3
as a model:
Accounts Receivable $ 1,600
Wages Payable 700
Owner’s Capital 28,700
Building 22,000
Cash ?
Chapter Assignments 35
LO6 Preparation of Financial Statements
SE 9. Tarech Company engaged in activities during the first year of its operations
that resulted in the following: service revenue, $4,800; expenses, $2,450; and
withdrawals, $410. In addition, the year-end balances of selected accounts were
as follows: Cash, $1,890; Other Assets, $1,000; Accounts Payable, $450; and
Owner’s Capital, $500. In proper format, prepare the income statement, state-
ment of retained earnings, and balance sheet for Tarech Company (assume the
year ends on December 31, 2010). (Hint: You must solve for the beginning and
ending balances of Owner’s Equity for 2010.)
Exercises
Exercises are more complex applications of chapter concepts than short exercises.
LO1 LO2 Discussion Questions
LO3 LO4
E 1. Develop a brief answer to each of the following questions:
1. What makes accounting a valuable discipline?
2. Why do managers in governmental and not-for-profit organizations need
to understand financial information as much as managers in profit-seeking
businesses do?
3. Are all economic events business transactions?
4. Sole proprietorships, partnerships, and corporations differ legally; how and
why does accounting treat them alike?
LO1 LO5 Discussion Questions
LO6 LO7
E 2. Develop a brief answer to each of the following questions:
1. How are expenses and withdrawals similar, and how are they different?
2. In what ways are CVS and Southwest Airlines comparable? Not comparable?
3. How do generally accepted accounting principles (GAAP) differ from the
laws of science?
4. What are some unethical ways in which a business may do its accounting or
prepare its financial statements?
LO1 LO2 The Nature of Accounting
LO3 LO7
E 3. Match the terms on the left with the descriptions on the right:
_____ 1. Bookkeeping a. The recording of all business trans-
actions in terms of money
_____ 2. Creditors
b. A process by which information
_____ 3. Money measure
is exchanged between individuals
_____ 4. F inancial Accounting
through a common system of
Standards Board (FASB)
symbols, signs, or behavior
_____ 5. Business transactions c. The process of identifying and assign-
_____ 6. Financial statements ing values to business transactions
d. Legislation ordering CEOs and
_____ 7. Communication
CFOs to swear that any reports
_____ 8. S ecurities and Exchange
they file with the SEC are accurate
Commission (SEC)
and complete
_____ 9. Investors e. Shows how well a company is
_____ 10. Sarbanes-Oxley Act meeting the goals of profitability
and liquidity
_____ 11. Management
f. Collectively, the people who have
_____ 12. M anagement information
overall responsibility for operating
system
a business and meeting its goals
36 CHAPTER 1 Uses of Accounting Information and the Financial Statements
g. People who commit money to earn
a financial return
h. The interconnected subsystems
that provide the information
needed to run a business
i. The most important body for
developing and issuing rules on
accounting practice, called Statements
of Financial Accounting Standards
j. An agency set up by Congress to
protect the public by regulating the
issuing, buying, and selling of stocks
k. Economic events that affect a busi-
ness’s financial position
l. People to whom money is due
LO2 LO4 Users of Accounting Information and Forms of Business Organization
E 4. Gottlieb Pharmacy has recently been formed to develop a new type of drug
treatment for cancer. Previously a partnership, Gottlieb has now become a cor- |
poration. Describe the various groups that will have an interest in the financial
statements of Gottlieb. What is the difference between a partnership and a corpo-
ration? What advantages does the corporate form have over the partnership form
of business organization?
LO3 Business Transactions
E 5. Velu owns and operates a minimart. Which of Velu’s actions described below
are business transactions? Explain why any other actions are not considered trans-
actions.
1. Velu reduces the price of a gallon of milk in order to match the price offered
by a competitor.
2. Velu pays a high school student cash for cleaning up the driveway behind the
market.
3. Velu fills his son’s car with gasoline in payment for his son’s restocking the
vending machines and the snack food shelves.
4. Velu pays interest to himself on a loan he made to the business three years ago.
LO3 LO4 Accounting Concepts
E 6. Financial accounting uses money measures to gauge the impact of business
transactions on a separate business entity. Indicate whether each of the following
words or phrases relates most closely to (a) a business transaction, (b) a separate
entity, or (c) a money measure:
1. Corporation 5. Sole proprietorship 9. Japanese yen
2. Euro 6. U.S. dollar 10. Purchase of supplies
3. Sales of products 7. Partnership
4. Receipt of cash 8. Owner’s investments
LO3 Money Measure
E 7. You have been asked to compare the sales and assets of four companies that
make computer chips to determine which company is the largest in each category.
You have gathered the following data, but they cannot be used for direct com-
parison because each company’s sales and assets are in its own currency:
Chapter Assignments 37
Company (Currency) Sales Assets
U.S. Chip (U.S. dollar) 2,750,000 1,300,000
Nanhai (Hong Kong dollar) 5,000,000 2,800,000
Tova (Japanese yen) 350,000,000 290,000,000
Holstein (Euro) 3,500,000 3,900,000
Assuming that the exchange rates in Table 1-1 are current and appropriate, con-
vert all the figures to U.S. dollars and determine which company is the largest in
sales and which is the largest in assets.
LO5 The Accounting Equation
E 8. Use the accounting equation to answer each question that follows. Show any
calculations you make.
1. The assets of Rasche Company are $380,000, and the owner’s equity is
$155,000. What is the amount of the liabilities?
2. The liabilities and owner’s equity of Lee Company are $65,000 and $79,500,
respectively. What is the amount of the assets?
3. The liabilities of Hurka Company equal one-third of the total assets, and
owner’s equity is $180,000. What is the amount of the liabilities?
4. At the beginning of the year, Jahis Company’s assets were $310,000, and its
owner’s equity was $150,000. During the year, assets increased $45,000 and
liabilities decreased $22,500. What is the owner’s equity at the end of the year?
LO5 LO6 Identification of Accounts
E 9.
1. Indicate whether each of the following accounts is an asset (A), a liability (L),
or a part of owner’s equity (OE):
a. Cash d. Owner’s Capital g. Supplies
b. Salaries Payable e. Land
c. Accounts Receivable f. Accounts Payable
2. Indicate whether each account below would be shown on the income state-
ment (IS), the statement of owner’s equity (OE), or the balance sheet (BS).
a. Repair Revenue d. Cash g. Withdrawals
b. Automobile e. Rent Expense
c. Fuel Expense f. Accounts Payable
LO6 Preparation of a Balance Sheet
E 10. Listed in random order are some of the account balances for the Uptime
Services Company as of December 31, 2011.
Accounts Payable $ 25,000 Accounts Receivable $31,250
Building 56,250 Cash 12,500
Owner’s Capital 106,250 Equipment 25,000
Supplies 6,250
Place the balances in proper order and prepare a balance sheet similar to the one
in Exhibit 1-3.
LO6 Preparation and Integration of Financial Statements
E 11. Proviso Company had the following accounts and balances during
2010: S ervice Revenue, $26,400; Rent Expense, $2,400; Wages Expense,
$16,680; Advertising Expense, $2,700; Utilities Expense, $1,800; and With-
drawals, $1,400. In addition, the year-end balances of selected accounts were |
38 CHAPTER 1 Uses of Accounting Information and the Financial Statements
as follows: Cash, $3,100; Accounts Receivable, $1,500; Supplies, $200; Land,
$2,000; Accounts Payable, $900; Investment by Owner, $2,480; and begin-
ning capital balance of $2,000.
In proper format, prepare the income statement, statement of owner’s equity,
and balance sheet for Proviso Company (assume the year ends on December 31,
2010). (Hint: You must solve for the beginning and ending balances of owner’s
equity for 2010.)
LO5 Owner’s Equity and the Accounting Equation
E 12. The total assets and liabilities at the beginning and end of the year for Schu-
pan Company are listed below.
Assets Liabilities
Beginning of the year $180,000 $ 68,750
End of the year 275,000 150,500
Determine Schupan Company’s net income or loss for the year under each of the
following alternatives:
1. The owner made no investments in or withdrawals from the business during
the year.
2. The owner made no investments in the business but withdrew $27,500
during the year.
3. The owner invested $16,250 in the business but made no withdrawals
during the year.
4. The owner invested $12,500 in the business and withdrew of $29,000
during the year.
LO6 Statement of Cash Flows
E 13. Martin Service Company began the year 2010 with cash of $55,900. In
addition to earning a net income of $38,000 and making cash withdrawals of
$19,500, Martin Service borrowed $78,000 from the bank and purchased equip-
ment with $125,000 of cash. Also, Accounts Receivable increased by $7,800, and
Accounts Payable increased by $11,700.
Determine the amount of cash on hand at December 31, 2010, by preparing a
statement of cash flows similar to the one in Exhibit 1–4.
LO4 LO5 Statement of Owner’s Equity
LO6
E 14. Below is information from the statement of owner’s equity of Mrs. Kitty’s
Cookies for a recent year.
Withdrawals 0
Net income ?
Owner’s Equity, January 31, 2010 $159,490
Owner’s Equity, January 31, 2009 $105,000
Prepare the statement of owner’s equity for Mrs. Kitty’s Cookies in good form.
You will need to solve for the amount of net income. What is owner’s equity? Why
might the owner decide not to make any withdrawals from the company?
LO7 Accounting Abbreviations
E 15. Identify the accounting meaning of each of the following abbreviations:
AICPA, SEC, PCAOB, GAAP, FASB, IRS, GASB, IASB, IMA, and CPA.
Chapter Assignments 39
Problems
LO6 Preparation and Interpretation of Financial Statements
P 1. B elow is a list of financial statement items.
____ Utilities expense ____ Equipment ____ Withdrawals
____ Building ____ Revenues ____ Fees earned
____ Owner’s capital ____ Accounts receivable ____ Cash
____ Net income ____ Accounts payable ____ Supplies
____ Land ____ Rent expense ____ Wages expense
Required
1. Indicate whether each item is found on the income statement (IS), statement
of owner’s equity (OE), and/or balance sheet (BS).
User insight (cid:2) 2. Which statement is most closely associated with the goal of profitability?
LO6 Integration of Financial Statements
P 2. The following three independent sets of financial statements have several
amounts missing:
Income Statement Set A Set B Set C
Revenues $5,320 $ 8,600 $ m
Expenses a g 2,010
Net income $ 510 $ h $ n
Statement of Owner’s Equity
Beginning balance $1,780 $15,400 $ 200
Net income b i 450
Less withdrawals c 1,000 o
Ending balance $ d $16,000 $ p
Balance Sheet
Total assets $ e $ j $1,900
Liabilities $ f $ 2,000 $1,300
Owner’s equity
Owner’s capital 2,100 k q
Total liabilities and owner’s equity $2,700 $ l $ r
Required
1. Complete each set of financial statements by determining the amounts that
correspond to the letters.
User insight (cid:2) 2. Why is it necessary to prepare the income statement prior to the balance sheet?
Curious if you got the right answer? Look at the Check Figures section that pre-
cedes Chapter 1.
LO1 LO6 Preparation and Interpretation of Financial Statements
P 3. Below are the financial accounts of Special Assets. The company has just
completed its 10th year of operations ended December 31, 2011.
Accounts Payable $ 3,600 |
Accounts Receivable 4,500
Cash 71,700
Commission Sales Revenue 400,000
Commissions Expense 225,000
Commissions Payable 22,700
40 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Equipment $59,900
Marketing Expense 20,100
Office Rent Expense 36,000
Owner’s Capital, December 31, 2010 64,300
Supplies 700
Supplies Expense 2,600
Telephone and Computer Expenses 5,100
Wages Expense 32,000
Withdrawals 33,000
Required
1. Prepare the income statement, statement of owner’s equity, and balance sheet
for Special Assets. There were no investments by the owner during the year.
User insight (cid:2) 2. The owner is considering expansion. What other statement would be useful to
the owner in assessing whether the company’s operations are generating suffi-
cient funds to support the expenses? Why would it be useful?
LO4 LO6 Preparation and Interpretation of Financial Statements
P 4. The following are the accounts of Unique Ad, an agency that develops mar-
keting materials for print, radio, and television. The agency’s first year of opera-
tions just ended on January 31, 2010.
Accounts Payable $ 19,400
Accounts Receivable 24,900
Advertising Service Revenue 165,200
Cash 1,800
Equipment Rental Expense 37,200
Marketing Expense 6,800
Office Rent Expense 13,500
Owner’s Capital 5,000*
Salaries Expense 86,000
Salaries Payable 1,300
Supplies 1,600
Supplies Expense 19,100
Withdrawals 0
*Represents the initial investment by the owner.
Required
1. Prepare the income statement, statement of owner’s equity, and balance sheet
for Unique Ad.
User insight (cid:2) 2. Review the financial statements and comment on the financial challenges
Unique Ad faces.
LO1 LO6 Use and Interpretation of Financial Statements
LO7
P 5. The financial statements for the Oros Riding Club follow.
Chapter Assignments 41
Oros Riding Club
Income Statement
For the Month Ended November 30, 2011
Revenues
Riding lesson revenue $4,650
Locker rental revenue 1,450
Total revenues $6,100
Expenses
Salaries expense $1,125
Feed expense 750
Utilities expense 450
Total expenses 2,325
Net income $3,775
Oros Riding Club
Statement of Owner’s Equity
For the Month Ended November 30, 2011
Owner’s capital, October 31, 2011 $35,475
Investment by owner 6,000
Net income for the month 3,775
Subtotal $45,250
Less withdrawals 2,400
Owner’s capital, November 30, 2011 $42,850
Oros Riding Club
Balance Sheet
November 30, 2011
Assets Liabilities
Cash $ 6,700 Accounts payable $11,250
Accounts receivable 900
Owner’s Equity
Supplies 750 Owner’s capital 42,850
Land 15,750
Building 22,500
Horses 7,500 Total liabilities and
Total assets $54,100 owner’s equity $54,100
42 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Oros Riding Club
Statement of Cash Flows
For the Month Ended November 30, 2011
Cash flows from operating activities
Net income $3,775
Adjustments to reconcile net income to
net cash flows from operating activities
Increase in accounts receivable $ (400)
Increase in supplies (550)
Increase in accounts payable 400 (550)
Net cash flows from operating activities $3,225
Cash flows from investing activities
Purchase of horses $2,000
Sale of horses (1,000)
Net cash flows from financing activities 1,000
Cash flows from financing activities
Investment by Owner $6,000
Cash withdrawals (2,400)
Net cash flows from financing activities 3,600
Net increase in cash $7,825
Cash at beginning of month 475
Cash at end of month $8,300
Required
User insight (cid:2) 1. Explain how the four statements for Oros Riding Club relate to each other.
User insight (cid:2) 2. Which statements are most closely associated with the goals of liquidity and
profitability? Why?
User insight (cid:2) 3. If you were the owner of this business, how would you evaluate the com-
pany’s performance? Give specific examples.
User insight (cid:2) 4. If you were a banker considering Oros Riding Club for a loan, why might
you want the company to be audited by an independent CPA? What would
the audit tell you?
Looking for more practice? Alternate problems have the same format and learn-
ing objectives as problems that appear earlier.
Alternate Problems |
LO6 Integration of Financial Statements
P 6. Below are three independent sets of financial statements with several amounts
missing.
Chapter Assignments 43
Income Statement Set A Set B Set C
Revenues $ 1,200 $ g $ 240
Expenses a 5,000 m
Net income $ b $ h $ 148
Statement of Owner’s Equity
Beginning balance $ 2,900 $24,400 $ 340
Net income c 1,600 n
Less withdrawals 200 i o
Ending balance $ 3,090 $ j $ p
Balance Sheet
Total assets $ d $30,000 $ q
Liabilities $1,600 $ 5,000 $ r
Owner’s equity
Owner’s capital e k 380
Total liabilities and owner’s equity $ f $ l $ 580
Required
1. Complete each set of financial statements by determining the amounts that
correspond to the letters.
User insight (cid:2) 2. In what order is it necessary to prepare the financial statements and why?
LO1 LO6 Preparation and Interpretation of Financial Statements
P 7. Below are the financial accounts of Metro Labs. The company has just com-
pleted its third year of operations ended November 30, 2011.
Accounts Payable $ 7,400
Accounts Receivable 51,900
Cash 115,750
Design Service Revenue 300,000
Marketing Expense 19,700
Office Rent Expense 50,000
Owner’s Capital, November 30, 2010 70,400
Salaries Expense 96,000
Salaries Payable 2,700
Supplies 800
Supplies Expense 6,350
Withdrawals 40,000
Required
1. Prepare the income statement, statement of owner’s equity, and balance sheet
for Metro Labs. There were no investments by the owner during the year.
User insight (cid:2) 2. Evaluate the company’s ability to meet its bills when they come due.
LO4 LO6 Preparation and Interpretation of Financial Statements
P 8. Below are the accounts of Giordano’s Pizza. The company has just com-
pleted its first year of operations ended September 30, 2010.
Accounts Payable $10,500
Accounts Receivable 13,200
Cash 2,600
Delivery Truck Rent Expense 7,200
44 CHAPTER 1 Uses of Accounting Information and the Financial Statements
Equipment $ 6,300
Equipment Rental Expense 2,900
Marketing Expense 1,500
Owner’s Capital 2,000*
Pizza Revenue 82,000
Salaries Expense 56,000
Salaries Payable 700
Supplies 400
Supplies Expense 4,100
Withdrawals 1,000
*Represents the initial investment by the owner
Required
1. Prepare the income statement, statement of owner’s equity, and balance
sheet for Giordano’s Pizza.
User insight (cid:2) 2. Why would the owner of Giordano’s Pizza set his business up as a sole pro-
prietorship and not a partnership? Discuss the advantages of the two forms of
business organizations.
LO6 Integration of Financial Statements
P 9. Below are three independent sets of financial statements with several amounts
missing.
Income Statement Set X Set Y Set Z
Revenues $1,100 $ g $240
Expenses a 5,200 m
Net income $ b $ h $ 80
Statement of Owner’s Equity
Beginning balance $2,900 $24,400 $240
Net income c 1,600 n
Less withdrawals 200 i o
Ending balance $3,000 $ j $ p
Balance Sheetz
Total assets $ d $31,000 $ q
Liabilities $1,600 $ 5,000 $ r
Owner’s equity
Owner’s capital e k 280
Total liabilities and owner’s equity $ f $ l $580
Required
1. Complete each set of financial statements by determining the amounts that
correspond to the letters.
User insight (cid:2) 2. In what order is it necessary to prepare the financial statements and why?
LO6 Preparation and Interpretation of Financial Statements
P 10. Below are the financial accounts of Brad Realty. The company has just com-
pleted its 10th year of operations ended December 31, 2011.
Accounts Payable $ 3,600
Accounts Receivable 4,500
Cash 91,600
Commission Sales Revenue 450,000
Commissions Expense 225,000
Commissions Payable 22,700
Chapter Assignments 45
Equipment $59,000
Marketing Expense 29,200
Office Rent Expense 36,000
Owner’s Capital, December 31, 2010 50,300
Supplies 700
Supplies Expense 2,600
Telephone and Computer Expenses 5,100
Wages Expense 32,000
Withdrawals 40,000
Required
1. Prepare the income statement, statement of owner’s equity, and balance sheet
for Brad Realty. There were no investments by the owner during the year.
User insight (cid:2) 2. The owner is considering expansion. What other statement would be useful to
the owner in assessing whether the company’s operations are generating suffi- |
cient funds to support expenses? Why would it be useful?
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 LO2 Business Activities and Management Functions
C 1. Costco Wholesale Corporation is America’s largest membership retail company.
According to its letter to stockholders:
Our mission is to bring quality goods and services to our members at
the lowest possible price in every market where we do business. . . .
A hallmark of Costco warehouses has been the extraordinary sales
volume we achieve.14
To achieve its business goals, Costco must organize its management by functions
that relate to the principal activities of a business. Discuss the three basic activities
Costco will engage in to achieve its goals, and suggest some examples of each.
What is the role of Costco’s management? What functions must its management
perform to carry out these activities?
LO5 Concept of an Asset
C 2. Southwest Airlines Co. is one of the most successful airlines in the United
States. Its annual report contains this statement: “We are a company of People,
not Planes. That is what distinguishes us from other airlines and other com-
panies. At Southwest Airlines, People are our most important asset.”15 Are
employees considered assets in the financial statements? Why or why not? Dis-
cuss in what sense Southwest considers its employees to be assets.
LO7 Generally Accepted Accounting Principles
C 3. Fidelity Investments Company is a well-known mutual fund investment
company. It makes investments worth billions of dollars in companies listed
on the New York Stock Exchange and other stock markets. Generally accepted
accounting principles (GAAP) are very important for Fidelity’s investment ana-
lysts. What are generally accepted accounting principles? Why are financial state-
ments that have been prepared in accordance with GAAP and audited by an
independent CPA useful for Fidelity’s investment analysts? What organizations
influence GAAP? Explain how they do so.
46 CHAPTER 1 Uses of Accounting Information and the Financial Statements
LO7 Professional Ethics
C 4. Discuss the ethical choices in the situations below. In each instance, describe
the ethical dilemma, determine the alternative courses of action, and tell what
you would do.
1. You are the payroll accountant for a small business. A friend asks you how
much another employee is paid per hour.
2. As an accountant for the branch office of a wholesale supplier, you discover
that several of the receipts the branch manager has submitted for reimburse-
ment as selling expenses actually stem from nights out with his spouse.
3. You are an accountant in the purchasing department of a construction com-
pany. When you arrive home from work on December 22, you find a large
ham in a box marked “Happy Holidays—It’s a pleasure to work with you.”
The gift is from a supplier who has bid on a contract your employer plans to
award next week.
4. As an auditor with one year’s experience at a local CPA firm, you are expected
to complete a certain part of an audit in 20 hours. Because of your lack of
experience, you know you cannot finish the job within that time. Rather
than admit this, you are thinking about working late to finish the job and
not telling anyone.
5. You are a tax accountant at a local CPA firm. You help your neighbor fill out
her tax return, and she pays you $200 in cash. Because there is no record of
this transaction, you are considering not reporting it on your tax return.
6. The accounting firm for which you work as a CPA has just won a new client,
a firm in which you own 200 shares of stock that you received as an inheri-
tance from your grandmother. Because it is only a small number of shares
and you think the company will be very successful, you are considering not
disclosing the investment.
LO6 LO7 Analysis of Four Basic Financial Statements
C 5. Refer to the CVS annual report in the Supplement to Chapter 5 to answer
the questions below. Keep in mind that every company, while following basic
principles, adapts financial statements and terminology to its own special needs. |
Therefore, the complexity of CVS’s financial statements and the terminology in
them will differ somewhat from the financial statements in the text.
1. What titles does CVS give to its four basic financial statements? (Note that
the word consolidated in the titles of the financial statements means that these
statements combine those of several companies owned by CVS.)
2. Prove that the accounting equation works for CVS on December 31, 2008,
by finding the amounts for the following equation: Assets (cid:2) Liabilities (cid:3)
Shareholders’ (Owner’s) Equity.
3. What were the total revenues of CVS for the year ended December 31,
2008?
4. Was CVS profitable in the year ended December 31, 2008? How much was
net income (loss) in that year, and did it increase or decrease from the year
ended December 29, 2007?
5. Did the company’s cash and cash equivalents increase from December 29,
2007, to December 31, 2008? If so, by how much? In what two places in the
statements can this number be found or computed?
6. Did cash flows from operating activities, cash flows from investing activities, and
cash flows from financing activities increase or decrease from 2007 to 2008?
7. Who is the auditor for the company? Why is the auditor’s report that accom-
panies the financial statements important?
Chapter Assignments 47
LO1 LO5 Performance Measures and Financial Statements
C 6. Refer to the CVS annual report and the financial statements of Southwest
Airlines Co. in the Supplement to Chapter 5 to answer these questions:
1. Which company is larger in terms of assets and in terms of revenues? What do
you think is the best way to measure the size of a company?
2. Which company is more profitable in terms of net income? What is the trend
of profitability over the past three years for both companies?
3. Which company has more cash? Which increased its cash the most in the last
year? Which has more liquidity as measured by cash flows from operating
activities?
C H A P T E R
2 Analyzing Business
Transactions
A ll business transactions require the application of three basic
Making a
Statement accounting concepts: recording a transaction at the right
time, placing the right value on it, and calling it by the right name.
INCOME STATEMENT
Most accounting frauds and mistakes violate one or more of these
Revenues
basic accounting concepts. What you learn in this chapter will help
– Expenses
you avoid making such mistakes. It will also help you recognize
correct accounting practices.
= Net Income
STATEMENT OF LEARNING OBJECTIVES
OWNER’S EQUITY
Beginning Balance LO1 Explain how the concepts of recognition, valuation, and
classification apply to business transactions and why they are
+ Net Income
important factors in ethical financial reporting. (pp. 50–53)
– Withdrawals
= Ending Balance LO2 Explain the double-entry system and the usefulness of
T accounts in analyzing business transactions. (pp. 54–57)
BALANCE SHEET LO3 Demonstrate how the double-entry system is applied to
Assets Liabilities
common business transactions. (pp. 58–65)
Owner’s LO4 Prepare a trial balance, and describe its value and
Equity limitations. (pp. 65–67)
A = L + OE LO5 Show how the timing of transactions affects cash flows and
liquidity. (pp. 68–69)
STATEMENT OF CASH FLOWS
Operating activities
+ Investing activities
+ Financing activities SUPPLEMENTAL OBJECTIVE
= Change in Cash
+ Beginning Balance SO6 Define the chart of accounts, record transactions in the general
= Ending Cash Balance journal, and post transactions to the ledger. (pp. 70–75)
Business transactions
can affect all the financial
statements.
48
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Is there a difference between an
economic event and a business
PAWS AND HOOFS CLINIC
transaction that should be
recorded in the accounting
records?
After graduating from veterinary school, Larry Cox started the Paws
and Hoofs Clinic. On his second day of business, he received a stand- (cid:2) Can a business transaction
benefit a business even though
ing order from Quarter Horse Stables to examine its horses on a
no cash is received when the |
monthly basis for one year. The fee for the service was to be $500
transaction takes place?
per visit, or $6,000 for the year. Confident that his agreement with
(cid:2) What is the difference between
Quarter Horse Stables will work out, Larry is thinking of including the
an asset and an expense?
$6,000 in his financial statements. He believes that doing so would
be a good advertisement for his business, but he must answer the
questions at right to determine if this is acceptable practice.
4499
50 CHAPTER 2 Analyzing Business Transactions
Measurement
Business transactions are economic events that affect a company’s financial posi-
Issues tion. As shown in Figure 2-1, to measure a business transaction, you must decide
when the transaction occurred (the recognition issue), what value to place on
LO1 Explain how the concepts the transaction (the valuation issue), and how the components of the transaction
should be categorized (the classification issue).
of recognition, valuation, and
These three issues—recognition, valuation, and classification—underlie almost
classification apply to business
every major decision in financial accounting today. They are at the heart of account-
transactions and why they are
ing for pension plans, mergers of giant companies, and international transactions.
important factors in ethical
In discussing these issues, we follow generally accepted accounting principles and
financial reporting.
use an approach that promotes an understanding of basic accounting concepts.
Keep in mind, however, that measurement issues can be controversial and resolu-
tions to them are not always as cut-and-dried as the ones presented here.
Recognition
The recognition issue refers to the difficulty of deciding when a business transac-
Study Note
tion should be recorded. The resolution of this issue is important because the date
In accounting, recognize means on which a transaction is recorded affects amounts in the financial statements.
to record a transaction or event. To illustrate some of the factors involved in the recognition issue, suppose a
company wants to purchase an office desk. The following events take place:
1. An employee sends a purchase requisition for the desk to the purchasing
department.
2. The purchasing department sends a purchase order to the supplier.
3. The supplier ships the desk.
4. The company receives the desk.
Study Note
5. The company receives the bill from the supplier.
A purchase should usually not
be recognized (recorded) before 6. The company pays the bill.
title is transferred, because
According to accounting tradition, a transaction should be recorded when
until that point, the vendor
title to merchandise passes from the supplier to the purchaser and creates an obli-
has not fulfilled its contractual
gation to pay. Thus, depending on the details of the shipping agreement for the
obligation and the buyer has no
desk, the transaction should be recognized (recorded) at the time of either event
liability.
3 or 4. This is the guideline we generally use in this book. However, many small
FIGURE 2-1
The Role of Measurement Issues ECONOMIC EVENTS
RECOGNITION
VALUATION
CLASSIFICATION
BUSINESS TRANSACTIONS THAT AFFECT FINANCIAL POSITION
Measurement Issues 51
FOCUS ON BUSINESS PRACTICE
Accounting Policies: Where Do You Find Them?
The Boeing Company, one of the world’s makers of air- this question and others about companies’ accounting poli-
liners, takes orders for planes years in advance. Although cies can be found in the Summary of Significant Accounting
it is an important economic event to both Boeing and the Policies in their annual reports. For example, in that section
buyer, neither the buyer nor the seller would record the of its annual report, Boeing states: “We recognize sales for
event as a transaction. So, how do you know when compa- commercial airplane deliveries as each unit is completed
nies record sales or purchase transactions? The answer to and accepted by the customer.”1
businesses that have simple accounting systems do not record a transaction until
they receive a bill (event 5) or pay it (event 6), because these are the implied |
points of title transfer. The predetermined time at which a transaction should be
recorded is the recognition point.
Although purchase requisitions and purchase orders (events 1 and 2) are eco-
nomic events, they do not affect a company’s financial position, and they are not
recognized in the accounting records. Even the most important economic events
may not be recognized in the accounting records.
Here are some more examples of economic events that should and should
not be recorded as business transactions:
Events That Are Not Recorded Events That Are Recorded
as Transactions as Transactions
A customer inquires about the A customer buys a service.
availability of a service.
A company hires a new employee. A company pays an employee
for work performed.
A company signs a contract to A company performs a service.
provide a service in the future.
The recognition issue can be difficult to resolve. Consider an advertising
agency that is planning a major advertising campaign for a client. Employees may
work on the plan several hours a day for a number of weeks. They add value to
the plan as they develop it. Should this added value be recognized as the plan is
being developed or at the time it is completed? Usually, the increase in value is
recorded at the time the plan is finished and the client is billed for it. However, if
a plan is going to take a long time to develop, the agency and the client may agree
that the client will be billed at key points during its development. In that case, a
transaction is recorded at each billing.
Valuation
Study Note
The valuation issue focuses on assigning a monetary value to a business trans-
action and accounting for the assets and liabilities that result from the business
The value of a transaction
transactions. Generally accepted accounting principles state that all business
usually is based on a business
document—a canceled check transactions should be valued at fair value when they occur. Fair value is defined
or an invoice. as the exchange price of an actual or potential business transaction between mar-
ket participants.2 This practice of recording transactions at exchange price at the
52 CHAPTER 2 Analyzing Business Transactions
FOCUS ON BUSINESS PRACTICE
The Challenge of Fair Value Accounting
The measurement of fair value is a major challenge in merg- h ypothetical transaction that in many cases is difficult to
ing international financial reporting standards (IFRS) with measure: It represents the selling price of an asset or the
U.S. GAAP. Both the International Accounting Standards payment price of a liability. It does not represent the price
Board (IASB) and the Financial Accounting Standards Board of acquiring the asset or assuming the liability. In practice,
(FASB) are committed to this effort. Fair value is the price the potential selling price of equipment used in a factory
to sell an asset or transfer a liability in an orderly market or an investment in a private company for which no ready
by an arm’s-length transaction. Fair value represents a market exists may not be easy to determine.
point of recognition is commonly referred to as the cost principle. It is used
because the cost, or exchange price, is verifiable. For example, when Larry Cox
performs the service for Quarter Horse Stables described in the Decision Point at
the beginning of this chapter, he and Quarter Horse Stables will record the trans-
action in their respective records at the price they have agreed on.
Normally, the value of an asset is held at its initial fair value or cost until the
asset is sold, expires, or is consumed. However, if there is evidence that the fair
value of the asset or liability has changed, an adjustment to the initial value may
be required. There are different rules for the application of fair value to different
classes of assets. For example, a building or equipment remains at cost unless
there is convincing evidence that the fair value is less than cost. In this case, a loss
should be recorded to reduce the value from its cost to fair value. Investments, |
on the other hand, are often accounted for at fair value, regardless of whether fair
value is greater or less than cost. Because these investments are available for sale,
the fair value is the best measure of the potential benefit to the company. In its
annual report, Intel Corporation states: “Investments designated as available-for-
sale on the balance sheet date are reported at fair value.”3
FOCUS ON BUSINESS PRACTICE
No Dollar Amount: How Can That Be?
Determining the value of a sale or purchase transaction (cid:2) An office supply company provides a year’s sup-
isn’t difficult when the value equals the amount of cash ply of computer paper to a local weekly newspaper
that changes hands. However, barter transactions, in which in exchange for an advertisement in 52 issues of the
exchanges are made but no cash changes hands, can make newspaper.
valuation more complicated. Barter transactions are quite
(cid:2) Two Internet companies each provide an advertisement
common in business today. Here are some examples:
and link to the other’s website on their own websites.
(cid:2) A consulting company provides its services to an auto
Determining the value of these transactions is a matter of
dealer in exchange for the loan of a car for a year.
determining the fair value of the items being traded.
Measurement Issues 53
Classification
The classification issue has to do with assigning all the transactions in which a
Study Note business engages to appropriate categories, or accounts. Classification of debts
can affect a company’s ability to borrow money, and classification of purchases
If CVS buys paper towels to
can affect its income. One of the most important classification issues in account-
resell to customers, the cost
ing is the difference between an expense and an asset, both represented by debits
would be recorded as an asset
in the accounts. To use the Decision Point case again as an example, if Larry Cox
in the Inventory account. If
buys medicines that are used immediately, their cost is classified as an expense. If
the paper towels are used for
the medicines will be used in the future, they are classified as assets.
cleaning in the store, the cost is
an expense. As we explain later in the chapter, proper classification depends not only on
correctly analyzing the effect of each transaction on a business but also on main-
taining a system of accounts that reflects that effect.
Ethics and Measurement Issues
Recognition, valuation, and classification are important factors in ethical financial
reporting, and generally accepted accounting principles provide direction about their
treatment. These guidelines are intended to help managers meet their obligation to
their company’s owners and to the public. Many of the worst financial reporting
frauds over the past several years have resulted from violations of these guidelines.
(cid:2) Computer Associates violated the guidelines for recognition when it kept its
books open a few days after the end of a reporting period so revenues could
be counted a quarter earlier than they should have been. In all, the company
prematurely reported $3.3 billion in revenues from 363 software contracts.
When the SEC ordered the company to stop the practice, Computer Associ-
ates’ stock price dropped by 43 percent in a single day.
(cid:2) Among its many other transgressions, Enron Corporation violated the guide-
lines for valuation when it valued assets that it transferred to related compa-
nies at far more than their actual value.
(cid:2) By a simple violation of the guidelines for classification, WorldCom (now
MCI) perpetrated the largest financial fraud in history, which resulted in the
largest bankruptcy in history. Over a period of several years, the company
recorded expenditures as expenses that should have been classified as assets;
this had the effect of understating the company’s expenses and overstating its
income by more than $10 billion.
STOP
& APPLY
Four major issues underlie every accounting transaction: recognition, valuation, classification, and
ethics. Match each of these issues to the statements below that are most closely associated with the |
issue. A company:
1. R ecords a piece of equipment at the price 3. R ecords the equipment as an expense in
paid for it. order to show lower earnings.
2. R ecords the purchase of the equipment on 4. R ecords the equipment as an asset because
the day on which it takes ownership. it will benefit future periods.
SOLUTION
1. valuation; 2. recognition; 3. ethics; 4. classification
54 CHAPTER 2 Analyzing Business Transactions
Double-Entry
The double-entry system, the backbone of accounting, evolved during the Renais-
System sance. The first systematic description of double-entry bookkeeping appeared in
1494, two years after Columbus discovered America, in a mathematics book by
LO2 Explain the double-entry Fra Luca Pacioli. Goethe, the famous German poet and dramatist, referred to
double-entry bookkeeping as “one of the finest discoveries of the human intellect.”
system and the usefulness of
Werner Sombart, an eminent economist-sociologist, believed that “double-entry
T accounts in analyzing business
bookkeeping is born of the same spirit as the system of Galileo and Newton.”
transactions.
What is the significance of the double-entry system? The system is based on
the principle of duality, which means that every economic event has two aspects—
Study Note effort and reward, sacrifice and benefit, source and use—that offset, or balance,
each other. In the double-entry system, each transaction must be recorded with
Each transaction must include
at least one debit and one credit, and the total amount of the debits must equal
at least one debit and one
the total amount of the credits. Because of the way it is designed, the whole sys-
credit, and the debit totals must
tem is always in balance. All accounting systems, no matter how sophisticated, are
equal the credit totals.
based on the principle of duality.
Accounts
Accounts are the basic storage units for accounting data and are used to accumulate
amounts from similar transactions. An accounting system has a separate account
for each asset, each liability, and each component of owner’s equity, including rev-
enues and expenses. Whether a company keeps records by hand or by computer,
managers must be able to refer to accounts so that they can study their company’s
financial history and plan for the future. A very small company may need only a
few dozen accounts; a multinational corporation may need thousands.
An account title should describe what is recorded in the account. How-
ever, account titles can be rather confusing. For example, Fixed Assets, Plant
and Equipment, Capital Assets, and Long-Lived Assets are all titles for long-
term assets. Moreover, many account titles change over time as preferences
and practices change.
When you come across an account title that you don’t recognize, examine
the context of the name—whether it is classified in the financial statements as an
asset, liability, or component of owner’s equity—and look for the kind of transac-
tion that gave rise to the account.
The T Account
The T account is a good place to begin the study of the double-entry system.
Study Note
Such an account has three parts: a title, which identifies the asset, liability, or
owner’s equity account; a left side, which is called the debit side; and a right side,
Many students have
which is called the credit side. The T account, so called because it resembles the
preconceived ideas about what
debit and credit mean. They letter T, is used to analyze transactions and is not part of the accounting records.
think debit means “decrease” It looks like this:
(or implies something bad)
and credit means “increase” (or
implies something good). It is
TITLE OF ACCOUNT
important to realize that debit
Debit Credit
simply means “left side” and
(left) side (right) side
credit simply means “right side.”
Any entry made on the left side of the account is a debit, and any entry
made on the right side is a credit. The terms debit (abbreviated Dr., from the
Latin debere) and credit (abbreviated Cr., from the Latin credere) are simply the
Double-Entry System 55
accountant’s words for “left” and “right” (not for “increase” or “decrease”). We |
present a more formal version of the T account, the ledger account form, later in
this chapter.
The T Account Illustrated
Suppose a company had several transactions during the month that involved the
receipt or payment of cash. These transactions can be summarized in the Cash
account by recording receipts on the left (debit) side of a T account and pay-
ments on the right (credit) side.
CASH
Dr. Cr.
100,000 70,000
3,000 400
1,200
103,000 71,600
Bal. 31,400
The cash receipts on the left total $103,000. (The total is written in smaller,
bold figures so that it cannot be confused with an actual debit entry.) The cash
payments on the right side total $71,600. These totals are simply working totals,
or footings. Footings, which are calculated at the end of each month, are an easy
way to determine cash on hand. The difference in dollars between the total debit
footing and the total credit footing is called the balance, or account balance. If
the balance is a debit, it is written on the left side. If it is a credit, it is written
on the right side. Notice that the Cash account has a debit balance of $31,400
($103,000 (cid:4) $71,600). This is the amount of cash the business has on hand at
the end of the month.
Rules of Double-Entry Accounting
The two rules of the double-entry system are that every transaction affects at least
two accounts and that total debits must equal total credits. In other words, for
every transaction, one or more accounts must be debited, or entered on the left
side of the T account, and one or more accounts must be credited, or entered on
the right side of the T account, and the total dollar amount of the debits must
equal the total dollar amount of the credits.
Look again at the accounting equation:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
You can see that if a debit increases assets, then a credit must be used to increase
liabilities or owner’s equity because they are on opposite sides of the equal sign.
Likewise, if a credit decreases assets, then a debit must be used to decrease liabili-
ties or owner’s equity. These rules can be shown as follows:
ASSETS (cid:2) LIABILITIES (cid:3) OWNER’S EQUITY
Debit Credit Debit Credit Debit Credit
for for for for for for
increases decreases decreases increases decreases increases
((cid:3)) ((cid:4)) ((cid:4)) ((cid:3)) ((cid:4)) ((cid:3))
56 CHAPTER 2 Analyzing Business Transactions
1. Debit increases in assets to asset accounts. Credit decreases in assets to asset
Study Note
accounts.
Although withdrawals are a 2. Credit increases in liabilities and owner’s equity to liability and owner’s
component of owner’s equity, equity accounts. Debit decreases in liabilities and owner’s equity to liability
they normally appear only
and owner’s equity accounts.
in the statement of owner’s
equity. They do not appear One of the more difficult points to understand is the application of double-
in the owner’s equity section entry rules to the components of owner’s equity. The key is to remember that
of the balance sheet or as withdrawals and expenses are deductions from owner’s equity. Thus, transac-
an expense on the income tions that increase withdrawals or expenses decrease owner’s equity. Consider this
statement. expanded version of the accounting equation:
Owner’s Equity
Assets (cid:2) Liabilities (cid:3) Owner’s (cid:4) Withdrawals (cid:3) Revenues (cid:4) Expenses
Capital
ASSETS LIABILITIES OWNER’S CAPITAL WITHDRAWALS REVENUES EXPENSES
(cid:3) (cid:4) (cid:4) (cid:3) (cid:4) (cid:3) (cid:3) (cid:4) (cid:4) (cid:3) (cid:3) (cid:4)
(Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.)
Normal Balance
The normal balance of an account is its usual balance and is the side (debit or
credit) that increases the account. Table 2-1 summarizes the normal account bal-
ances of the major account categories. If you have difficulty remembering the
normal balances and the rules of debit and credit, try using the acronym AWE:
Asset accounts, Withdrawals, and Expenses are always increased by debits. All
other normal accounts are increased by credits. |
Owner’s Equity Accounts
Figure 2-2 illustrates how owner’s equity accounts relate to each other and to
the financial statements. The distinctions among these accounts are important for
both legal purposes and financial reporting.
TABLE 2-1
Increases Recorded by Normal Balance
Normal Account Balances of Major
Account Categories Account Category Debit Credit Debit Credit
Assets x x
Liabilities x x
Owner’s equity:
Owner’s Capital x x
Withdrawals x x
Revenues x x
Expenses x x
Double-Entry System 57
FIGURE 2-2
Relationships of Owner’s Equity BALANCE SHEET
Accounts
ASSETS = LIABILITIES +
OWNER’S
EQUITY
Study Note
Although revenues and
expenses are components of OWNER’S
WITHDRAWALS REVENUES EXPENSES
owner’s equity, they appear CAPITAL
on the income statement, not
SHOWN ON
in the owner’s equity section
INCOME STATEMENT
of the balance sheet. Figure 2-2
illustrates this point.
SHOWN ON STATEMENT OF OWNER’S EQUITY
STOP
& APPLY
You are given the following list of accounts with dollar amounts:
J. Morgan, Withdrawals $ 75 Cash $625
Accounts Payable 200 J. Morgan, Capital 400
Wages Expense 150 Fees Revenue 250
Insert the account title at the top of the corresponding T account that follows and enter the dollar
amount as a normal balance in the account. Then show that the accounting equation is in balance.
OWNER’S EQUITY
J. MORGAN, J. MORGAN,
ASSETS (cid:2) LIABILITIES (cid:3) CAPITAL (cid:4) WITHDRAWALS (cid:3) REVENUES (cid:4) EXPENSES
SOLUTION
ACCOUNTS J. MORGAN, J. MORGAN, FEES WAGES
CASH PAYABLE CAPITAL WITHDRAWALS REVENUE EXPENSE
625 200 400 75 250 150
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
$625 (cid:2) $200 (cid:3) ($400 (cid:2) $75 (cid:3) $250 (cid:2) $150)
$625 (cid:2) $200 (cid:3) $425
$625 (cid:2) $625
58 CHAPTER 2 Analyzing Business Transactions
Business
In the pages that follow, we show how to apply the double-entry system to some
Transaction common business transactions. Source documents—invoices, receipts, checks, or
contracts—usually support the details of a transaction. We focus on the transactions
Analysis
of a small firm, Miller Design Studio. For each transaction, we follow these steps:
LO3 Demonstrate how 1. State the transaction.
the double-entry system is
2. Analyze the transaction to determine which accounts are affected.
applied to common business
3. Apply the rules of double-entry accounting by using T accounts to show how the
transactions.
transaction affects the accounting equation. It is important to note that this step is
not part of the accounting records but is undertaken before recording a transaction
in order to understand the effects of the transaction on the accounts.
4. Show the transaction in journal form. The journal form is a way of record-
Study Note
ing a transaction with the date, debit account, and debit amount shown on
T accounts are used to one line, and the credit account (indented) and credit amount on the next
understand and visualize line. The amounts are shown in their respective debit and credit columns.
the double-entry effects of a This step represents the initial recording of a transaction in the records and takes
transaction on the accounting the following form:
equation. They help in then
recording the journal entry in Dr. Cr.
the general journal. Date Debit Account Name Amount
Credit Account Name Amount
A series of transactions in this form results in a chronological record of
the transactions called a general journal. Periodically, each debit and credit
in an entry is transferred to its appropriate account in a list of accounts called
the general ledger. We discuss the relationship of the general journal to the
general ledger later in this chapter.
5. Provide a comment that will help you apply the rules of double entry.
The formal process of recording and posting of transactions in the records is illus-
trated under SO 6 at the end of this chapter. Chapters 3 and 4 cover other steps
necessary to produce financial statements.
Owner’s Investment to Form the Business
July 1: Joan Miller invests $40,000 in cash to form Miller Design Studio.
Analysis: An owner’s investment in the business increases the asset account Cash with |
a debit and increases the owner’s equity account J. Miller, Capital with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH J. MILLER, CAPITAL
Dr. Cr. Dr. Cr.
July 1 40,000 July 1 40,000
Entry in Journal Form:
Dr. Cr.
July 1 Cash 40,000
J. Miller, Capital 40,000
Comment: If Joan Miller had invested assets other than cash in the business, the
appropriate asset accounts would be increased with a debit.
Business Transaction Analysis 59
Economic Event That Is Not a Business Transaction
July 2: Orders office supplies, $5,200.
Comment: When an economic event does not constitute a business transaction,
no entry is made. In this case, there is no confirmation that the supplies have been
shipped or that title has passed.
Prepayment of Expenses in Cash
July 3: Rents an office; pays two months’ rent in advance, $3,200.
Analysis: The prepayment of office rent in cash increases the asset account Pre-
paid Rent with a debit and decreases the asset account Cash with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH
Dr. Cr.
July 1 40,000 July 3 3,200
PREPAID RENT
Dr. Cr.
July 3 3,200
Entry in Journal Form:
Dr. Cr.
July 3 Prepaid Rent 3,200
Cash 3,200
Comment: A prepaid expense is an asset because the expenditure will benefit
future operations. This transaction does not affect the totals of assets or liabili-
ties and owner’s equity because it simply trades one asset for another asset. If
the company had paid only July’s rent, the owner’s equity account Rent Expense
would be debited because the total benefit of the expenditure would be used up
in the current month.
Purchase of an Asset on Credit
July 5: Receives office supplies ordered on July 2 and an invoice for $5,200.
Analysis: The purchase of office supplies on credit increases the asset account
Office Supplies with a debit and increases the liability account Accounts Payable
with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
OFFICE SUPPLIES ACCOUNT PAYABLE
Dr. Cr. Dr. Cr.
July 5 5,200 July 5 5,200
Entry in Journal Form:
Dr. Cr.
July 5 Office Supplies 5,200
Accounts Payable 5,200
60 CHAPTER 2 Analyzing Business Transactions
Comment: Office supplies are considered an asset (prepaid expense) because they
will not be used up in the current month and thus will benefit future periods.
Accounts Payable is used when there is a delay between the time of the purchase
and the time of payment.
Purchase of an Asset Partly in Cash
and Partly on Credit
July 6: Purchases office equipment, $16,320; pays $13,320 in cash and agrees to
pay the rest next month.
Analysis: The purchase of office equipment in cash and on credit increases the
asset account Office Equipment with a debit, decreases the asset account Cash with
a credit, and increases the liability account Accounts Payable with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH ACCOUNT PAYABLE
Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 5 5,200
6 13,320 6 3,000
OFFICE EQUIPMENT
July 6 16,320
Entry in Journal Form:
Dr. Cr.
July 6 Office Equipment 16,320
Cash 13,320
Accounts Payable 3,000
Comment: As this transaction illustrates, assets may be paid for partly in cash and
partly on credit. When more than two accounts are involved in a journal entry, as
they are in this one, it is called a compound entry.
Payment of a Liability
July 9: Makes a partial payment of the amount owed for the office supplies
received on July 5, $2,600.
Analysis: A payment of a liability decreases the liability account Accounts Payable
with a debit and decreases the asset account Cash with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH ACCOUNT PAYABLE
Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 9 2,600 July 5 5,200
6 13,320 6 3,000
9 2,600
Entry in Journal Form:
Dr. Cr.
July 9 Accounts Payable 2,600
Cash 2,600
Business Transaction Analysis 61
Comment: Note that the office supplies were recorded when they were purchased
on July 5.
Revenue in Cash
July 10: Performs a service for an investment advisor by designing a series of bro- |
chures and collects a fee in cash, $2,800.
Analysis: Revenue received in cash increases the asset account Cash with a debit
and increases the owner’s equity account Design Revenue with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH DESIGN REVENUE
Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 10 2,800
10 2,800 6 13,320
9 2,600
Entry in Journal Form:
Dr. Cr.
July 10 Cash 2,800
Design Revenue 2,800
Comment: For this transaction, revenue is recognized when the service is pro-
vided and the cash is received.
Revenue on Credit
July 15: Performs a service for a department store by designing a TV commercial;
bills for the fee now but will collect the fee later, $9,600.
Analysis: A revenue billed to a customer increases the asset account Accounts
Receivable with a debit and increases the owner’s equity account Design Revenue
with a credit. Accounts Receivable is used to indicate the company’s right to col-
lect the money in the future.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
ACCOUNTS RECEIVABLE DESIGN REVENUE
Dr. Cr. Dr. Cr.
July 15 9,600 July 10 2,800
15 9,600
Entry in Journal Form:
Dr. Cr.
July 15 Accounts Receivable 9,600
Design Revenue 9,600
Comment: In this case, there is a delay between the time revenue is earned and
the time the cash is received. Revenues are recorded at the time they are earned
and billed regardless of when cash is received.
Revenue Collected in Advance
July 19: Accepts an advance fee as a deposit on a series of brochures to be
designed, $1,400.
62 CHAPTER 2 Analyzing Business Transactions
Analysis: Revenue received in advance increases the asset account Cash with a debit
and increases the liability account Unearned Design Revenue with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH UNEARNED DESIGN REVENUE
Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 19 1,400
10 2,800 6 13,320
19 1,400 9 2,600
Entry in Journal Form:
Dr. Cr.
July 19 Cash 1,400
Unearned Design Revenue 1,400
Comment: In this case, cash is received before the fees are earned. Unearned Design
Revenue is a liability because the firm must provide the service or return the deposit.
Collection on Account
July 22: Receives cash from customer previously billed on July 15, $5,000.
Analysis: Collection of an account receivable from a customer previously billed
increases the asset account Cash with a debit and decreases the asset account
Accounts Receivable with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH
Dr. Cr.
July 1 40,000 July 3 3,200
10 2,800 6 13,320
19 1,400 9 2,600
22 5,000
ACCOUNTS RECEIVABLE
Dr. Cr.
July 15 9,600 July 22 5,000
Entry in Journal Form:
Dr. Cr.
July 22 Cash 5,000
Accounts Receivable 5,000
Comment: Note that the revenue related to this transaction was recorded on
July 15. Thus, no revenue is recorded at this time.
Expense Paid in Cash
July 26: Pays employees four weeks’ wages, $4,800.
Business Transaction Analysis 63
Analysis: This cash expense increases the owner’s equity account Wages Expense
with a debit and decreases the asset account Cash with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH WAGES EXPENSE
Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 26 4,800
10 2,800 6 13,320
19 1,400 9 2,600
22 5,000 26 4,800
Entry in Journal Form:
Dr. Cr.
July 26 Wages Expense 4,800
Cash 4,800
Comment: Note that the increase in Wages Expense will decrease owner’s equity.
Expense to Be Paid Later
July 30: Receives, but does not pay, the utility bill that is due next month, $680.
Analysis: This cash expense increases the owner’s equity account Utilities
Expense with a debit and increases the liability account Accounts Payable with a
credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
ACCOUNTS PAYABLE UTILITIES EXPENSE
Dr. Cr. Dr. Cr.
July 9 2,600 July 5 5,200 July 30 680
6 3,000
30 680
Entry in Journal Form:
Dr. Cr.
July 30 Utilities Expense 680
Accounts Payable 680
Comment: The expense is recorded if the benefit has been received and the |
amount is owed, even if the cash is not to be paid until later. Note that the
increase in Utilities Expense will decrease owner’s equity.
Withdrawals
July 31: Withdraws $2,800 in cash.
Analysis: A cash withdrawal increases the owner’s equity account Withdrawals
with a debit and decreases the asset account Cash with a credit.
64 CHAPTER 2 Analyzing Business Transactions
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH J. MILLER, WITHDRAWALS
Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 31 2,800
10 2,800 6 13,320
19 1,400 9 2,600
22 5,000 26 4,800
31 2,800
Entry in Journal Form:
Dr. Cr.
July 31 J. Miller, Withdrawals 2,800
Cash 2,800
Comment: Note that the increase in Withdrawals will decrease owner’s equity.
EXHIBIT 2-1 Summary of Transactions of Miller Design Studio
Assets (cid:3) Liabilities (cid:4) Owner’s Equity
Cash Accounts Payable J. Miller, Capital
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 40,000 July 3 3,200 July 9 2,600 July 5 5,200 July 1 40,000
10 2,800 6 13,320 6 3,000
19 1,400 9 2,600 30 680 J. Miller, Withdrawals
22 5,000 26 4,800
2,600 8,880 July 31 2,800
31 2,800
Bal. 6,280
49,200 26,720
This account links to the statement of cash flows.
Bal. 22,480
Accounts Receivable Unearned Design Revenue Design Revenue
Dr. Cr. Dr. Cr. Dr. Cr.
July 15 9,600 July 22 5,000 July 19 1,400 July 10 2,800
15 9,600
Bal. 4,600
Bal. 12,400
Office Supplies Wages Expense
Dr. Cr. Dr. Cr.
July 5 5,200 July 26 4,800
Prepaid Rent Utilities Expense
Dr. Cr. Dr. Cr.
July 3 3,200 July 30 680
Office Equipment
These accounts link to the income statement.
Dr. Cr.
July 6 16,320
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
$51,800 (cid:2) $7,680 (cid:3) $44,120
The Trial Balance 65
Summary of Transactions
Exhibit 2-1 uses the accounting equation to summarize the transactions of Miller Design
Studio. Note that the income statement accounts appear under owner’s equity and that
the transactions in the Cash account will be reflected on the statement of cash flows.
STOP
& APPLY
The following accounts are applicable to Leona’s Nail Salon, a company that provides manicures
and pedicures:
1. Cash 5. Accounts Payable
2. Accounts Receivable 6. Services Revenue
3. Supplies 7. Wages Expense
4. Equipment 8. Rent Expense
For Leona’s Nail Salon, enter the number corresponding to the proper account for each debit and
credit for the following transactions:
Debit Credit
a. Made a rent payment for the current month. 8 1
b. Received cash from customers for current services.
c. Agreed to accept payment next month from a client for current services.
d. Purchased supplies on credit.
e. Purchased a new chair and table for cash.
f. Made a payment on accounts payable.
SOLUTION
Debit Credit
a. Made a rent payment for the current month. 8 1
b. Received cash from customers for current services. 1 6
c. Agreed to accept payment next month from a client 2 6
for current services.
d. Purchased supplies on credit. 3 5
e. Purchased a new chair and table for cash. 4 1
f. Made a payment on accounts payable. 5 1
The Trial
For every amount debited, an equal amount must be credited. This means that
Balance the total of debits and credits in the T accounts must be equal. To test this, the
accountant periodically prepares a trial balance. Exhibit 2-2 shows a trial balance
LO4 Prepare a trial balance, for Miller Design Studio. It was prepared from the accounts in Exhibit 2-1.
and describe its value and
limitations. Preparation and Use of a Trial Balance
Although a trial balance may be prepared at any time, it is usually prepared on the
last day of the accounting period. The preparation involves these steps:
66 CHAPTER 2 Analyzing Business Transactions
EXHIBIT 2-2
Miller Design Studio
Trial Balance
Trial Balance
July 31, 2011
Cash $22,480
Accounts Receivable 4,600
Office Supplies 5,200
Prepaid Rent 3,200
Office Equipment 16,320
Accounts Payable $ 6,280
Unearned Design Revenue 1,400
J. Miller, Capital 40,000
J. Miller, Withdrawals 2,800
Design Revenue 12,400
Wages Expense 4,800
680
Utilities Expense
$60,080 $60,080
1. List each account that has a balance, with debit balances in the left column |
Study Note
and credit balances in the right column. Accounts are listed in the order in
The trial balance is usually which they appear in the financial statements.
prepared at the end of an
2. Add each column.
accounting period. It is an initial
check that the accounts are in 3. Compare the totals of the columns.
balance.
Once in a while, a transaction leaves an account with a balance that isn’t
“normal.” For example, when a company overdraws its bank account, its Cash
account (an asset) will show a credit balance instead of a debit balance. The
“abnormal” balance should be copied into the trial balance columns as it stands,
as a debit or a credit.
The trial balance proves whether the accounts are in balance. In balance
means that the total of all debits recorded equals the total of all credits recorded.
But the trial balance does not prove that the transactions were analyzed correctly
or recorded in the proper accounts. For example, there is no way of determining
from the trial balance that a debit should have been made in the Office Sup-
plies account rather than in the Office Equipment account. And the trial balance
does not detect whether transactions have been omitted, because equal debits
and credits will have been omitted. Also, if an error of the same amount is made
in both a debit and a credit, it will not be evident in the trial balance. The trial
balance proves only that the debits and credits in the accounts are in balance.
FOCUS ON BUSINESS PRACTICE
Are All Trial Balances Created Equal?
In computerized accounting systems, posting is done software packages for small businesses list the trial balance
automatically, and the trial balance can be easily prepared amounts in a single column and show credit balances as
as often as needed. Any accounts with abnormal balances minuses. In such cases, the trial balance is in balance if the
are highlighted for investigation. Some general ledger total is zero.
The Trial Balance 67
Finding Trial Balance Errors
If the debit and credit balances in a trial balance are not equal, look for one or
more of the following errors:
1. A debit was entered in an account as a credit, or vice versa.
2. The balance of an account was computed incorrectly.
3. An error was made in carrying the account balance to the trial balance.
4. The trial balance was summed incorrectly.
Other than simply adding the columns incorrectly, the two most common
mistakes in preparing a trial balance are
1. Recording an account as a credit when it usually carries a debit balance, or
vice versa. This mistake causes the trial balance to be out of balance by an
amount divisible by 2.
2. Transposing two digits when transferring an amount to the trial balance (for
example, entering $23,459 as $23,549). This error causes the trial balance to
be out of balance by an amount divisible by 9.
So, if a trial balance is out of balance and the addition of the columns is correct,
determine the amount by which the trial balance is out of balance and divide it
first by 2 and then by 9. If the amount is divisible by 2, look in the trial balance
for an amount that is equal to the quotient. If you find such an amount, chances
are it’s in the wrong column. If the amount is divisible by 9, trace each amount
back to the T account balance, checking carefully for a transposition error. If
neither of these techniques is successful in identifying the error, first recompute
the balance of each T account. Then, if you still have not found the error, retrace
each posting to the journal or the T account.
STOP
& APPLY
Prepare a trial balance from the following list of accounts (in alphabetical order) of the Jasoni
Company as of March 31, 2011. Compute the balance of cash.
Accounts Payable $ 9 Jasoni, Capital $16
Accounts Receivable 5 Equipment 2
Building 10 Land 1
Cash ? Inventory 3
SOLUTION
Jasoni Company
Trial Balance
March 31, 2011
Cash $ 4
Accounts Receivable 5
Inventory 3
Land 1
Building 10
Equipment 2
Accounts Payable $ 9
Jasoni, Capital 16
Totals $25 $25
68 CHAPTER 2 Analyzing Business Transactions
Cash Flows To avoid financial distress, a company must be able to pay its bills on time. Because |
and the Timing the timing of cash flows is critical to maintaining adequate liquidity to pay bills,
managers and other users of financial information must understand the difference
of Transactions
between transactions that generate immediate cash and those that do not. Con-
sider the transactions of Miller Design Studio shown in Figure 2-3. Most of them
LO5 Show how the timing involve either an inflow or outflow of cash.
of transactions affects cash As you can see in Figure 2-3, Miller’s Cash account has more transactions
flows and liquidity. than any of its other accounts. Look at the transactions of July 10, 15, and 22:
(cid:2) July 10: Miller received a cash payment of $2,800.
(cid:2) July 15: The firm billed a customer $9,600 for a service it had already per-
formed.
(cid:2) July 22: The firm received a partial payment of $5,000 from the customer,
but it had not received the remaining $4,600 by the end of the month.
Because Miller incurred expenses in providing this service, it must pay careful
Study Note
attention to its cash flows and liquidity.
Recording revenues and One way Miller can manage its expenditures is to rely on its creditors to give
expenses when they occur will it time to pay. Compare the transactions of July 3, 5, and 9 in Figure 2-3.
provide a clearer picture of a
(cid:2) July 3: Miller prepaid rent of $3,200. That immediate cash outlay may have
company’s profitability on the
caused a strain on the business.
income statement. The change
in cash flows will provide a (cid:2) July 5: The firm received an invoice for office supplies in the amount of
clearer picture of a company’s $5,200. In this case, it took advantage of the opportunity to defer payment.
liquidity on the statement of
(cid:2) July 9: The firm paid $2,600, but it deferred paying the remaining $2,600
cash flows.
until after the end of the month.
Large companies face the same challenge, but often on a much greater
scale. For example, it can take Boeing a number of years to plan and make the
aircraft that customers order. At the end of 2008, Boeing had orders totaling
$352 b illion.4 Think of the cash outlays Boeing must make before it delivers the
planes and collects payment for them. To maintain liquidity so that Boeing can
eventually reap the rewards of delivering the planes, Boeing’s management must
carefully plan the company’s needs for cash.
FIGURE 2-3
Transactions of Miller Design Studio
Design Revenue Cash Cash Cash Prepaid Rent Office Supplies
Sale Purchase
July 10 2,800 July 10 2,800 Ju ly 3 3,200 Ju ly 3 3,200 July 5 5,200
15 9,600 22 5,000 9 2,600
Credit Collection Payment on Credit
Sale on Account Account Purchase
Accounts Receivable Accounts Payable
July 15 9,600 July 22 5,000 Ju ly 9 2,600 Ju ly 5 5,200
Cash Flows and the Timing of Transactions 69
FOCUS ON BUSINESS PRACTICE
Should Earnings Be Aligned with Cash Flows?
Electronic Data Systems Corporation (EDS), the large 40 percent of EDS’s revenue had been recognized well before
computer services company, announced that it was reducing the cash was to be received. Analysts’ response to the change
past earnings by $2.24 billion to implement a new accounting in EDS’s accounting was very positive. “Finally, maybe, we’ll
rule that would more closely align its earnings with cash see cash flows moving in line with earnings,” said one.5
flows. Analysts had been critical of EDS for recording rev- Although there are natural and unavoidable differences
enue from its long-term contracts when the contracts were between earnings and cash flows, it is best if accounting
signed rather than when the cash was received. In fact, about rules are not used to exaggerate these differences.
STOP
& APPLY
A company engaged in the following transactions:
Oct. 1 Performed services for cash, Oct. 4 Performed services on credit, $900.
$1,050.
5 Paid on account, $350.
2 Paid expenses in cash, $550.
6 Collected on account, $600.
3 Incurred expenses on credit, $650.
Enter the correct titles in the following T accounts, and enter the transactions above in the
accounts. Determine the cash balance after these transactions, the amount still to be received, and |
the amount still to be paid.
Cash Sale Cash Purchase
Credit Purchase
Credit Collection on Payment on
Sale Account Account
SOLUTION
Design Fees Earned Cash Expenses
Cash Sale Cash Purchase
Oct. 1 1,050 Oct. 1 1,050 Oct. 2 550 Oct. 2 550
4 900 6 600 5 350 3 650 Credit
Purchase
Credit Collection on Payment on
Sale Account Account
Accounts Receivable Accounts Payable
Oct. 4 900 Oct. 6 600 Oct. 5 350 Oct. 3 650
Cash balance after transactions: $1,050 (cid:3) $600 (cid:4) $550 (cid:4) $350 (cid:2) $750
Amount still to be received: $900 (cid:4) $600 (cid:2) $300
Amount still to be paid: $650 (cid:4) $350 (cid:2) $300
70 CHAPTER 2 Analyzing Business Transactions
Recording
Earlier in the chapter, we described how transactions are analyzed according to
and Posting the rules of double entry and how a trial balance is prepared. As Figure 2-4 shows,
transaction analysis and preparation of a trial balance are the first and last steps
Transactions
in a four-step process. The two intermediate steps are recording the entry in the
general journal and posting the entry to the ledger. In this section, we demon-
SO6 Define the chart of
strate how these steps are accomplished in a manual accounting system.
accounts, record transactions
in the general journal, and post
Chart of Accounts
transactions to the ledger.
In a manual accounting system, each account is kept on a separate page or card.
These pages or cards are placed together in a book or file called the general
ledger. In the computerized systems that most companies have today, accounts
are maintained electronically. However, as a matter of convenience, accountants
Study Note still refer to the group of company accounts as the general ledger, or simply the
ledger.
A chart of accounts is a table
To help identify accounts in the ledger and make them easy to find, the
of contents for the ledger.
accountant often numbers them. A list of these numbers with the correspond-
Typically, it lists accounts in the
ing account titles is called a chart of accounts. A very simple chart of accounts
order in which they appear in
appears in Exhibit 2-3. The first digit in the account number identifies the major
the ledger, which is usually the
financial statement classification—that is, an account number that begins with
order in which they appear in
the digit 1 means that the account is an asset account, an account number that
the financial statements. The
begins with a 2 means that the account is a liability account, and so forth. The
numbering scheme allows for
some flexibility. second and third digits identify individual accounts. The gaps in the sequence of
numbers allow the accountant to expand the number of accounts.
General Journal
Although transactions can be entered directly into the ledger accounts, this
Study Note
method makes identifying individual transactions or finding errors very diffi-
The journal is a chronological cult because the debit is recorded in one account and the credit in another. The
record of events. solution is to record all transactions chronologically in a journal. The journal is
sometimes called the book of original entry because it is where transactions first
enter the accounting records. Later, the debit and credit portions of each transac-
tion are transferred to the appropriate accounts in the ledger. A separate journal
entry is used to record each transaction; the process of recording transactions is
called journalizing.
Most businesses have more than one kind of journal. The simplest and most
flexible kind is the general journal, the one we focus on here. Businesses will also
have several special-purpose journals, each for recording a common transaction,
FIGURE 2-4 such as credit sales, credit purchases, cash receipts, and cash disbursements. At this
Analyzing and Processing Transactions
STEP 1 STEP 2 STEP 3 STEP 4
Analyze the trans- Record the entry. Post the entry. Prepare the
action according trial balance.
to the rules of General Ledger
General Journal Page 1 Office Supplies Account No. 116
double entry. Date Description P Ro es ft .. Debit Credit Date Item P Ro es ft .. Debit Credit DeB ba itlan Cc re edit Acct Name Debit Credit
20xx 20xx |
SALES INVOICE July 5 O ff Aic ce c oS uu np tp sl i Pe as yable 1 21 16 2 5,200 5,200 July 5 J1 5,200 5,200 Cash 36,800
P ofu fir cc eh a ss ue p po lf ies Office Supplies 5,200
on credit General Ledger Prepaid Rent 3,200
Accounts Payable Account No. 212 Accts Payable 5,200
Date Item P Ro es ft .. Debit Credit DeB ba itlan Cc re edit Owner’s Capital 40,000
2 Ju0 lx yx 5 J1 5,200 5,200 45,200 45,200
$5,200
Recording and Posting Transactions 71
EXHIBIT 2-3 Chart of Accounts for a Small Business
Account Account
Number Name Description
Assets
111 Cash Money and any medium of exchange (coins, currency, checks, money orders,
and money on deposit in a bank)
112 Notes Receivable Promissory notes (written promises to pay defi nite sums of money at fi xed
future dates) due from others
113 Accounts Receivable Amounts due from others for revenues or sales on credit (sales on account)
116 Offi ce Supplies Prepaid expense; offi ce supplies purchased and not used
117 Prepaid Rent Prepaid expense; rent paid in advance and not used
118 Prepaid Insurance Prepaid expense; insurance purchased and not expired
141 Land Property owned for use in the business
142 Buildings Structures owned for use in the business
143 Accumulated Periodic allocation of the cost of buildings to expense; deducted from
Depreciation–Buildings buildings
146 Offi ce Equipment Offi ce equipment owned for use in the business
147 Accumulated Periodic allocation of the cost of offi ce equipment to expense; deducted
Depreciation–Offi ce from Offi ce Equipment
Equipment
Liabilities
211 Notes Payable Promissory notes due to others
212 Accounts Payable Amounts due to others for purchases on credit
213 Unearned Design Revenue Unearned revenue; advance deposits for design services to be provided in
the future
214 Wages Payable Amounts due to employees for wages earned and not paid
Owner’s Equity
311 Owner’s Capital Owner’s investments in a company and claims against company assets
derived from profi table operations
313 Withdrawals Distributions of assets (usually cash) that reduce owner’s capital
314 Income Summary Temporary account used at the end of the accounting period to summarize
the revenues and expenses for the period
Revenues
411 Design Revenue Revenues derived from design services
Expenses
511 Wages Expense Amounts earned by employees
512 Utilities Expense Amounts for utilities, such as water, electricity, and gas, used
513 Telephone Expense Amounts of telephone services used
514 Rent Expense Amounts of rent on property and buildings used
515 Insurance Expense Amounts for insurance expired
517 Offi ce Supplies Expense Amounts for offi ce supplies used
518 Depreciation Amount of buildings’ cost allocated to expense
Expense–Buildings
520 Depreciation Amount of offi ce equipment cost allocated to expense
Expense–Offi ce
Equipment
72 CHAPTER 2 Analyzing Business Transactions
EXHIBIT 2-4
General Journal Page 1
The General Journal
Post.
Date Description Ref. Debit Credit
2010
July 3 Prepaid Rent 3,200
A (cid:3) L (cid:4) OE
(cid:3) 3,200 Cash 3,200
(cid:4) 3,200 Paid two months’ rent in advance
5 Office Supplies 5,200
A (cid:3) L (cid:4) OE
(cid:3) 5,200 (cid:3) 5,200 Accounts Payable 5,200
Purchase of office supplies on credit
point, we cover only the general journal. Exhibit 2-4, which displays two of the
transactions of Miller Design Studio that we discussed earlier, shows the format
for recording entries in a general journal. As you can see in Exhibit 2-4, the entries
in a general journal include the following information about each transaction:
1. The date. The year appears on the first line of the first column, the month on
the next line of the first column, and the day in the second column opposite
the month. For subsequent entries on the same page for the same month and
year, the month and year can be omitted.
2. The names of the accounts debited and credited, which appear in the Descrip-
tion column. The names of the accounts that are debited are placed next
to the left margin opposite the dates; on the line below, the names of the
accounts credited are indented. |
3. The debit amounts, which appear in the Debit column opposite the accounts
that are debited, and the credit amounts, which appear in the Credit column
opposite the accounts credited.
4. An explanation of each transaction, which appears in the Description column
below the account names. An explanation should be brief but sufficient to
explain and identify the transaction.
5. The account numbers in the Post. Ref. column, if they apply.
At the time the transactions are recorded, nothing is placed in the Post. Ref.
(posting reference) column. (This column is sometimes called LP or Folio.) Later,
if the company uses account numbers to identify accounts in the ledger, the
account numbers are filled in. They provide a convenient cross-reference from
the general journal to the ledger and indicate that the entry has been posted to
the ledger. If the accounts are not numbered, the accountant uses a checkmark
(✓) to signify that the entry has been posted.
General Ledger
The general journal is used to record the details of each transaction. The general
ledger is used to update each account.
The Ledger Account Form The ledger account form, which contains four
columns for dollar amounts, is illustrated in Exhibit 2-5.
The account title and number appear at the top of the account form. As in the
journal, the transaction date appears in the first two columns. The Item column
Recording and Posting Transactions 73
EXHIBIT 2-5
General Ledger
Accounts Payable
in the General Ledger Accounts Payable Account No. 212
Balance
Post.
Date Item Ref. Debit Credit Debit Credit
2010
July 5 J1 5,200 5,200
6 J1 3,000 8,200
9 J1 2,600 5,600
30 J2 680 6,280
is rarely used to identify transactions because explanations already appear in the
Study Note journal. The Post. Ref. column is used to note the journal page on which the
original entry for the transaction can be found. The dollar amount is entered in
A T account is a means of
the appropriate Debit or Credit column, and a new account balance is computed
quickly analyzing a set of
in the last two columns opposite each entry. The advantage of this account form
transactions. It is simply
over the T account is that the current balance of the account is readily available.
an abbreviated version of
a ledger account. Ledger
accounts, which provide more Posting After transactions have been entered in the journal, they must be trans-
information, are used in the ferred to the ledger. The process of transferring journal entry information from
accounting records. the journal to the ledger is called posting. Posting is usually done after several
entries have been made—for example, at the end of each day or less frequently,
depending on the number of transactions. As Exhibit 2-6 shows, in posting, each
amount in the Debit column of the journal is transferred to the Debit column of
the appropriate account in the ledger, and each amount in the Credit column of
the journal is transferred to the Credit column of the appropriate account in the
ledger. The steps in the posting process are as follows:
1. In the ledger, locate the debit account named in the journal entry.
2. Enter the date of the transaction in the ledger and, in the Post. Ref. column,
the journal page number from which the entry comes.
3. In the Debit column of the ledger account, enter the amount of the debit as
it appears in the journal.
4. Calculate the account balance and enter it in the appropriate Balance
column.
5. Enter in the Post. Ref. column of the journal the account number to which
the amount has been posted.
6. Repeat the same five steps for the credit side of the journal entry.
Notice that Step 5 is the last step in the posting process for each debit and
credit. As noted earlier, in addition to serving as an easy reference between the
journal entry and the ledger account, this entry in the Post. Ref. column of the
journal indicates that the entry has been posted to the ledger.
Some Notes on Presentation
A ruled line appears in financial reports before each subtotal or total to indicate
that the amounts above are added or subtracted. It is common practice to use a |
double line under a final total to show that it has been verified.
74 CHAPTER 2 Analyzing Business Transactions
EXHIBIT 2-6
General Journal Page 2
Posting from the General Journal
to the Ledger Post.
Date Description Ref. Debit Credit
2010
A (cid:3) L (cid:4) OE July 30 Utilities Expense 512 680
(cid:3)680 (cid:4)680
Accounts Payable 212 680
Received bill from
utility company
General Ledger
Accounts Payable Account No. 212
Balance
Post.
Date Item Ref. Debit Credit Debit Credit
2010
July 5 J1 5,200 5,200
6 J1 3,000 8,200
9 J1 2,600 5,600
30 J2 680 6,280
General Ledger
Utilities Expense Account No. 512
Balance
Post.
Date Item Ref. Debit Credit Debit Credit
2010
July 30 J2 680 680
Dollar signs ($) are required in all financial statements and on the trial bal-
ance and other schedules. On these reports, a dollar sign should be placed before
the first amount in each column and before the first amount in a column follow-
ing a ruled line. Dollar signs in the same column are aligned. Dollar signs are not
used in journals and ledgers.
On normal, unruled paper, commas and decimal points are used when record-
ing dollar amounts. On the paper used in journals and ledgers, commas and deci-
mal points are unnecessary because ruled columns are provided to properly align
dollars and cents. Commas, dollar signs, and decimal points are also unnecessary
in electronic spreadsheets. In this book, because most problems and illustrations
are in whole dollar amounts, the cents column usually is omitted. When accoun-
tants deal with whole dollars, they often use a dash in the cents column to indi-
cate whole dollars rather than taking the time to write zeros.
Account names are capitalized when referenced in text or listed in work doc-
uments like the journal or ledger. In financial statements, however, only the first
word of an account name is capitalized.
Paws and Hoofs Clinic: Review Problem 75
STOP
& APPLY
Record the following transactions in proper journal form and use the following account num-
bers—Cash, 111; Supplies 114; and Accounts Payable, 212—to show in the Post Ref. columns
that the entries have been posted:
June 4 Purchased supplies for $40 on credit,
8 Paid for the supplies purchased on June 4
SOLUTION
Post.
Date Description Ref. Debit Credit
June 4 Supplies 114 40
Accounts Payable 212 40
Purchased supplies on credit
8 Accounts Payable 212 40
Cash 114 40
Paid amount due for supplies
(cid:2) PAWS AND HOOFS CLINIC: REVIEW PROBLEM
In the Decision Point at the beginning of the chapter, we described the standing order
for monthly service that Quarter Horse Stables placed with Paws and Hoofs Clinic. We
noted that Larry Cox, the owner of the clinic, was confident of receiving $6,000 in fees
over the course of the year and that he was thinking of including the fees in his financial
statements. We asked these questions:
• Is there a difference between an economic event and a business transaction that
should be recorded in the accounting records?
• Can a business transaction benefit a business even though no cash is received
when the transaction takes place?
• What is the difference between an asset and an expense?
Paws and Hoofs Clinic engaged in the following economic events during May 2010:
Transaction Analysis,
T Accounts, Journalizing, May 1 Larry Cox invested $20,000 in cash to form Paws and Hoofs Clinic.
and the Trial Balance 2 Made an agreement to provide $6,000 in services over the next year to
Quarter Horse Stables.
LO1 LO3
3 Paid $600 in advance for two months’ rent of an offi ce.
LO4 SO6
9 Purchased medical supplies for $400 in cash.
12 Purchased $4,000 of equipment on credit; made a 25 percent down
payment.
15 Delivered a calf for a fee of $350 on credit.
18 Made a payment of $500 on the equipment purchased on May 12.
27 Paid a utility bill of $140.
76 CHAPTER 2 Analyzing Business Transactions
Required
1. Identify the company’s business transactions, and record them in journal form.
2. Post the transactions to the following T accounts: Cash, Accounts Receivable,
Medical Supplies, Prepaid Rent, Equipment, Accounts Payable, L. Cox, Capital; |
Veterinary Fees Earned, and Utilities Expense.
3. Prepare a trial balance for the month of May.
4. User insight: Answer the following questions:
a. How does the event on May 2 illustrate the difference between an economic
event and a business transaction?
b. How does the business transaction of May 15 benefit the business even
though no cash was received?
c. How do the transactions of May 9 and May 27 illustrate the difference
between an asset and an expense?
Answers to 1. Transactions recorded in journal form:
Review Problem
Paws and Hoofs Clinic: Review Problem 77
2. Transactions posted to T accounts:
3. Trial balance:
4. User insight:
a. Despite its importance as an economic event, the standing order on May 2
did not constitute a business transaction. Neither the buyer nor the seller
should have recognized it in their accounting records. At the time of the
78 CHAPTER 2 Analyzing Business Transactions
agreement, Larry Cox had provided no services. Even “firm” orders like this
one may be changed or canceled sometime during the year.
b. Cox provided a service on May 15 and thus earned a revenue and added an
asset to accounts receivable, which will provide cash for the business when
the client pays the bill.
c. Although closely related and recorded by debits, assets and expenses are
different in how they affect future operations. The supplies purchased on
May 9 are classified as an asset because they will benefit future accounting
periods. The payment for utilities is classified as an expense because it is
used up and will not benefit future periods.
Stop & Review 79
STOP
& REVIEW
LO1 Explain how the concepts To measure a business transaction, you must determine when the transaction
of recognition, valuation, occurred (the recognition issue), what value to place on the transaction (the val-
and classifi cation apply uation issue), and how the components of the transaction should be categorized
to business transactions (the classification issue). In general, recognition occurs when title passes, and
and why they are impor- a transaction is valued at the exchange price—the fair value or cost at the time
tant factors in ethical the transaction is recognized. Classification refers to assigning transactions to
fi nancial reporting. the appropriate accounts. GAAP provide guidance about the treatment of these
three basic measurement issues. Failure to follow these guidelines is a major rea-
son some companies issue unethical financial statements.
LO2 Explain the double- In the double-entry system, each transaction must be recorded with at least one
entry system and the debit and one credit, and the total amount of the debits must equal the total
usefulness of T accounts amount of the credits. Each asset, liability, and component of owner’s equity,
in analyzing business including revenues and expenses, has a separate account, which is a device for
transactions. storing transaction data. The T account is a useful tool for quickly analyzing the
effects of transactions. It shows how increases and decreases in assets, liabilities,
and owner’s equity are debited and credited to the appropriate accounts.
LO3 Demonstrate how the The double-entry system is applied by analyzing transactions to determine which
double-entry system is accounts are affected and by using T accounts to show how the transactions affect
applied to common busi- the accounting equation. The transactions may be recorded in journal form with
ness transactions. the date, debit account, and debit amount shown on one line, and the credit
account (indented) and credit amount on the next line. The amounts are shown
in their respective debit and credit columns.
LO4 Prepare a trial balance, A trial balance is used to check that the debit and credit balances are equal. It
and describe its value is prepared by listing each account balance in the appropriate Debit or Credit
and limitations. column. The two columns are then added, and the totals are compared. The
major limitation of a trial balance is that even when it shows that debit and credit |
balances are equal, it does not guarantee that the transactions were analyzed cor-
rectly or recorded in the proper accounts.
LO5 Show how the timing of Some transactions generate immediate cash. For those that do not, there is a
transactions aff ects cash holding period in either Accounts Receivable or Accounts Payable before the
fl ows and liquidity. cash is received or paid. The timing of cash flows is critical to a company’s ability
to maintain adequate liquidity so that it can pay its bills on time.
Supplemental Objective
SO6 Defi ne the chart of The chart of accounts is a list of account numbers and titles; it serves as a table
accounts, record trans- of contents for the ledger. The general journal is a chronological record of all
actions in the general transactions; it contains the date of each transaction, the titles of the accounts
journal, and post trans- involved, the amounts debited and credited, and an explanation of each entry.
actions to the ledger. After transactions have been entered in the general journal, they are posted to the
80 CHAPTER 2 Analyzing Business Transactions
ledger. Posting is done by transferring the amounts in the Debit and Credit col-
umns of the general journal to the Debit and Credit columns of the correspond-
ing account in the ledger. After each entry is posted, a new balance is entered in
the appropriate Balance column.
REVIEW of Concepts and Terminology
The following concepts and terms Double-entry system 54 (LO2) Normal balance 56 (LO2)
were introduced in this chapter:
Fair value 51 (LO1) Posting 73 (SO6)
Accounts 54 (LO2)
Footings 55 (LO2) Recognition 50 (LO1)
Balance 55 (LO2)
General journal 70 (SO6) Recognition point 51 (LO1)
Chart of accounts 70 (SO6)
General ledger 70 (SO6) Source documents 58 (LO3)
Classification 53 (LO1)
Journal 70 (SO6) T account 54 (LO2)
Compound entry 60 (LO3)
Journal entry 70 (SO6) Trial balance 65 (LO4)
Cost principle 52 (LO1)
Journal form 58 (LO3) Valuation 51 (LO1)
Credit 54 (LO2)
Journalizing 70 (SO6)
Debit 54 (LO2)
Ledger account form 72 (SO6)
Chapter Assignments 81
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
Short exercises are simple applications of chapter material for one or more learn-
ing objectives. If you need help locating the related text discussions, refer to the
LO numbers in the margin.
LO1 Recognition
SE 1. Which of the following events would be recognized and entered in the
accounting records of Kazuo Company? Why?
Jan. 10 Kazuo Company places an order for office supplies.
Feb. 15 Kazuo Company receives the office supplies and a bill for them.
Mar. 1 Kazuo Company pays for the office supplies.
LO1 LO3 Recognition, Valuation, and Classification
SE 2. Tell how the concepts of recognition, valuation, and classification apply to
this transaction:
CASH SUPPLIES
Dr. Cr. Dr. Cr.
June 1 1,000 June 1 1,000
LO1 Classification of Accounts
SE 3. Tell whether each of the following accounts is an asset, a liability, a revenue,
an expense, or none of these:
a. Accounts Payable
b. Supplies
c. Withdrawals
d. Fees Earned
e. Supplies Expense
f. Accounts Receivable
g. Unearned Revenue
h. Equipment
LO2 Normal Balances
SE 4. Tell whether the normal balance of each account in SE 3 is a debit or a
credit.
LO3 Transaction Analysis
SE 5. Leon Bear started a computer programming business, Bear’s Programming
Service. For each transaction that follows, indicate which account is debited and
which account is credited.
May 2 Leon Bear invested $5,000.
5 Purchased a computer for $2,500 in cash.
7 Purchased supplies on credit for $300.
19 Received cash for programming services performed, $500.
22 Received cash for programming services to be performed, $600.
25 Paid the rent for May, $650.
31 Billed a customer for programming services performed, $250.
82 CHAPTER 2 Analyzing Business Transactions
LO3 Recording Transactions in T Accounts
SE 6. Set up T accounts and record each transaction in SE 5. Determine the
balance of each account.
LO4 Preparing a Trial Balance
SE 7. From the T accounts created in SE 6, prepare a trial balance dated |
May 31, 2010.
LO5 Timing and Cash Flows
SE 8. Use the T account for Cash below to record the portion of each of the fol-
lowing transactions, if any, that affect cash. How do these transactions affect the
company’s liquidity?
CASH
Jan. 2 Provided services for cash, $1,200
4 Paid expenses in cash, $700
8 Provided services on credit, $1,100
9 Incurred expenses on credit, $800
SO6 Recording Transactions in the General Journal
SE 9. Prepare a general journal form like the one in Exhibit 2-4 and label it Page 4.
Record the following transactions in the journal:
Sept. 6 Billed a customer for services performed, $3,800.
16 R eceived partial payment from the customer billed on
Sept. 6, $1,800.
SO6 Posting to the Ledger Accounts
SE 10. Prepare ledger account forms like the ones in Exhibit 2-5 for the fol-
lowing accounts: Cash (111), Accounts Receivable (113), and Service Revenue
(411). Post the transactions that are recorded in SE 9 to the ledger accounts for
2011, at the same time making the proper posting references. Also prepare a trial
balance.
SO6 Recording Transactions in the General Journal
SE 11. Record the transactions in SE 5 in the general journal for 2011.
Exercises
LO1 LO2 Discussion Questions
LO3
E 1. Develop a brief answer to each of the following questions.
1. Which is the most important issue in recording a transaction: recognition,
valuation, or classification?
2. What is an example of how a company could make false financial statements
through a violation of the recognition concept?
3. How are assets and expenses related, and why are the debit and credit effects
for assets and expenses the same?
4. In what way are unearned revenues the opposite of prepaid expenses?
LO4 LO5 Discussion Questions
SO6
E 2. Develop a brief answer to each of the following questions.
1. Which account would be most likely to have an account balance that is not
normal?
Chapter Assignments 83
2. A company incurs a cost for a part that is needed to repair a piece of equip-
ment. Is the cost an asset or an expense? Explain.
3. If a company’s cash flows for expenses temporarily exceed its cash flows from
revenues, how might it make up the difference so that it can maintain liquidity?
4. How would the asset accounts in the chart of accounts for Miller Design Stu-
dio differ if it were a retail company that sold promotional products instead
of a service company?
LO1 Recognition
E 3. Which of the following events would be recognized and recorded in the
accounting records of Villa Company on the date indicated?
Jan. 15 Villa Company offers to purchase a tract of land for $140,000.
There is a high likelihood that the offer will be accepted.
Feb. 2 Villa Company receives notice that its rent will increase from
$500 to $600 per month effective March 1.
Mar.2 9 Villa Company receives its utility bill for the month of March.
The bill is not due until April 9.
June 10 Villa Company places an order for new office equipment costing
$21,000.
July 6 The office equipment Villa Company ordered on June 10 arrives.
Payment is not due until August 1.
LO1 Application of Recognition Point
E 4. Torez Flower Shop uses a large amount of supplies in its business. The fol-
lowing table summarizes selected transaction data for supplies that Torez Flower
Shop purchased:
Order Date Shipped Date Received Amount
a June 26 July 5 $300
b July 10 15 750
c 16 22 400
d 23 30 600
e 27 Aug. 1 750
f Aug. 3 7 500
Determine the total purchases of supplies for July alone under each of the follow-
ing assumptions:
1. Torez Flower Shop recognizes purchases when orders are shipped.
2. Torez Flower Shop recognizes purchases when orders are received.
LO2 T Accounts, Normal Balance, and the Accounting Equation
E 5. You are given the following list of accounts with dollar amounts:
Rent Expense $ 450
Cash 1,725
Service Revenue 750
M. Powell, Withdrawals 375
Accounts Payable 600
M. Powell, Capital 1,200
Insert each account name at the top of its corresponding T account and enter the
dollar amount as a normal balance in the account. Then show that the accounting
equation is in balance. |
84 CHAPTER 2 Analyzing Business Transactions
Owner’s Equity
Assets Liabilities M. Powell, M. Powell, Revenues Expenses
Capital Withdrawals
LO2 Classification of Accounts
E 6. The following ledger accounts are for the Tuner Service Company:
a. Cash m. Fees Earned
b. Wages Expense n. R. Shuckman, Withdrawals
c. Accounts Receivable o. Wages Payable
d. R. Shuckman, Capital p. Unearned Revenue
e. Service Revenue q. Office Equipment
f. Prepaid Rent r. Rent Payable
g. Accounts Payable s. Notes Receivable
h. Investments in Securities t. Interest Expense
i. Land u. Notes Payable
j. Supplies Expense v. Supplies
k. Prepaid Insurance w. Interest Receivable
l. Utilities Expense x. Rent Expense
Complete the following table, using X’s to indicate each account’s classification
and normal balance (whether a debit or a credit increases the account).
Type of Account
Normal Balance
Owner’s Equity (increases balance)
R. Shuckman, R. Shuckman,
Item Asset Liability Capital W ithdrawals Revenue Expense Debit Credit
a. X X
LO3 Transaction Analysis
E 7. Analyze transactions a–g, following the example below.
a. Sarah Lopez invested $2,500 in cash to establish Sarah’s Beauty Parlor.
b. Paid two months’ rent in advance, $1,680.
c. Purchased supplies on credit, $120.
d. Received cash for barbering services, $700.
e. Paid for supplies purchased in c.
f. Paid utility bill, $72.
g. Withdrew $100 in cash.
Example
a. The asset account Cash was increased. Increases in assets are recorded by
debits. Debit Cash $2,500. A component of owner’s equity, S. Lopez, Capi-
tal, was increased. Increases in owner’s capital are recorded by credits. Credit
S. Lopez, Capital $2,500.
Chapter Assignments 85
LO3 Transaction Analysis
E 8. The following accounts are applicable to Dale’s Lawn Service, a company
that maintains condominium grounds:
1. Cash
2. Accounts Receivable
3. Supplies
4. Equipment
5. Accounts Payable
6. Lawn Services Revenue
7. Wages Expense
8. Rent Expense
Dale’s Lawn Service completed the following transactions:
Debit Credit
a. Paid for supplies purchased on credit last month. 5 1
b. Received cash from customers billed last month.
c. Made a payment on accounts payable.
d. Purchased supplies on credit.
e. Billed a client for lawn services.
f. Made a rent payment for the current month.
g. Received cash from customers for lawn services.
h. Paid employee wages.
i. Ordered equipment.
j. Received and paid for the equipment ordered in i.
Analyze each transaction and show the accounts affected by entering the corre-
sponding numbers in the appropriate debit or credit columns as shown in trans-
action a. Indicate no entry, if appropriate.
LO3 Recording Transactions in T Accounts
E 9. Open the following T accounts: Cash; Repair Supplies; Repair Equipment;
Accounts Payable; T. Ornega, Capital; Withdrawals; Repair Fees Earned; Sala-
ries Expense; and Rent Expense. Record the following transactions for the
month of June directly in the T accounts; use the letters to identify the trans-
actions in your T accounts. Determine the balance in each account.
a. Tony Ornega opened Ornega Repair Service by investing $4,300 in cash and
$1,600 in repair equipment.
b. Paid $800 for the current month’s rent.
c. Purchased repair supplies on credit, $1,100.
d. Purchased additional repair equipment for cash, $600.
e. Paid salary to a helper, $900.
f. Paid $400 of amount purchased on credit in c.
g. Accepted cash for repairs completed, $3,720.
h. Withdrew $1,000 in cash.
LO4 Trial Balance
E 10. After recording the transactions in E 9, prepare a trial balance in proper
sequence for Ornega Repair Service as of June 30, 2011.
86 CHAPTER 2 Analyzing Business Transactions
LO3 Analysis of Transactions
E 11. Explain each transaction (a–h) entered in the following T accounts:
CASH ACCOUNTS RECEIVABLE EQUIPMENT
a. 20,000 b. 7,500 c. 4,000 g. 750 b. 7,500 h. 450
g. 750 e. 1,800 d. 4,500
h. 450 f. 2,250
ACCOUNTS PAYABLE B. CALDWELL, CAPITAL SERVICE REVENUE
f. 2,250 d. 4,500 a. 20,000 c. 4,000
WAGES EXPENSE
e. 1,800
LO4 Preparing a Trial Balance
E 12. The list that follows presents the accounts (in alphabetical order) of the |
Dymarski Company as of March 31, 2011. The list does not include the amount
of Accounts Payable.
Accounts Payable ?
Accounts Receivable $ 2,800
Building 20,400
Cash 5,400
K. Dymarski, Capital 18,870
Equipment 7,200
Land 3,120
Notes Payable 10,000
Prepaid Insurance 660
Prepare a trial balance with the proper heading (see Exhibit 2-2) and with the
accounts listed in the chart of accounts sequence (see Exhibit 2-3). Compute the
balance of Accounts Payable.
LO4 Effects of Errors on a Trial Balance
E 13. Which of the following errors would cause a trial balance to have unequal
totals? Explain your answers.
a. A payment to a creditor was recorded as a debit to Accounts Payable for
$129 and as a credit to Cash for $102.
b. A payment of $150 to a creditor for an account payable was debited to
Accounts Receivable and credited to Cash.
c. A purchase of office supplies of $420 was recorded as a debit to Office Sup-
plies for $42 and as a credit to Cash for $42.
d. A purchase of equipment for $450 was recorded as a debit to Supplies for
$450 and as a credit to Cash for $450.
LO4 Correcting Errors in a Trial Balance
E 14. The trial balance for Marek Services at the end of July 2011 appears at the
top of the opposite page. It does not balance because of a number of errors.
Marek’s accountant compared the amounts in the trial balance with the ledger,
recomputed the account balances, and compared the postings. He found the fol-
lowing errors:
a. The balance of Cash was understated by $800.
b. A cash payment of $420 was credited to Cash for $240.
c. A debit of $120 to Accounts Receivable was not posted.
d. Supplies purchased for $60 were posted as a credit to Supplies.
e. A debit of $180 to Prepaid Insurance was not posted.
Chapter Assignments 87
Marek Services
Trial Balance
July 31, 2011
Cash $ 3,440
Accounts Receivable 5,660
Supplies 120
Prepaid Insurance 180
Equipment 7,400
Accounts Payable $ 4,540
T. Marek, Capital 10,560
T. Marek, Withdrawals 700
Revenues 5,920
Salaries Expense 2,600
Rent Expense 600
Advertising Expense 340
Utilities Expense 26
$20,366 $21,720
f. The Accounts Payable account had debits of $5,320 and credits of $9,180.
g. The Notes Payable account, with a credit balance of $2,400, was not
included on the trial balance.
h. The debit balance of T. Marek, Withdrawals was listed in the trial balance as
a credit.
i. A $200 debit to T. Marek, Withdrawals was posted as a credit.
j. The actual balance of Utilities Expense, $260, was listed as $26 in the trial
balance.
Prepare a corrected trial balance.
LO5 Cash Flow Analysis
E 15. A company engaged in the following transactions:
Dec. 1 Performed services for cash, $750.
1 Paid expenses in cash, $550.
2 Performed services on credit, $900.
3 Collected on account, $600.
4 Incurred expenses on credit, $650.
5 Paid on account, $350.
Enter the correct titles on the following T accounts and enter the above transac-
tions in the accounts. Determine the cash balance after these transactions, the
amount still to be received, and the amount still to be paid.
Cash Sale Cash Purchase
Credit Purchase
Credit Collection on Payment on
Sale Account Account
SO6 Recording Transactions in the General Journal
E 16. Record the transactions in E 9 in the general journal.
88 CHAPTER 2 Analyzing Business Transactions
LO3 SO6 Analysis of Unfamiliar Transactions
E 17. Managers and accountants often encounter transactions with which they
are unfamiliar. Use your analytical skills to analyze and record in journal form
the following transactions, which have not yet been discussed in the text.
May 1 Purchased merchandise inventory on account, $1,200.
2 Purchased marketable securities for cash, $3,000.
3 Returned part of merchandise inventory purchased for full
credit, $250.
4 Sold merchandise inventory on account, $800 (record sale only).
5 Purchased land and a building for $300,000. Payment is $60,000
cash, and there is a 30-year mortgage for the remainder. The
purchase price is allocated as follows: $100,000 to the land and
$200,000 to the building.
6 Received an order for $12,000 in services to be provided. With |
the order was a deposit of $3,500.
SO6 Recording Transactions in the General Journal and Posting
to the Ledger Accounts
E 18. Open a general journal form like the one in Exhibit 2-4, and label it Page 10.
After opening the form, record the following transactions in the journal:
Dec. 14 P urchased equipment for $6,000, paying $2,000 as a cash down
payment.
28 Paid $3,000 of the amount owed on the equipment.
Prepare three ledger account forms like the one shown in Exhibit 2-5. Use the
following account numbers: Cash, 111; Office Equipment, 146; and Accounts
Payable, 212. Then post the two transactions from the general journal to the
ledger accounts, being sure to make proper posting references. Assume that
the Cash account has a debit balance of $8,000 on the day prior to the first
transaction.
Problems
LO2 T Accounts, Normal Balance, and The Accounting Equation
P 1. Delux Design Company creates radio and television advertising for local
businesses in the twin cities. The following alphabetical list shows Delux Design’s
account balances as of January 31, 2011:
Accounts Payable $ 3,210
Accounts Receivable 39,000
Cash 9,200
Design Revenue 105,000
Equipment ?
J. Smith, Capital 37,000
J. Smith, Withdrawals 18,000
Loans Payable 5,000
Rent Expense 5,940
Telephone Expense 480
Unearned Revenue 9,000
Wages Expense 62,000
Chapter Assignments 89
Required
Insert the account title at the top of its corresponding T account and enter the
dollar amount as a normal balance in the account. Determine the balance of
Equipment and then show that the accounting equation is in balance.
Owner’s Equity
Assets (cid:2) Liabilities (cid:3) J. Smith, (cid:4) J. Smith, (cid:3) Revenues (cid:4) Expenses
Capital Withdrawals
LO3 Transaction Analysis
P 2. The following accounts are applicable to Tom’s Warehouse Sweeps:
1. Cash 7. Accounts Payable
2. Accounts Receivable 8. T. Henzel, Capital
3. Supplies 9. T. Henzel, Withdrawals
4. Prepaid Insurance 10. Service Revenue
5. Equipment 11. Rent Expense
6. Notes Payable 12. Repair Expense
Tom’s Warehouse Sweeps completed the following transactions:
Debit Credit
7 1
a. Paid for supplies purchased on credit last month.
b. Billed customers for services performed.
c. Paid the current month’s rent.
d. Purchased supplies on credit.
e. Received cash from customers for services
performed but not yet billed.
f. Purchased equipment on account.
g. Received a bill for repairs.
h. Returned part of the equipment purchased in
f for a credit.
i. Received payments from customers previously
billed.
j. Paid the bill received in g.
k. Received an order for services to be performed.
l. Paid for repairs with cash.
m. Made a payment to reduce the principal of the
note payable.
n. Made a cash withdrawal.
90 CHAPTER 2 Analyzing Business Transactions
Required
Analyze each transaction and show the accounts affected by entering the
corresponding numbers in the appropriate debit or credit column as shown in
transaction a. Indicate no entry, if appropriate.
LO3 LO4 Transaction Analysis, T Accounts, and Trial Balance
LO5
P 3. C armen Dahlen opened a secretarial school called Star Office Training.
a. Dahlen contributed the following assets to the business:
Cash $5,700
Computers 5,000
Office Equipment 3,600
b. Found a location for her business and paid the first month’s rent, $260.
c. Paid for an advertisement announcing the opening of the school, $190.
d. Received applications from three students for a four-week secretarial pro-
gram and two students for a ten-day keyboarding course. The students will
be billed a total of $1,300.
e. Purchased supplies on credit, $330.
f. Billed the enrolled students, $2,040.
g. Purchased a second-hand computer, $480, and office equipment, $380, on
credit.
h. Paid for the supplies purchased on credit in e, $330.
i. Paid cash to repair a broken computer, $40.
j. Received partial payment from students previously billed, $1,380.
k. Paid the utility bill for the current month, $90.
l. Paid an assistant one week’s salary, $440.
m. Made a cash withdrawal of $300.
Required
1. Set up the following T accounts: Cash; Accounts Receivable; Supplies; Com- |
puters; Office Equipment; Accounts Payable; C. Dahlen, Capital; C. Dahlen,
Withdrawals; Tuition Revenue; Salaries Expense; Utilities Expense; Rent
Expense; Repair Expense; and Advertising Expense.
2. Record the transactions directly in the T accounts, using the transaction let-
ter to identify each debit and credit.
3. Prepare a trial balance using today’s date.
User insight (cid:2) 4. Examine transactions f and j. What were the revenues, and how much cash
was received from the revenues? What business issues might you see arising
from the differences in these numbers?
LO1 LO3 Transaction Analysis, Journal Form, T Accounts, and Trial Balance
LO4
P 4. Melvin Patel bid for and won a concession to rent bicycles in the local park
during the summer. During the month of June, Patel completed the following
transactions for his bicycle rental business:
June 2 Began business by placing $7,200 in a business checking account
in the name of the company.
3 Purchased supplies on account for $150.
4 Purchased 10 bicycles for $2,500, paying $1,200 down and
agreeing to pay the rest in 30 days.
Chapter Assignments 91
June 5 Paid $2,900 in cash for a small shed to store the bicycles and to
use for other operations.
8 Paid $400 in cash for shipping and installation costs (considered
an addition to the cost of the shed) to place the shed at the park
entrance.
9 Hired a part-time assistant to help out on weekends at
$7 per hour.
10 Paid a maintenance person $75 to clean the grounds.
13 Received $970 in cash for rentals.
17 Paid $150 for the supplies purchased on June 3.
18 Paid a $55 repair bill on bicycles.
23 Billed a company $110 for bicycle rentals for an employee outing.
25 Paid the $100 fee for June to the Park District for the right to
operate the bicycle concession.
27 Received $960 in cash for rentals.
29 Paid the assistant $240.
30 Made a cash withdrawal of $500.
Required
1. Prepare entries to record these transactions in journal form.
2. Set up the following T accounts and post all the journal entries: Cash;
Accounts Receivable; Supplies; Shed; Bicycles; Accounts Payable; M. Patel,
Capital; M. Patel, Withdrawals; Rental Revenue; Wages Expense; Mainte-
nance Expense; Repair Expense; and Concession Fee Expense.
3. Prepare a trial balance for Patel Rentals as of June 30, 2011.
User insight (cid:2) 4. Compare and contrast how the issues of recognition, valuation, and classifi-
cation are settled in the transactions of June 3 and 10.
LO3 LO4 Transaction Analysis, General Journal, Ledger Accounts, and Trial Balance
LO5 SO6
P 5. Alpha Pro Company is a marketing firm. The company’s trial balance on
July 31, 2011, appears below.
Alpha Pro Company
Trial Balance
July 31, 2011
Cash (111) $10,590
Accounts Receivable (113) 5,500
Office Supplies (116) 610
Office Equipment (146) 4,200
Accounts Payable (212) $ 2,600
K. Yating, Capital (311) 18,300
$20,900 $20,900
During the month of August, the company completed the following transactions:
92 CHAPTER 2 Analyzing Business Transactions
Aug. 2 Paid rent for August, $650.
3 Received cash from customers on account, $2,300.
7 Ordered supplies, $380.
10 Billed customers for services provided, $2,800.
12 Made a payment on accounts payable, $1,300.
14 Received the supplies ordered on August 7 and agreed to pay for
them in 30 days, $380.
17 Discovered some of the supplies were not as ordered and
returned them for full credit, $80.
19 Received cash from a customer for services provided, $4,800.
24 Paid the utility bill for August, $250.
26 Received a bill, to be paid in September, for advertisements
placed in the local newspaper during the month of August to
promote Alpha Pro Company, $700.
29 Billed a customer for services provided, $2,700.
30 Paid salaries for August, $3,800.
31 Made a cash withdrawal of $1,200.
Required
1. Open accounts in the ledger for the accounts in the trial balance plus the
following accounts: K. Yating, Withdrawals (313); Marketing Fees (411);
Salaries Expense (511); Rent Expense (514); Utilities Expense (512); and
Advertising Expense (516).
2. Enter the July 31, 2011, account balances from the trial balance. |
3. Enter the August transactions in the general journal (Pages 22 and 23).
4. Post the journal entries to the ledger accounts. Be sure to make the appropri-
ate posting references in the journal and ledger as you post.
5. Prepare a trial balance as of August 31, 2011.
User insight (cid:2) 6. Examine the transactions for August 3, 10, 19, and 29. What were the rev-
enues, and how much cash was received from the revenues? What business
issues might you see arising from the differences in these numbers?
Alternate Problems
LO2 T Accounts, Normal Balance, and the Accounting Equation
P 6. The Stewart Construction Company builds foundations for buildings and
parking lots. The following alphabetical list shows Stewart Construction’s account
balances as of April 30, 2011:
A. Stewart, Capital $20,000
A. Stewart, Withdrawals 3,500
Accounts Payable 1,950
Accounts Receivable 5,060
Cash ?
Equipment 13,750
Notes Payable 10,000
Revenue Earned 8,700
Supplies 3,250
Supplies Expense 3,600
Utilities Expense 210
Wages Expense 4,400
Chapter Assignments 93
Required
Insert the account at the top of its corresponding T account, and enter the dollar
amount as a normal balance in the account. Determine the balance of cash and
then show that the accounting equation is in balance.
Owner’s Equity
Assets (cid:2) Liabilities (cid:3) A. Stewart, (cid:4) A. Stewart, (cid:3) Revenues (cid:4) Expenses
Capital Withdrawals
LO1 LO3 Transaction Analysis, T Accounts, and Trial Balances
LO4
P 7. Brad Cupello began an upholstery cleaning business on October 1 and
engaged in the following transactions during the month:
Oct. 1 Began business by depositing $15,000 in a bank account in the
name of the company.
2 Ordered cleaning supplies, $3,000.
3 Purchased cleaning equipment for cash, $2,800.
4 Made two months’ van lease payment in advance, $1,200.
7 Received the cleaning supplies ordered on October 2 and agreed
to pay half the amount in 10 days and the rest in 30 days.
9 Paid for repairs on the van with cash, $1,080.
12 Received cash for cleaning upholstery, $960.
17 Paid half the amount owed on supplies purchased on
October 7, $1,500.
21 Billed customers for cleaning upholstery, $1,340.
24 Paid cash for additional repairs on the van, $80.
27 Received $600 from the customers billed on October 21.
31 Made a cash withdrawal of $700.
Required
1. Set up the following T accounts: Cash; Accounts Receivable; Cleaning Sup-
plies; Prepaid Lease; Cleaning Equipment; Accounts Payable; B. Cupello,
Capital; B. Cupello, Withdrawals; Cleaning Revenue; and Repair Expense.
2. Record transactions directly in the T accounts. Identify each entry by date.
3. Prepare a trial balance for Cupello Upholstery Cleaning as of October 31,
2011.
User insight (cid:2) 4. Compare and contrast how the issues of recognition, valuation, and classifi-
cation are settled in the transactions of October 7 and 9.
94 CHAPTER 2 Analyzing Business Transactions
LO3 LO4 Transaction Analysis, General Journal, Ledger Accounts, and Trial Balance
LO5 SO6 P 8. The Golden Nursery School Company provides baby-sitting and child-care
programs. On January 31, 2011, the company had the following trial balance:
Golden Nursery School Company
Trial Balance
January 31, 2011
Cash (111) $ 2,070
Accounts Receivable (113) 1,700
Equipment (146) 1,040
Buses (148) 17,400
Notes Payable (211) $15,000
Accounts Payable (212) 1,640
T. Kuo, Capital (311) 5,570
$22,210 $22,210
During the month of February, the company completed the following
transactions:
Feb. 2 Paid this month’s rent, $400.
3 Received fees for this month’s services, $650.
4 Purchased supplies on account, $85.
5 Reimbursed the bus driver for gas expenses, $40.
6 Ordered playground equipment, $1,000.
8 Made a payment on account, $170.
9 Received payments from customers on account, $1,200.
10 Billed customers who had not yet paid for this month’s
services, $700.
11 Paid for the supplies purchased on February 4.
13 Purchased and received playground equipment ordered on
February 6 for cash, $1,000.
17 Purchased equipment on account, $290.
19 Paid this month’s utility bill, $145. |
22 Received payment for one month’s services from customers
previously billed, $500.
26 Paid part-time assistants for services, $460.
27 Purchased gas and oil for the bus on account, $325.
28 Made a cash withdrawal of $200.
Required
1. Open accounts in the ledger for the accounts in the trial balance plus the fol-
lowing ones: Supplies (116); T. Kuo, Withdrawals (313); Service Revenue
(411); Rent Expense (514); Gas and Oil Expense (510); Wages Expense
(511); and Utilities Expense (512).
2. Enter the January 31, 2011, account balances from the trial balance.
3. Enter the above transactions in the general journal (Pages 17 and 18).
4. Post the entries to the ledger accounts. Be sure to make the appropriate post-
ing references in the journal and ledger as you post.
5. Prepare a trial balance as of February 28, 2011.
User insight (cid:2) 6. Examine the transactions for February 3, 9, 10, and 22. What were the rev-
enues, and how much cash was received from the revenues? What business
issue might you see arising from the differences in these numbers?
Chapter Assignments 95
LO3 Transaction Analysis
P 9. The following accounts are applicable to Walter’s Chimney Sweeps:
1. Cash
2. Accounts Receivable
3. Supplies
4. Prepaid Insurance
5. Equipment
6. Notes Payable
7. Accounts Payable
8. W. Norman, Capital
9. W. Norman, Withdrawals
10. Service Revenue
11. Rent Expense
12. Repair Expense
Walter’s Chimney Sweeps completed the following transactions:
Debit Credit
a. Paid for supplies purchased on credit last month. 7 1
b. Billed customers for services performed.
c. Paid the current month’s rent.
d. Purchased supplies on credit.
e. Received cash from customers for services
performed but not yet billed.
f. Purchased equipment on account.
g. Received a bill for repairs.
h. Returned part of the equipment purchased in f for
a credit.
i. Received payments from customers previously billed.
j. Paid the bill received in g.
k. Received an order for services to be performed.
l. Paid for repairs with cash.
m. M ade a payment to reduce the principal of the
note payable.
n. Made a cash withdrawal.
Required
Analyze each transaction and show the accounts affected by entering the corre-
sponding numbers in the appropriate debit or credit column as shown in transac-
tion a. Indicate no entry, if appropriate.
LO3 LO4 Transaction Analysis, T Accounts, and Trial Balance
LO5
P 10. Bob Lutz opened a secretarial school called Best Secretarial Training.
a. Lutz contributed the following assets to the business:
Cash $5,700
Computers 4,300
Office Equipment 3,600
b. Found a location for his business and paid the first month’s rent, $260.
c. Paid for an advertisement announcing the opening of the school, $190.
d. Received applications from three students for a four-week secretarial
program and two students for a ten-day keyboarding course. The students
will be billed a total of $1,300.
e. Purchased supplies on credit, $330.
f. Billed the enrolled students, $1,740.
96 CHAPTER 2 Analyzing Business Transactions
g. Purchased a second-hand computer, $480, and office equipment, $380, on credit.
h. Paid for the supplies purchased on credit in e, $330.
i. Paid cash to repair a broken computer, $40.
j. Received partial payment from students previously billed, $1,080.
k. Paid the utility bill for the current month, $90.
l. Paid an assistant one week’s salary, $440.
m. Made a cash withdrawal of $300.
Required
1. Set up the following T accounts: Cash; Accounts Receivable; Supplies; Com-
puters; Office Equipment; Accounts Payable; B. Lutz, Capital; B. Lutz,
Withdrawals; Tuition Revenue; Salaries Expense; Utilities Expense; Rent
Expense; Repair Expense; and Advertising Expense.
2. Record the transactions directly in the T accounts, using the transaction let-
ter to identify each debit and credit.
3. Prepare a trial balance using today’s date.
User insight (cid:2) 4. Examine transactions f and j. What were the revenues and how much cash
was received from the revenues? What business issues might you see arising
from the differences in these numbers?
ENHANCING Your Knowledge, Skills, and Critical Thinking |
LO1 Valuation Issue
C 1. Nike, Inc. manufactures athletic shoes and related products. In one of its
annual reports, Nike made this statement: “Property, plant, and equipment are
recorded at cost.”6 Given that the property, plant, and equipment undoubtedly
were purchased over several years and that the current value of those assets is
likely to be very different from their original cost, what authoritative basis is there
for carrying the assets at cost? Does accounting generally recognize changes in
value after the purchase of property, plant, and equipment? Assume you are an
accountant for Nike. Write a memo to management explaining the rationale
underlying Nike’s approach.
LO5 Cash Flows
C 2. You have been promoted recently and now have access to the firm’s monthly
financial statements. Business is good. Revenues are increasing rapidly, and
income is at an all-time high. The balance sheet shows growth in receivables, and
accounts payable have declined. However, the chief financial officer is concerned
about the firm’s cash flows from operating activities because they are decreasing.
What are some reasons why a company with a positive net income may fall short
of cash from its operating activities? What could be done to improve this situa-
tion?
LO1 Recognition Point and Ethical Considerations
C 3. Jerry Hasbrow, a sales representative for Penn Office Supplies Company,
is compensated on a commission basis and receives a substantial bonus if he
Chapter Assignments 97
meets his annual sales goal. The company’s recognition point for sales is the day of
shipment. On December 31, Hasbrow realizes he needs sales of $2,000 to reach
his sales goal and receive the bonus. He calls a purchaser for a local insurance
company, whom he knows well, and asks him to buy $2,000 worth of copier paper
today. The purchaser says, “But Jerry, that’s more than a year’s supply for us.”
Hasbrow says, “Buy it today. If you decide it’s too much, you can return however
much you want for full credit next month.” The purchaser says, “Okay, ship it.”
The paper is shipped on December 31 and recorded as a sale. On January 15, the
purchaser returns $1,750 worth of paper for full credit (approved by H asbrow)
against the bill. Should the shipment on December 31 be recorded as a sale?
Discuss the ethics of Hasbrow’s action.
LO1 LO3 Valuation and Classification Issues for Dot-Coms
C 4. The dot-com business has raised many issues about accounting practices, some
of which are of great concern to both the SEC and the FASB. Important ones
relate to the valuation and classification of revenue transactions. Many dot-com
companies seek to report as much revenue as possible because revenue growth is
seen as a key performance measure for these companies. Amazon.com is a good
example. Consider the following situations:
a. An Amazon.com customer orders and pays $28 for a video game on the
Internet. Amazon sends an email to the company that makes the product,
which sends the video game to the customer. Amazon collects $28 from the
customer and pays $24 to the other company. Amazon never owns the
video game.
b. Amazon agrees to place a banner advertisement on its website for another
dot-com company. Instead of paying cash for the advertisement, the other
company agrees to let Amazon advertise on its website.
c. Assume the same facts as in situation b except that Amazon agrees to accept
the other company’s common stock in this barter transaction. Over the next
six months, the price of that stock declines.
Divide the class into three groups. Assign each group one of the above situations.
Each group should discuss the valuation and classification issues that arise in the
assigned situation, including how Amazon should account for each transaction.
LO1 Recognition, Valuation, and Classification
C 5. Refer to the Summary of Significant Accounting Policies in the notes to
the financial statements in the CVS Corporation annual report at the end of
Chapter 5 to answer these questions:
1. How does the concept of recognition apply to advertising costs? |
2. How does the concept of valuation apply to inventories?
3. How does the concept of classification apply to cash and cash equivalents?
Revenue Recognition
C 6. Refer to the financial statements of CVS and Southwest Airlines Co. in the
Supplement to Chapter 5. What is the total revenue for CVS and Southwest on
the respective income statements? How do you think the nature of each business
will affect revenue recognition for prescriptions filled for CVS versus airline tick-
ets for Southwest? When do you think cash is received and revenues are earned
for each company?
C H A P T E R
3 Measuring Business
Income
Making a I ncome, or earnings, is the most important measure of a com-
Statement pany’s success or failure. Thus, the incentive to manage, or mis-
state, earnings by manipulating the numbers can be powerful, and
INCOME STATEMENT
because earnings are based on estimates, manipulation can be easy.
Revenues
For these reasons, ethical behavior is extremely important when
– Expenses
measuring business income.
= Net Income
LEARNING OBJECTIVES
STATEMENT OF
OWNER’S EQUITY LO1 Define net income, and explain the assumptions underlying
income measurement and their ethical application. (pp. 100–104)
Beginning Balance
+ Net Income LO2 Define accrual accounting, and explain how it is
– Withdrawals accomplished. (pp. 104–106)
= Ending Balance LO3 Identify four situations that require adjusting entries, and
illustrate typical adjusting entries. (pp. 107–116)
BALANCE SHEET
LO4 Prepare financial statements from an adjusted trial
Assets Liabilities
balance. (pp. 116–119)
Owner’s LO5 Use accrual-based information to analyze cash flows.
Equity
(pp. 119–120)
A = L + OE
STATEMENT OF CASH FLOWS
Operating activities
+ Investing activities
+ Financing activities
= Change in Cash
+ Beginning Balance
= Ending Cash Balance
Adjusting entries affect the
balance sheet and income
statement but not the
statement of cash flows.
98
DECISION POINT (cid:2) A USER’S FOCUS
(cid:2) What assumptions must Reliable
RELIABLE ANSWERING Answering Service make to
SERVICE account for transactions that
span accounting periods?
Reliable Answering Service takes telephone messages for doctors, (cid:2) How does Reliable assign its
revenues and expenses to the
lawyers, and other professionals and relays them immediately when
proper accounting period so
they involve an emergency. At the end of any accounting period,
that net income is properly
Reliable has many transactions that will affect future periods. Exam-
measured?
ples appear in the company’s trial balance on the following page.
(cid:2) Why are the adjustments that
They include office supplies and prepaid expenses, which, though paid
these transactions require
in the period just ended, will benefit future periods and are there-
important to Reliable’s financial
fore recorded as assets. Another example is unearned revenue, which performance?
represents receipts for services the company will not perform and
earn until a future period. If prepaid expenses and unearned revenue
are not accounted for properly at the end of a period, the company’s
income will be misstated. Similar misstatements can occur when a
company fails to record (accrue) expenses that it incurred or revenue
that it has earned but not yet received. Knowing the answers to the
questions at right will help prevent such misstatements.
9999
100 CHAPTER 3 Measuring Business Income
Profitability
As you know, profitability and liquidity are the two major goals of a business. For
Measurement: a business to succeed, or even to survive, it must earn a profit. Profit, however,
means different things to different people. Accountants prefer to use the term net
Issues and Ethics
income because it can be precisely defined from an accounting point of view as
the net increase in owner’s equity that results from a company’s operations.
LO1 Define net income, and Net income is reported on the income statement, and management, owners,
explain the assumptions under- and others use it to measure a company’s progress in meeting the goal of profitabil-
lying income measurement and ity. Readers of income statements need to understand what net income means and |
their ethical application. be aware of its strengths and weaknesses as a measure of a company’s performance.
Net Income
Net income is accumulated in the owner’s Capital account. In its simplest form,
it is measured as the difference between revenues and expenses when revenues
exceed expenses:
Net Income (cid:2) Revenues (cid:4) Expenses
Study Note
WWhen expenses exceed revenues, a net loss occurs.
The essence of revenue is that
Revenues are increases in owner’s equity resulting from selling goods, render-
something has been earned
iing services, or performing other business activities. When a business delivers a
through the sale of goods
pproduct or provides a service to a customer, it usually receives cash or is prom-
or services. That is why cash
iised that it will receive cash in the near future. The amount of cash promised is
received through a loan does
rrecorded in either Accounts Receivable or Notes Receivable. The total of these
not constitute revenue.
aaccounts and the total cash received from customers in an accounting period are
tthe company’s revenues for that period.
Profitability Measurement: Issues and Ethics 101
Expenses are decreases in owner’s equity resulting from the cost of selling
Study Note
ggoods or rendering services and the cost of the activities necessary to carry on a
bbusiness, such as attracting and serving customers. In other words, expenses are
The primary purpose of an
tthe cost of the goods and services used in the course of earning revenues. Exam-
expense is to generate revenue.
pples include salaries expense, rent expense, advertising expense, utilities expense,
aand depreciation (allocation of cost) of a building or office equipment. These
expenses are often called the cost of doing business or expired costs.
Not all increases in owner’s equity arise from revenues, nor do all decreases in
owner’s equity arise from expenses. Owner’s investments increase owner’s equity but
are not revenues, and withdrawals decrease owner’s equity but are not expenses.
Income Measurement Assumptions
Users of financial reports should be aware that estimates and assumptions play a
major role in the measurement of net income and other key indicators of perfor-
mance. The management of Netflix, the online movie rental company, acknowl-
edges this in its annual report, as follows:
The preparation of . . . financial statements in conformity with generally
accepted accounting principles in the United States requires management to
make estimates and assumptions that affect the reported amounts of assets
and liabilities, . . . and the reported amount of revenues and expenses.1
The major assumptions made in measuring business income have to do with con-
tinuity, periodicity, and matching.
Continuity Measuring business income requires that certain expense and reve-
nue transactions be allocated over several accounting periods. Choosing the num-
ber of accounting periods raises the issue of continuity. What is the expected life
of the business? Many businesses last less than five years, and in any given year,
thousands of businesses go bankrupt. The majority of companies present annual
financial statements on the assumption that the business will continue to oper-
ate indefinitely—that is, that the company is a going concern. The continuity
assumption is as follows:
Unless there is evidence to the contrary, the accountant assumes that the
business will continue to operate indefinitely.
Justification for all the techniques of income measurement rests on the
assumption of continuity. Consider, for example, the value of assets on the bal-
ance sheet. The continuity assumption allows the cost of certain assets to be held
on the balance sheet until a future accounting period, when the cost will become
an expense on the income statement.
When a firm is facing bankruptcy, the accountant may set aside the assump-
tion of continuity and prepare financial statements based on the assumption that
the firm will go out of business and sell all of its assets at liquidation value—that
is, for what they will bring in cash. |
Periodicity Measuring business income requires assigning revenues and
expenses to a specific accounting period. However, not all transactions can be eas-
ily assigned to specific periods. For example, when a company purchases a build-
ing, it must estimate the number of years the building will be in use. The portion
of the cost of the building that is assigned to each period depends on this estimate
and requires an assumption about periodicity. The assumption is as follows:
Although the lifetime of a business is uncertain, it is nonetheless useful to
estimate the business’s net income in terms of accounting periods.
102 CHAPTER 3 Measuring Business Income
FOCUS ON BUSINESS PRACTICE
Fiscal Years Vary
The fiscal years of many schools and governmental agen- Company Last Month of Fiscal Year
cies end on June 30 or September 30. The table at the right Apple Computer September
shows the last month of the fiscal year of some well-known Caesars World July
companies.
Fleetwood Enterprises April
H.J. Heinz March
Kelly Services December
MGM-UA Communications August
Toys “R” Us January
Financial statements may be prepared for any time period, but generally, to
Study Note
make comparisons easier, the periods are of equal length. A 12-month account-
Accounting periods are of equal ing period is called a fiscal year; accounting periods of less than a year are called
length so that one period can interim periods. The fiscal year of many organizations is the calendar year, Janu-
be compared with the next. ary 1 to December 31. However, retailers often end their fiscal years during a
slack season, and in this case, the fiscal year corresponds to the yearly cycle of
business activity.
Matching To measure net income adequately, revenues and expenses must be
assigned to the accounting period in which they occur, regardless of when cash is
received or paid. This is an application of the matching rule:
Revenues must be assigned to the accounting period in which the goods are
sold or the services performed, and expenses must be assigned to the account-
ing period in which they are used to produce revenue.
In other words, expenses should be recognized in the same accounting period
as the revenues to which they are related. However, a direct cause-and-effect rela-
tionship between expenses and revenues is often difficult to identify. When there is
no direct means of connecting expenses and revenues, costs are allocated in a sys-
tematic way among the accounting periods that benefit from the costs. For example,
a building’s cost is expensed over the building’s expected useful life, and interest on
investments is recorded as income even though it may not have been received.
The cash basis of accounting differs from the matching rule in that it is the
practice of accounting for revenues in the period in which cash is received and
for expenses in the period in which cash is paid. Some individuals and businesses
use this method to account for income taxes. With this method, taxable income
is calculated as the difference between cash receipts from revenues and cash pay-
ments for expenses.
Although the cash basis of accounting works well for some small businesses
and many individuals, it does not meet the needs of most businesses.
Ethics and the Matching Rule
As shown in Figure 3-1, applying the matching rule involves making assumptions.
It also involves exercising judgment. Consider the assumptions and judgment
involved in estimating the useful life of a building. The estimate should be based
Profitability Measurement: Issues and Ethics 103
FIGURE 3-1
Assumptions and the Matching Rule NET INCOME
Revenues minus Expenses
MATCHING RULE
ASSUMPTIONS
Periodicity Going Concern
on realistic assumptions, but management has latitude in making that estimate,
and its judgment will affect the final net income that is reported.
The manipulation of revenues and expenses to achieve a specific outcome is
called earnings management. Research has shown that companies that manage
their earnings are much more likely to exceed projected earnings targets by a little |
than to fall short by a little. Why would management want to manage earnings to
keep them from falling short? It may want to
(cid:2) Meet a previously announced goal and thus meet the expectations of
the m arket.
(cid:2) Keep the company’s stock price from dropping.
(cid:2) Meet a goal that will enable it to earn bonuses.
(cid:2) Avoid embarrassment.
Earnings management, though not the best practice, is not illegal. However,
when the estimates involved in earnings management begin moving outside a
reasonable range, the financial statements become misleading. For instance, net
income is misleading when revenue is overstated or expenses are understated by
significant amounts. As noted earlier in the text, the preparation of financial state-
ments that are intentionally misleading constitutes fraudulent financial reporting.
Most of the enforcement actions that the Securities and Exchange Com-
mission has brought against companies in recent years involve misapplications
of the matching rule resulting from improper accrual accounting. For example,
FOCUS ON BUSINESS PRACTICE
Are Misstatements of Earnings Always Overstatements?
Not all misstatements of earnings are overstatements. For for understating its income. Microsoft, a very successful
instance, privately held companies, which do not have to company, accomplished this by overstating its unearned
be concerned about the effect of their earnings announce- revenue on the balance sheet. The company’s motive in
ments on owners or investors, may understate income to trying to appear less successful than it actually was may
reduce or avoid income taxes. In an unusual case involv- have been that it was facing government charges of being
ing a public company, the SEC cited and fined Microsoft a monopoly.2
104 CHAPTER 3 Measuring Business Income
Dell Computer had to restate four years of its financial results because senior
executives improperly applied accrual accounting to give the impression that the
company was meeting quarterly earnings targets. After the SEC action, the com-
pany conducted an internal investigation that resulted in many changes in its
accounting controls.3 In the rest of this chapter, we focus on accrual accounting
and its proper application.
STOP
& APPLY
Match the assumptions or actions with the concepts below:
_____ 1. I ncreases in owner’s equity resulting _____ 3. I ncrease in owner’s equity that
from selling goods, rendering ser- results from a company’s operations.
vices, or performing other business _____ 4. D ecreases in owner’s equity result-
activities ing from the cost of selling goods,
_____ 2. M anipulation of revenues and rendering services, and other busi-
expenses to achieve a specific ness activities.
change in owner’s equity
a. Net income b. Revenues c. Expenses d. Earnings management
SOLUTION
1. b; 2. d; 3. a; 4. c
Accrual Accrual accounting encompasses all the techniques accountants use to apply the
matching rule. In accrual accounting, revenues and expenses are recorded in the peri-
Accounting
ods in which they occur rather than in the periods in which they are received or paid.
Accrual accounting is accomplished in the following ways:
LO2 Define accrual account-
ing, and explain how it is 1. Recording revenues when they are earned.
accomplished.
2. Recording expenses when they are incurred.
3. Adjusting the accounts.
Recognizing Revenues
As you may recall, the process of determining when revenue should be recorded is
called revenue recognition. The Securities and Exchange Commission requires
that all the following conditions be met before revenue is recognized:4
(cid:2) Persuasive evidence of an arrangement exists.
(cid:2) A product or service has been delivered.
(cid:2) The seller’s price to the buyer is fixed or determinable.
(cid:2) Collectibility is reasonably assured.
For example, suppose Miller Design Studio has created a brochure for a cus-
tomer and that the transaction meets the SEC’s four criteria: Miller and the
Accrual Accounting 105
FOCUS ON BUSINESS PRACTICE
Revenue Recognition: Principles Versus Rules |
Revenue recognition highlights the differences between the other hand, has one broad IFRS for revenue recognition
international and U.S. accounting standards. Although U.S. and leaves it to companies and their auditors to determine
standards are referred to as generally accepted accounting how to apply the broad principle. As a result, revenue recog-
principles, the FASB has issued extensive rules for revenue nition is an issue that will provide a challenge to achieving
recognition in various situations and industries. The IASB, on international convergence of accounting practices.
customer agree that the customer owes for the service, the service has been
rendered, both parties understand the price, and there is a reasonable expec-
tation that the customer will pay the bill. When Miller bills the customer, it
records the transaction as revenue by debiting Accounts Receivable and credit-
ing Design Revenue. Note that revenue can be recorded even though cash has
not been collected; all that is required is a reasonable expectation that cash will
be received.
Recognizing Expenses
Expenses are recorded when there is an agreement to purchase goods or ser-
vices, the goods have been delivered or the services rendered, a price has been
established or can be determined, and the goods or services have been used to
produce revenue. For example, when Miller Design Studio receives its utility
bill, it recognizes the expense as having been incurred and as having helped pro-
duce revenue. Miller records this transaction by debiting Utilities Expense and
crediting Accounts Payable. Until the bill is paid, Accounts Payable serves as a
holding account. Note that recognition of the expense does not depend on the
payment of cash.
Adjusting the Accounts
Accrual accounting also involves adjusting the accounts. Adjustments are neces-
Study Note sary because the accounting period, by definition, ends on a particular day. The
balance sheet must list all assets and liabilities as of the end of that day, and the
Even though certain revenues
income statement must contain all revenues and expenses applicable to the period
and expenses theoretically
ending on that day. Although operating a business is a continuous process, there
change during the period,
must be a cutoff point for the periodic reports. Some transactions invariably span
there usually is no need to
the cutoff point, and some accounts therefore need adjustment.
adjust them until the end of
the period, when the financial As you can see in Exhibit 3-1, some of the accounts in Miller Design Studio’s
statements are prepared. trial balance as of July 31 do not show the correct balances for preparing the
financial statements. The trial balance lists prepaid rent of $3,200. At $1,600 per
month, this represents rent for the months of July and August. So, on July 31,
one-half of the $3,200 represents rent expense for July, and the remaining $1,600
represents an asset that will be used in August. An adjustment is needed to reflect
the $1,600 balance in the Prepaid Rent account on the balance sheet and the
$1,600 rent expense on the income statement.
As you will see, several other accounts in Miller Design Studio’s trial balance
do not reflect their correct balances. Like the Prepaid Rent account, they need to
be adjusted.
106 CHAPTER 3 Measuring Business Income
EXHIBIT 3-1
Trial Balance Miller Design Studio
Trial Balance
July 31, 2011
Cash $22,480
Accounts Receivable 4,600
Office Supplies 5,200
Prepaid Rent 3,200
Office Equipment 16,320
Accounts Payable $ 6,280
Unearned Design Revenue 1,400
J. Miller, Capital 40,000
J. Miller, Withdrawals 2,800
Design Revenue 12,400
Wages Expense 4,800
Utilities Expense 680
$60,080 $60,080
Adjustments and Ethics
Accrual accounting can be difficult to understand. The account adjustments take time
to calculate and enter in the records. Also, adjusting entries do not affect cash flows
in the current period because they never involve the Cash account. You might ask,
“Why go to all the trouble of making them? Why worry about them?” For one thing, |
the SEC has identified issues related to accrual accounting and adjustments as an area
of utmost importance because of the potential for abuse and misrepresentation.5
All adjustments are important because of their effect on performance measures
of profitability and liquidity. Adjusting entries affect net income on the income
statement, and they affect profitability comparisons from one accounting period
to the next. They also affect assets and liabilities on the balance sheet and thus
provide information about a company’s future cash inflows and outflows. This
information is needed to assess management’s performance in achieving sufficient
liquidity to meet the need for cash to pay ongoing obligations. The potential for
abuse arises because considerable judgment underlies the application of adjusting
entries. When this judgment is misused, performance measures can be misleading.
STOP
& APPLY
Four conditions must be met before revenue can be recognized. Identify which of these conditions
applies to the following actions:
a. Determines that the firm has a good credit rating. c. Performs services.
b. Agrees to a price for services before it p erforms d. Signs a contract to perform
them. services.
SOLUTION
a. Collectibility is reasonably assured. c. A product or service has been delivered.
b. The seller’s price to the buyer is fixed or determinable. d. Persuasive evidence of an arrangement exists.
The Adjustment Process 107
The Adjustment When transactions span more than one accounting period, accrual accounting
requires the use of adjusting entries. Figure 3-2 shows the four situations in
Process
which adjusting entries must be made. Each adjusting entry affects one balance
sheet account and one income statement account. As we have already noted,
LO3 Identify four situations
adjusting entries never affect the Cash account.
that require adjusting entries,
The four types of adjusting entries are as follows:
and illustrate typical adjusting
entries. Type 1. Allocating recorded costs between two or more accounting periods.
Examples of these costs are prepayments of rent, insurance, and supplies and the
depreciation of plant and equipment. The adjusting entry in this case involves an
asset account and an expense account.
Type 2. Recognizing unrecorded, incurred expenses. Examples of these expenses
are wages and interest that have been incurred but are not recorded during an
accounting period. The adjusting entry involves an expense account and a liabil-
ity account.
Type 3. Allocating recorded, unearned revenues between two or more account-
ing periods. Examples include cash received in advance and deposits made on
goods or services. The adjusting entry involves a liability account and a revenue
account.
Type 4. Recognizing unrecorded, earned revenues. An example is revenue that a
company has earned for providing a service but for which it has not billed or col-
lected a fee by the end of the accounting period. The adjusting entry involves an
asset account and a revenue account.
Adjusting entries are either deferrals or accruals.
Study Note
(cid:2) A deferral is the postponement of the recognition of an expense already paid
Adjusting entries provide
(Type 1 adjustment) or of revenue received in advance (Type 3 adjustment).
information about past or future
The cash payment or receipt is recorded before the adjusting entry is made.
cash flows but never involve an
entry to the Cash account. (cid:2) An accrual is the recognition of a revenue (Type 4 adjustment) or expense
(Type 2 adjustment) that has arisen but not been recorded during the
accounting period. The cash receipt or payment occurs in a future account-
ing period, after the adjusting entry has been made.
Type 1 Adjustment: Allocating Recorded Costs
(Deferred Expenses)
Companies often make expenditures that benefit more than one period. These
costs are debited to an asset account. At the end of an accounting period, the
FIGURE 3-2 BALANCE SHEET
The Four Types of Adjustments Asset Liability
I
N
C 1. Allocating recorded 2. Recognizing
O
costs between two unrecorded, incurred
M Expense |
or more accounting expenses.
E
periods.
S
T
A
4. Recognizing 3. Allocating recorded,
T
unrecorded, unearned revenues
E Revenue
M earned revenues. between two or more
E accounting periods.
N
T
108 CHAPTER 3 Measuring Business Income
When transactions span more than
one accounting period, an adjusting
entry is necessary. Depreciation of
plant and equipment, such as that
found in this warehouse, is a type of
transaction that requires an adjusting
entry. In this case, the adjusting entry
involves an asset account and an
expense account.
Courtesy of Timothy Babasade/
istockphoto.com.
amount of the asset that has been used is transferred from the asset account to an
expense account. Two important adjustments of this type are for prepaid expenses
and the depreciation of plant and equipment.
Prepaid Expenses Companies customarily pay some expenses, including
Study Note
those for rent, supplies, and insurance, in advance. These costs are called pre-
The expired portion of a paid expenses. By the end of an accounting period, a portion or all of prepaid
prepayment is converted to an services or goods will have been used or have expired. The required adjust-
expense; the unexpired portion ing entry reduces the asset and increases the expense, as shown in Figure 3-3.
remains an asset. The amount of the adjustment equals the cost of the goods or services used or
expired.
FIGURE 3-3
Adjustment for Prepaid (Deferred) Expenses
BALANCE SHEET
Asset
1. Allocating recorded costs between two or more accounting periods.
I
Asset Account Expense Account
N
C
O Adjusting Adjusting Liability
M Expense Entry Entry
E Credit Debit
2. Recognizing
S Amount equals cost unrecorded, incurred
T of goods or services
expenses.
A used up or expired.
T
E
M
E
4. Recognizing 3. Allocating recorded,
N
unrecorded, unearned revenues
T Revenue
earned revenues. between two or more
accounting periods.
The Adjustment Process 109
If adjusting entries for prepaid expenses are not made at the end of an
accounting period, both the balance sheet and the income statement will present
incorrect information. The company’s assets will be overstated, and its expenses
will be understated. Thus, owner’s equity on the balance sheet and net income on
the income statement will be overstated.
To illustrate this type of adjusting entry and the others discussed below, we
refer again to the transactions of Miller Design Studio.
At the beginning of July, Miller Design Studio paid two months’ rent in
advance. The advance payment resulted in an asset consisting of the right to
occupy the office for two months. As each day in the month passed, part of
the asset’s cost expired and became an expense. By July 31, one-half of the
asset’s cost had expired and had to be treated as an expense. The adjustment
is as follows:
Adjustment for Prepaid Rent
July 31: Expiration of one month’s rent, $1,600.
Analysis: Expiration of prepaid rent decreases the asset account Prepaid Rent with
a credit and increases the owner’s equity account Rent Expense with a debit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
PREPAID RENT RENT EXPENSE
Dr. Cr. Dr. Cr.
July 3 3,200 July 31 1,600 July 31 1,600
Bal. 1,600
Entry in Journal Form:
Dr. Cr.
July 31 Rent Expense 1,600
Prepaid Rent 1,600
Comment: The Prepaid Rent account now has a balance of $1,600, which rep-
resents one month’s rent that will be expensed during August. The logic in this
analysis applies to all prepaid expenses.
Miller Design Studio purchased $5,200 of office supplies in early July. A care-
ful inventory of the supplies is made at the end of the month. It records the
number and cost of supplies that have not yet been consumed and are thus still
assets of the company. Suppose the inventory shows that office supplies costing
$3,660 are still on hand. This means that of the $5,200 of supplies originally
purchased, $1,540 worth were used (became an expense) in July. The adjustment
is as follows:
Adjustment for Supplies
July 31: Consumption of supplies, $1,540
Analysis: Consumption of office supplies decreases the asset account Office Supplies |
with a credit and increases the expense account Office Supplies Expense with a debit.
110 CHAPTER 3 Measuring Business Income
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
OFFICE SUPPLIES OFFICE SUPPLIES EXPENSE
Dr. Cr. Dr. Cr.
July 5 5,200 July 31 1,540 July 31 1,540
Bal. 3,660
Entry in Journal Form:
Dr. Cr.
July 31 Office Supplies Expense 1,540
Office Supplies 1,540
Comment: The asset account Office Supplies now reflects the correct balance of
$3,660 of supplies yet to be consumed. The logic in this example applies to all
kinds of supplies.
Depreciation of Plant and Equipment When a company buys a long-term
Study Note
asset—such as a building, truck, computer, or store fixture—it is, in effect,
In accounting, depreciation prepaying for the usefulness of that asset for as long as it benefits the com-
refers only to the allocation pany. Because a long-term asset is a deferral of an expense, the accountant must
of an asset’s cost, not to any allocate the cost of the asset over its estimated useful life. The amount allocated
decline in the asset’s value. to any one accounting period is called depreciation, or depreciation expense.
Depreciation, like other expenses, is incurred during an accounting period to
produce revenue.
It is often impossible to tell exactly how long an asset will last or how much
Study Note
of the asset has been used in any one period. For this reason, depreciation must
be estimated. Accountants have developed a number of methods for estimat-
The difficulty in estimating
ing depreciation and for dealing with the related complex problems. (In the
an asset’s useful life is further
evidence that the net income discussion that follows, we assume that the amount of depreciation has been
figure is, at best, an estimate. established.)
To maintain historical cost in specific long-term asset accounts, separate
accounts—called Accumulated Depreciation accounts—are used to accu-
mulate the depreciation on each long-term asset. These accounts, which are
deducted from their related asset accounts on the balance sheet, are called con-
tra accounts. A contra account is a separate account that is paired with a related
account—in this case, an asset account. The balance of a contra account is shown
on a financial statement as a deduction from its related account. The net amount
is called the carrying value, or book value, of the asset. As the months pass, the
amount of the accumulated depreciation grows, and the carrying value of the
asset declines.
Adjustment for Plant and Equipment
July 31: Depreciation of office equipment, $300
Analysis: Depreciation decreases the asset account Office Equipment by increas-
ing the contra account Accumulated Depreciation–Office Equipment with a credit
and increasing the owner’s equity account Depreciation Expense–Office Equip-
ment with a debit.
The Adjustment Process 111
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
OFFICE EQUIPMENT DEPRECIATION EXPENSE–
Dr. Cr. OFFICE EQUIPMENT
July 6 16,320 Dr. Cr.
July 31 300
ACCUMULATED DEPRECIATION–
OFFICE EQUIPMENT
Dr. Cr.
July 31 300
Entry in Journal Form:
Dr. Cr.
July 31 Depreciation Expense–Office
Equipment 300
Accumulated Depreciation–
Office Equipment 300
Comment: The carrying value of Office Equipment is $16,020 ($16,320 (cid:4) $300)
and is presented on the balance sheet as follows:
PROPERTY, PLANT, AND EQUIPMENT
Office equipment $16,320
Less accumulated depreciation 300 $16,020
Application to Netflix, Inc. Netflix has prepaid expenses and property and
equipment similar to those in the examples we have presented. Among Netflix’s
prepaid expenses are payments made in advance to movie companies for rights
to DVDs. By paying in advance, Netflix is able to negotiate lower prices. These
fixed payments are debited to Prepaid Expense. When the movies produce reve-
nue, the prepaid amounts are transferred to expense through adjusting entries.6
Type 2 Adjustment: Recognizing Unrecorded,
Incurred Expenses (Accrued Expenses)
Usually, at the end of an accounting period, some expenses incurred during the |
Study Note period have not been recorded in the accounts. These expenses require adjust-
ing entries. One such expense is interest on borrowed money. Each day, interest
Remember that in accrual
accumulates on the debt. As shown in Figure 3-4, at the end of the account-
accounting, an expense must be
ing period, an adjusting entry is made to record the accumulated interest, which
recorded in the period in which
is an expense of the period, and the corresponding liability to pay the interest.
it is incurred regardless of when
Other common unrecorded expenses are wages and utilities. As the expense and
payment is made.
the corresponding liability accumulate, they are said to accrue—hence, the term
accrued expenses.
To illustrate how adjustments are made for unrecorded, incurred wages, sup-
pose Miller Design Studio has two pay periods a month rather than one. In July,
its pay periods end on the 12th and the 26th, as indicated in the calendar on the
next page.
112 CHAPTER 3 Measuring Business Income
FIGURE 3-4 BALANCE SHEET
Adjustment for Unrecorded
Liability
(Accrued) Expenses
2. Recognizing unrecorded, incurred expenses.
Liability Account Expense Account
Asset Adjusting Adjusting
I Entry Entry
N Credit Debit
C 1. Allocating recorded
MO Expense costs between two Amount equals cost
or more accounting
E of expense incurred.
periods.
S
T
A 4. Recognizing 3. Allocating recorded,
T
unrecorded, unearned revenues
E Revenue
M earned revenues. between two or more
E accounting periods.
N
T
JULY
SUN M T W TH F SAT
1 2 3 4 5 6
7 8 9 10 11 12 13
14 15 16 17 18 19 20
21 22 23 24 25 26 27
28 29 30 31
By the end of business on July 31, Miller’s assistant will have worked three days
(Monday, Tuesday, and Wednesday) beyond the last pay period. The employee
has earned the wages for those days but will not be paid until the first payday in
August. The wages for these three days are rightfully an expense for July, and
the liabilities should reflect that the company owes the assistant for those days.
Because the assistant’s wage rate is $2,400 every two weeks, or $240 per day
($2,400(cid:5)10 working days), the expense is $720 ($240 (cid:6) 3 days).
Adjustment for Unrecorded Wages
July 31: Accrual of unrecorded wages, $720
Analysis: Accrual of wages increases the owner’s equity account Wages Expense
with a debit and increases the liability account Wages Payable with a credit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
WAGES PAYABLE WAGES EXPENSE
Dr. Cr. Dr. Cr.
July 31 720 July 26 4,800
31 720
Bal. 5,520
Entry in Journal Form:
Dr. Cr.
July 31 Wages Expense 720
Wages Payable 720
The Adjustment Process 113
Comment: Note that the increase in Wages Expense will decrease owner’s equity
and that total wages for the month are $5,520, of which $720 will be paid next
month.
Application to Netflix, Inc. In 2008, Netflix had accrued expenses of
$31,394,000.7 If the expenses had not been accrued, Netflix’s liabilities would be
significantly understated, as would the corresponding expenses on Netflix’s income
statement. The end result would be an overstatement of the company’s earnings.
Type 3 Adjustment: Allocating Recorded,
Unearned Revenues (Deferred Revenues)
Just as expenses can be paid before they are used, revenues can be received before
Study Note they are earned. When a company receives revenues in advance, it has an obli-
gation to deliver goods or perform services. Unearned revenues are therefore
Unearned revenue is a liability
shown in a liability account.
because there is an obligation
For example, publishing companies usually receive cash in advance for maga-
to deliver goods or perform
zine subscriptions. These receipts are recorded in a liability account, Unearned
a service, or to return the
Subscriptions. If the company fails to deliver the magazines, subscribers are enti-
payment. Once the goods have
tled to their money back. As the company delivers each issue of the magazine, it
been delivered or the service
performed, the liability is earns a part of the advance receipts. This earned portion must be transferred from |
transferred to revenue. the Unearned Subscriptions account to the Subscription Revenue account, as
shown in Figure 3-5.
During July, Miller Design Studio received $1,400 from another firm as
advance payment for a series of brochures. By the end of the month, it had com-
pleted $800 of work on the brochures, and the other firm had accepted the work.
Adjustment for Unearned Revenue
July 31: Performance of services for which cash was received in advance, $800
Analysis: Performing the services for which cash was received in advance increases
the owner’s equity account Design Revenue with a credit and decreases the liability
account Unearned Design Revenue with a debit.
FIGURE 3-5
Adjustment for Unearned (Deferred) Revenues
BALANCE SHEET
Asset Liability
I
N
C 1. Allocating recorded 2. Recognizing
O Expense costs between two unrecorded, incurred
M
or more accounting expenses.
E
periods.
S
T
A
4. Recognizing
T 3. Allocating recorded, unearned revenues between two or more
unrecorded,
E Revenue accounting periods.
M earned revenues.
E
Liability Account Revenue Account
N
T
Adjusting Adjusting
Entry Entry
Debit Credit
Amount equals price
of services performed
or goods delivered.
114 CHAPTER 3 Measuring Business Income
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
UNEARNED DESIGN REVENUE DESIGN REVENUE
Dr. Cr. Dr. Cr.
July 31 800 July 19 1,400 July 10 2,800
Bal. 600 15 9,600
31 800
Bal. 13,200
Entry in Journal Form:
Dr. Cr.
July 31 Unearned Design Revenue 800
Design Revenue 800
Comment: Unearned Design Revenue now reflects the amount of work still to be
performed, $600.
Application to Netflix, Inc. Netflix has a current liability account called
Deferred (Unearned) Revenue. Deferred revenue consists of subscriptions
(monthly payments) billed in advance to customers for which revenues have not
yet been earned. Subscription revenues are recognized by prorating them over
each subscriber’s monthly subscription period. As time passes and customers use
the service, the revenue is transferred from Netflix’s Deferred Revenue account
to its Subscription Revenue account.
Type 4 Adjustment: Recognizing Unrecorded,
Earned Revenues (Accrued Revenues)
Accrued revenues are revenues that a company has earned by performing
a service or delivering goods but for which no entry has been made in the
accounting records. Any revenues earned but not recorded during an account-
ing period require an adjusting entry that debits an asset account and credits a
revenue account, as shown in Figure 3-6. For example, the interest on a note
FIGURE 3-6 BALANCE SHEET
Adjustment for Unrecorded
Asset Liability
(Accrued) Revenues
1. Allocating recorded 2. Recognizing
I Expense costs between two unrecorded, incurred
N or more accounting expenses.
C periods.
O
M
E
4. Recognizing unrecorded, earned revenues.
3. Allocating recorded,
S unearned revenues
T Asset Account Revenue Account between two or more
A accounting periods.
T
Adjusting Adjusting
E
M Revenue Entry Entry
E Debit Credit
N
T
Amount equals price
of services performed.
The Adjustment Process 115
receivable is earned day by day but may not be received until another account-
ing period. The Interest Receivable account should be debited and the Interest
Income account should be credited for the interest accrued at the end of the
current period.
When a company earns revenue by performing a service—such as designing
a series of brochures or developing marketing plans—but will not receive the
revenue for the service until a future accounting period, it must make an adjust-
ing entry. This type of adjusting entry involves an asset account and a revenue
account.
During July, Miller Design Studio agreed to create two advertisements for
Maggio’s Pizza Company. It also agreed that the first advertisement would be
finished by July 31. By the end of the month, Miller had earned $400 for com-
pleting the first advertisement. The client will not be billed until the entire proj-
ect has been completed.
Adjustment for Design Revenue
July 31: Accrual of unrecorded revenue, $400
Analysis: Accrual of unrecorded revenue increases the owner’s equity account |
Design Revenue with a credit and increases the asset account Accounts Receivable
with a debit.
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
ACCOUNTS RECEIVABLE DESIGN REVENUE
Dr. Cr. Dr. Cr.
July 15 9,600 July 22 5,000 July 10 2,800
31 400 15 9,600
Bal. 5,000 31 800
31 400
Bal. 13,600
Entry in Journal Form:
Dr. Cr.
July 31 Accounts Receivable 400
Design Revenue 400
Comment: Design Revenue now reflects the total revenue earned during July,
$13,600. Some companies prefer to debit an account called Unbilled Accounts
Receivable. Other companies simply flag the transactions in Accounts Receivable
as “unbilled.” On the balance sheet, they are usually combined with accounts
receivable.
Application to Netflix, Inc. Since Netflix’s subscribers pay their subscrip-
tions in advance by credit card, Netflix does not need to bill customers for ser-
vices provided but not paid. The company is in the enviable position of having no
accounts receivable and thus a high degree of liquidity.
A Note About Journal Entries
Thus far, we have presented a full analysis of each journal entry. The analyses
showed you the thought process behind each entry. By now, you should be fully
116 CHAPTER 3 Measuring Business Income
aware of the effects of transactions on the accounting equation and the rules
of debit and credit. For this reason, in the rest of the book, we present journal
entries without full analysis.
STOP
& APPLY
The four types of adjusting entries are as follows:
Type 1. Allocating recorded costs between two Type 3. Allocating recorded, unearned revenues
or more accounting periods between two or more accounting periods
Type 2. Recognizing unrecorded, incurred Type 4. Recognizing unrecorded, earned revenues
expenses
For each of the following items, identify the type of adjusting entry required:
___ a. Revenues earned but not yet collected or billed to customers
___ b. Interest incurred but not yet recorded
___ c. Unused supplies
___ d. Costs of plant and equipment
SOLUTION
a. Type 4; b. Type 2; c. Type 1; d. Type 1
Using the
After adjusting entries have been recorded and posted, an adjusted trial balance
Adjusted Trial is prepared by listing all accounts and their balances. If the adjusting entries have
been posted to the accounts correctly, the adjusted trial balance will have equal
Balance to
debit and credit totals. The adjusted trial balance for Miller Design Studio is
Prepare Financial
shown in Exhibit 3-2.
Statements Some accounts in Exhibit 3-2, such as Cash and Accounts Payable, have the
same balances as in the trial balance in Exhibit 3-1 because no adjusting entries
affected them. The balances of other accounts, such as Office Supplies and Pre-
LO4 Prepare financial
paid Rent, differ from those in the trial balance because adjusting entries did affect
statements from an adjusted
them. The adjusted trial balance also has some new accounts, such as depreciation
trial balance.
accounts and Wages Payable, that are not in the trial balance.
The adjusted trial balance facilitates the preparation of the financial state-
ments. As shown in Exhibit 3-2, the revenue and expense accounts are used to
prepare the income statement.
Using the Adjusted Trial Balance to Prepare Financial Statements 117
EXHIBIT 3-2 Relationship of the Adjusted Trial Balance to the Income Statement
Miller Design Studio Miller Design Studio
Adjusted Trial Balance Income Statement
July 31, 2011 For the Month Ended July 31, 2011
Cash $22,480 Revenues
Accounts Receivable 5,000 Design revenue $13,600
Office Supplies 3,660 Expenses
Prepaid Rent 1,600 Wages expense $5,520
Office Equipment 16,320 Utilities expense 680
Accumulated Depreciation– Rent expense 1,600
Office Equipment $ 300 Office supplies expense 1,540
Accounts Payable 6,280 Depreciation expense–
300
Unearned Design Revenue 600 office equipment
9,640
Wages Payable 720 Total expenses
$ 3,960
J. Miller, Capital 40,000 Net income
J. Miller, Withdrawals 2,800
Design Revenue 13,600 Study Note
Wages Expense 5,520
The net income figure from the
Utilities Expense 680 income statement is needed to |
Rent Expense 1,600 prepare the statement of owner’s
equity, and the bottom-line figure of
Office Supplies Expense 1,540
that statement is needed to prepare
Depreciation Expense–
the balance sheet. This dictates the
300
Office Equipment order in which the statements are
$61,500 $61,500
prepared.
Then, as shown in Exhibit 3-3, the statement of owner’s equity and the bal-
Study Note ance sheet are prepared. Notice that the net income from the income statement
is combined with the Withdrawals account on the statement of owner’s equity to
The adjusted trial balance is a
give the net change in the J. Miller, Capital account.
second check that the ledger
The resulting balance of J. Miller, Capital at July 31 is used in preparing the
is still in balance. Because it
balance sheet, as are the asset and liability account balances in the adjusted trial
reflects updated information
balance.
from the adjusting entries, it is
used in preparing the formal
financial statements. It does not
mean there are no accounting
errors.
118 CHAPTER 3 Measuring Business Income
EXHIBIT 3-3 Relationship of the Adjusted Trial Balance to the Balance Sheet and Statement of Owner’s Equity
Miller Design Studio Miller Design Studio
Adjusted Trial Balance Balance Sheet
July 31, 2011 July 31, 2011
Cash $22,480 Assets
Accounts Receivable 5,000
Cash $22,480
Office Supplies 3,660
Accounts receivable 5,000
Prepaid Rent 1,600
Office supplies 3,660
Office Equipment 16,320
Prepaid rent 1,600
Accumulated Depreciation–
Office equipment $16,320
Office Equipment $ 300
Less accumulated
Accounts Payable 6,280 300 16,020
depreciation
Unearned Design Revenue 600 $48,760
Total assets
Wages Payable 720
J. Miller, Capital 40,000 Liabilities
J. Miller, Withdrawals 2,800 Accounts payable $ 6,280
Design Revenue 13,600 Unearned design revenue 600
Wages Expense 5,520 Wages payable 720
Utilities Expense 680 Total liabilities $ 7,600
Rent Expense 1,600
Owner’s Equity
Office Supplies Expense 1,540
41,160
J. Miller, Capital
Depreciation Expense–Office
Equipment 300 Total liabilities and owner’s equity
$48,760
$61,500 $61,500
Miller Design Studio
Statement of Owner’s Equity
For the Month Ended July 31, 2011
J. Miller, Capital, July 1, 2011 $ 0
Investment by J. Miller 40,000
3,960
Net income
Subtotal $43,960
2,800
Less withdrawals
$41,160
J. Miller, Capital, July 31, 2011
Cash Flows from Accrual-Based Information 119
STOP
& APPLY
The adjusted trial balance for Carroll Company on December 31, 2010, contains the follow-
ing accounts and balances: D. C arroll, Capital, $300; D. Carroll, W ithdrawals, $100; Service
Revenue, $1,000; Rent Expense, $300; Wages Expense, $400; and Telephone Expense, $100.
Compute net income and prepare a statement of owner’s equity in proper form for the month
of December.
SOLUTION
Net income (cid:2) $1,000 (cid:4) $300 (cid:4) $400 (cid:4) $100 Carroll Company
(cid:2) $1,000 (cid:4) $800 Statement of Owner’s Equity
(cid:2) $200 For the Month Ended December 31, 2010
D. Carroll, Capital, Dec. 1, 2010 $ 300
Net income 200
Subtotal $ 500
Less withdrawals 100
D. Carroll, Capital, Dec. 31, 2010 $ 400
Cash Flows
Management has the short-range goal of ensuring that its company has sufficient
from Accrual- cash to pay ongoing obligations—in other words, management must ensure the
company’s liquidity. To plan payments to creditors and assess the need for short-
Based
term borrowing, managers must know how to use accrual-based information to
Information
analyze cash flows.
Almost every revenue or expense account on the income statement has one
LO5 Use accrual-based or more related accounts on the balance sheet. For instance, Office Supplies
information to analyze cash flows. Expense is related to Office Supplies, Wages Expense is related to Wages Payable,
and Design Revenue is related to Unearned Design Revenue. As we have shown,
these accounts are related by making adjusting entries, the purpose of which is to
apply the matching rule to the measurement of net income.
The cash inflows that a company’s operations generate and the cash outflows
Study Note that they require can also be determined by analyzing these relationships. For exam- |
ple, suppose that after receiving the financial statements in Exhibits 3-2 and 3-3,
Income as determined by
management wants to know how much cash was expended for office supplies. On
accrual accounting is important
the income statement, Office Supplies Expense is $1,540, and on the balance sheet,
to a company’s profitability.
Office Supplies is $3,660. Because July was the company’s first month of operation,
Cash flows are related to a
company’s liquidity. Both are there was no prior balance of office supplies, so the amount of cash expended for
important to a company’s office supplies during the month was $5,200 ($1,540 (cid:3) $3,660 (cid:2) $5,200).
success. Thus, the cash flow used in purchasing office supplies—$5,200—was much
greater than the amount expensed in determining income—$1,540. In planning
for August, management can anticipate that the cash needed may be less than
the amount expensed because, given the large inventory of office supplies, the
company will probably not have to buy office supplies in the coming month.
Understanding these cash flow effects enables management to better predict the
business’s need for cash in August.
The general rule for determining the cash flow received from any revenue
or paid for any expense (except depreciation, which is a special case not covered
120 CHAPTER 3 Measuring Business Income
here) is to determine the potential cash payments or cash receipts and deduct the
amount not paid or not received. As shown below, the application of the general
rule varies with the type of asset or liability account:
Potential Payment or
Receipt Not Paid or
Type of Account Received Result
Prepaid Expense Ending Balance (cid:3) Expense (cid:2) Cash Payments for
for the Period (cid:4) Beginning Expenses
Balance
Unearned Revenue Ending Balance (cid:3) Revenue (cid:2) Cash Receipts from
for the Period (cid:4) Beginning Revenues
Balance
Accrued Expense Beginning Balance (cid:3) (cid:2) Cash Payments for
Expense for the Period (cid:4) Expenses
Ending Balance
Accrued Revenue Beginning Balance (cid:3) (cid:2) Cash Receipts from
Revenue for the Period (cid:4) Revenues
Ending Balance
For instance, suppose that on May 31, a company had a balance of $480 in
Prepaid Insurance and that on June 30, the balance was $670. If the insurance
expense during June was $120, the amount of cash expended on insurance dur-
ing June can be computed as follows:
Prepaid Insurance at June 30 $670
Insurance Expense during June 120
Potential cash payments for insurance $790
Less Prepaid Insurance at May 31 480
Cash payments for insurance during June $310
The beginning balance is deducted because it was paid in a prior accounting
period. Note that the cash payments equal the expense plus the increase in the
balance of the Prepaid Insurance account [$120 (cid:3) ($670 (cid:4) $480) (cid:2) $310]. In
this case, the cash paid was almost three times the amount of insurance expense.
In future months, cash payments are likely to be less than the expense.
STOP
& APPLY
Supplies had a balance of $400 at the end of May and $360 at the end of June. Supplies Expense
was $550 for the month of June. How much cash was received for services provided during June?
SOLUTION
Supplies at June 30 $360
Supplies Expense during June 550
Potential cash payments for supplies $910
Less Supplies at May 31 400
Cash payments for supplies during June $510
Reliable Answering Service: Review Problem 121
(cid:2) RELIABLE ANSWERING SERVICE: REVIEW PROBLEM
In the Decision Point at the beginning of the chapter, we noted that Reliable Answering
Service has many transactions that span accounting periods. We asked these questions:
• What assumptions must Reliable Answering Service make to account for
transactions that span accounting periods?
• How does Reliable assign its revenues and expenses to the proper accounting
period so that net income is properly measured?
• Why are the adjustments that these transactions require important to Reliable’s
financial performance?
Two of the assumptions Reliable must make are that it will continue as a going con- |
cern for an indefinite time (the continuity assumption) and that it can make useful esti-
mates of its income in terms of accounting periods (the periodicity assumption). These
assumptions enable the company to apply the matching rule—that is, revenues are
assigned to the accounting period in which goods are sold or services are performed, and
Posting to T Accounts,
expenses are assigned to the accounting period in which they are used to produce rev-
Determining Adjusting
enue. These adjustments are important in order to measure net income adequately.
Entries, and Using an
Adjusted Trial Balance
to Prepare Financial
In addition to Reliable’s trial balance, which appears at the beginning of the chapter,
Statements the following information is also available for the company on December 31, 2011:
LO3 LO4
• Why are the adjustments that these transactions require important to Reliable’s
financial performance?
a. Insurance that expired during December amounted to $40.
b. Office supplies on hand on December 31 totaled $75.
c. Depreciation for December totaled $100.
d. Accrued wages on December 31 totaled $120.
e. Revenues earned for services performed in December but not billed by the
end of the month totaled $300.
f. R evenues received in December in advance of services yet to be performed
totaled $160.
Required
1. Prepare T accounts for the accounts in the trial balance, and enter the balances.
2. Determine the required adjusting entries, and record them directly in the
T accounts. Open new T accounts as needed.
3. Prepare an adjusted trial balance.
4. Prepare an income statement, a statement of owner’s equity, and a balance
sheet for the month ended December 31, 2011.
5. User insight: Which accounts on Reliable’s income statement are potentially
affected by adjusting entries? Which account on Reliable’s balance sheet is
never affected by an adjusting entry?
122 CHAPTER 3 Measuring Business Income
Answers to
1. T accounts set up and amounts from trial balance entered
Review Problem 2. Adjusting entries recorded
Reliable Answering Service: Review Problem 123
3. Adjusted trial balance prepared
4. Financial statements prepared
124 CHAPTER 3 Measuring Business Income
5. All accounts on the income statement are potentially affected by adjusting
entries. Cash on the balance sheet is never affected by an adjusting entry.
Stop & Review 125
STOP
& REVIEW
LO1 Defi ne net income, and Net income is the net increase in owner’s equity that results from a company’s
explain the assump- operations. Net income equals revenues minus expenses; when expenses exceed
tions underlying income revenues, a net loss results. Revenues equal the price of goods sold or services
measurement and their rendered during a specific period. Expenses are the costs of goods and services
ethical application. used in the process of producing revenues.
The continuity assumption recognizes that even though businesses face
an uncertain future, without evidence to the contrary, accountants must
assume that a business will continue to operate indefinitely. The periodicity
assumption recognizes that although the lifetime of a business is uncertain, it
is nonetheless useful to estimate the business’s net income in terms of account-
ing periods. The matching rule holds that revenues must be assigned to the
accounting period in which the goods are sold or the services performed, and
expenses must be assigned to the accounting period in which they are used to
produce revenue.
Because applying the matching rule involves making assumptions and exercis-
ing judgment, it can lead to earnings management, which is the manipulation of
revenues and expenses to achieve a specific outcome. When the estimates involved
in earnings management move outside a reasonable range, financial statements
become misleading. Financial statements that are intentionally misleading consti-
tute fraudulent financial reporting.
LO2 Defi ne accrual account- Accrual accounting consists of all the techniques accountants use to apply the
ing, and explain how it is matching rule. It is accomplished by recognizing revenues when they are earned, |
accomplished. by recognizing expenses when they are incurred, and by adjusting the accounts.
LO3 Identify four situations Adjusting entries are required when (1) recorded costs must be allocated between
that require adjusting two or more accounting periods, (2) unrecorded expenses exist, (3) recorded,
entries, and illustrate unearned revenues must be allocated between two or more accounting periods,
typical adjusting entries. and (4) unrecorded, earned revenues exist. The preparation of adjusting entries is
summarized as follows:
Type of Account
Type of Adjusting Entry Debited Credited Examples of Balance Sheet Accounts
1. Allocating recorded costs Expense Asset (or Prepaid rent
(previously paid, expired) contra-asset) Prepaid insurance
Office supplies
Accumulated depreciation–office
equipment
2. Accrued expenses (incurred, Expense Liability Interest payable
not paid) Wages payable
3. Allocating recorded, unearned Liability Revenue Unearned design revenue
revenues (previously received,
earned)
4. Accrued revenues (earned, not Asset Revenue Accounts receivable
received) Interest receivable
126 CHAPTER 3 Measuring Business Income
LO4 Prepare fi nancial state- An adjusted trial balance is prepared after adjusting entries have been posted to the
ments from an adjusted accounts. Its purpose is to test whether the adjusting entries have been posted cor-
trial balance. rectly before the financial statements are prepared. The balances in the revenue and
expense accounts in the adjusted trial balance are used to prepare the income state-
ment. The balances in the asset and liability accounts in the adjusted trial balance
and in the statement of owner’s equity are used to prepare the b alance sheet.
LO5 Use accrual-based infor- To ensure a company’s liquidity, managers must know how to use accrual-based
mation to analyze cash information to analyze cash flows. The general rule for determining the cash flow
fl ows. received from any revenue or paid for any expense (except depreciation) is to
determine the potential cash receipts or cash payments and deduct the amount
not received or not paid.
REVIEW of Concepts and Terminology
The following concepts and terms Cash basis of accounting 102 (LO1) Matching rule 102 (LO1)
were introduced in this chapter: Continuity 101 (LO1) Net income 100 (LO1)
Accrual 107 (LO3) Contra account 110 (LO3) Net loss 100 (LO1)
Accrual accounting 104 (LO2) Deferral 107 (LO3) Periodicity 101 (LO1)
Accrued expenses 111 (LO3) Depreciation 110 (LO3) Prepaid expenses 108 (LO3)
Accrued revenues 114 (LO3) Earnings management 103 (LO1) Profit 100 (LO1)
Accumulated Depreciation Expenses 101 (LO1) Revenue recognition 104 (LO2)
accounts 110 (LO3)
Fiscal year 102 (LO1) Revenues 100 (LO1)
Adjusted trial balance 116 (LO4)
Going concern 101 (LO1) Unearned revenues 113 (LO3)
Adjusting entries 107 (LO3)
Interim periods 102 (LO1)
Carrying value 110 (LO3)
Chapter Assignments 127
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 LO2 Accrual Accounting Concepts
SE 1. Match the concepts of accrual accounting on the right with the assumptions
or actions on the left:
___ 1. Assumes expenses should be assigned a. Periodicity
to the accounting period in which they b. Continuity
are used to produce revenues c. Matching rule
___ 2. Assumes a business will last indefinitely d. Revenue recognition
___ 3. Assumes revenues are earned at a point
in time
___ 4. Assumes net income that is measured
for a short period of time, such as one
quarter, is a useful measure
LO3 Adjustment for Prepaid Insurance
SE 2. The Prepaid Insurance account began the year with a balance of $920. Dur-
ing the year, insurance in the amount of $2,080 was purchased. At the end of the
year (December 31), the amount of insurance still unexpired was $1,400. Prepare
the year-end entry in journal form to record the adjustment for insurance expense
for the year.
LO3 Adjustment for Supplies
SE 3. The Supplies account began the year with a balance of $760. During the year, sup-
plies in the amount of $1,960 were purchased. At the end of the year (December 31), |
the inventory of supplies on hand was $880. Prepare the year-end entry in journal
form to record the adjustment for supplies expense for the year.
LO3 Adjustment for Depreciation
SE 4. The depreciation expense on office equipment for the month of March is
$100. This is the third month that the office equipment, which cost $1,900, has
been owned. Prepare the adjusting entry in journal form to record depreciation
for March and show the balance sheet presentation for office equipment and
related accounts after the March 31 adjustment.
LO3 Adjustment for Accrued Wages
SE 5. Wages are paid each Saturday for a six-day workweek. Wages are currently
running $1,380 per week. Prepare the adjusting entry required on June 30,
assuming July 1 falls on a Tuesday.
LO3 Adjustment for Unearned Revenue
SE 6. During the month of August, deposits in the amount of $2,200 were
received for services to be performed. By the end of the month, services in the
amount of $1,520 had been performed. Prepare the necessary adjustment for
Service Revenue at the end of the month.
128 CHAPTER 3 Measuring Business Income
LO4 Preparation of an Income Statement and Statement of Owner’s Equity
from an Adjusted Trial Balance
SE 7. The adjusted trial balance for Shimura Company on December 31, 2010,
contains the following accounts and balances: J. Shimura, Capital, $4,300;
J. Shimura, Withdrawals, $175; Service Revenue, $1,300; Rent Expense, $200;
Wages Expense, $450; Utilities Expense, $100; and Telephone Expense, $25.
Prepare an income statement and statement of owner’s equity in proper form for
the month of December.
LO5 Determination of Cash Flows
SE 8. Unearned Revenue had a balance of $650 at the end of November and $450
at the end of December. Service Revenue was $2,550 for the month of December.
How much cash was received for services provided during December?
Exercises
LO1 LO2 Discussion Questions
LO3
E 1. Develop a brief answer to each of the following questions.
1. When a company has net income, what happens to its assets and/or to its
liabilities?
2. Is accrual accounting more closely related to a company’s goal of profitability
or liquidity?
3. Will the carrying value of a long-term asset normally equal its market value?
LO4 Discussion Questions
E 2. Develop a brief answer to each of the following questions.
1. If, at the end of the accounting period, you were looking at the T account for
a prepaid expense like supplies, would you look for the amounts expended in
cash on the debit or credit side? On which side would you find the amount
expensed during the period?
2. Would you expect net income to be a good measure of a company’s liquid-
ity? Why or why not?
LO1 LO2 Applications of Accounting Concepts Related to Accrual Accounting
LO3
E 3. The accountant for Ronaldo Company makes the assumptions or per-
forms the activities listed below. Tell which of the following concepts of accrual
accounting most directly relates to each assumption or action: (a) periodicity,
(b) continuity, (c) matching rule, (d) revenue recognition, (e) deferral, and (f)
accrual.
1. In estimating the life of a building, assumes that the business will last
indefinitely
2. Records a sale when the customer is billed
3. Postpones the recognition of a one-year insurance policy as an expense by
initially recording the expenditure as an asset
4. Recognizes the usefulness of financial statements prepared on a monthly basis
even though they are based on estimates
5. Recognizes, by making an adjusting entry, wages expense that has been
incurred but not yet recorded
6. Prepares an income statement that shows the revenues earned and the
expenses incurred during the accounting period
Chapter Assignments 129
LO2 Application of Conditions for Revenue Recognition
E 4. Four conditions must be met before revenue should be recognized. In each
of the following cases, tell which condition has not been met.
a. Company A accepts a contract to perform services in the future for $2,000.
b. Company B ships products worth $3,000 to another company without an
order from the other company but tells the company it can return the prod- |
ucts if it does not sell them.
c. Company C performs $10,000 of services for a firm with financial problems.
d. Company D agrees to work out a price later for services that it performs for
another company.
LO3 Adjusting Entry for Unearned Revenue
E 5. Fargo Voice of Fargo, North Dakota, publishes a monthly magazine featur-
ing local restaurant reviews and upcoming social, cultural, and sporting events.
Subscribers pay for subscriptions either one year or two years in advance. Cash
received from subscribers is credited to an account called Magazine Subscriptions
Received in Advance. On December 31, 2009, the end of the company’s fiscal
year, the balance of this account is $840,000. Expiration of subscriptions revenue
is as follows:
During 2009 $175,000
During 2010 415,000
During 2011 250,000
Prepare the adjusting entry in journal form for December 31, 2009.
LO3 Adjusting Entries for Prepaid Insurance
E 6. An examination of the Prepaid Insurance account shows a balance of $16,845
at the end of an accounting period, before adjustment. Prepare entries in journal
form to record the insurance expense for the period under the following indepen-
dent assumptions:
1. An examination of the insurance policies shows unexpired insurance that cost
$8,270 at the end of the period.
2. An examination of the insurance policies shows insurance that cost $2,150
has expired during the period.
LO3 Adjusting Entries for Supplies: Missing Data
E 7. Each of the following columns represents a Supplies account:
a b c d
Supplies on hand at July 1 $264 $346 $196 $ ?
Supplies purchased during the month 113 ? 174 1,928
Supplies consumed during the month 194 972 ? 1,741
Supplies on hand at July 31 ? 436 85 1,118
1. Determine the amounts indicated by the question marks.
2. Make the adjusting entry for column a, assuming supplies purchased are deb-
ited to an asset account.
LO3 Adjusting Entry for Accrued Salaries
E 8. Hugo Company has a five-day workweek and pays salaries of $35,000 each
Friday.
1. Prepare the adjusting entry required on May 31, assuming that June 1 falls
on a Wednesday.
2. Prepare the entry to pay the salaries on June 3, including the amount of sala-
ries payable from requirement 1.
130 CHAPTER 3 Measuring Business Income
LO3 Revenue and Expense Recognition
E 9. Optima Company produces computer software that Tech Company sells.
Optima receives a royalty of 15 percent of sales. Tech Company pays royalties
to Optima Company semiannually—on May 1 for sales made in July through
December of the previous year and on November 1 for sales made in January
through June of the current year. Royalty expense for Tech Company and royalty
income for Optima Company in the amount of $6,000 were accrued on Decem-
ber 31, 2008. Cash in the amounts of $6,000 and $10,000 was paid and received
on May 1 and November 1, 2009, respectively. Software sales during the July to
December 2009 period totaled $150,000.
1. Calculate the amount of royalty expense for Tech Company and royalty
income for Optima during 2009.
2. Record the adjusting entry that each company made on December 31, 2009.
LO4 Preparation of Financial Statements
E 10. Prepare the monthly income statement, monthly statement of owner’s
equity, and the balance sheet at August 31, 2011, for Alvin Cleaning Company
from the data provided in the adjusted trial balance below. The owner made no
investments during the period.
Alvin Cleaning Company
Adjusted Trial Balance
August 31, 2011
Cash $ 4,750
Accounts Receivable 2,592
Prepaid Insurance 380
Prepaid Rent 200
Cleaning Supplies 152
Cleaning Equipment 3,875
Accumulated Depreciation–Cleaning Equipment $ 320
Truck 7,200
Accumulated Depreciation–Truck 720
Accounts Payable 420
Wages Payable 295
Unearned Janitorial Revenue 1,690
A. Wish, Capital 15,034
A. Wish, Withdrawals 2,000
Janitorial Revenue 14,620
Wages Expense 5,680
Rent Expense 1,350
Gas, Oil, and Other Truck Expenses 580
Insurance Expense 380
Supplies Expense 2,920
Depreciation Expense–Cleaning Equipment 320
Depreciation Expense–Truck 720
$33,099 $33,099
Chapter Assignments 131
LO3 Adjusting Entries |
E 11. Prepare year-end adjusting entries for each of the following:
1. Office Supplies has a balance of $336 on January 1. Purchases debited to
Office Supplies during the year amount to $1,660. A year-end inventory
reveals supplies of $1,140 on hand.
2. Depreciation of office equipment is estimated to be $2,130 for the year.
3. Property taxes for six months, estimated at $1,800, have accrued but have
not been recorded.
4. Unrecorded interest income on U.S. government bonds is $850.
5. Unearned Revenue has a balance of $1,800. Services for $750 received in
advance have now been performed.
6. Services totaling $800 have been performed; the customer has not yet been
billed.
LO3 Accounting for Revenue Received in Advance
E 12. Robert Shapiro, a lawyer, received $84,000 on October 1 to represent a cli-
ent in real estate negotiations over the next 12 months.
1. Record the entries required in Shapiro’s records on October 1 and at the end
of the fiscal year, December 31.
2. How would this transaction be reflected on the income statement and bal-
ance sheet on December 31?
LO5 Determination of Cash Flows
E 13. After adjusting entries had been made, the balance sheets of Ramiro’s Com-
pany showed the following asset and liability amounts at the end of 2009 and
2010:
2010 2009
Prepaid insurance $2,400 $2,900
Wages payable 1,200 2,200
Unearned fees 4,200 1,900
The following amounts were taken from the 2010 income statement:
Insurance expense $ 3,800
Wages expense 19,500
Fees earned 8,900
Calculate the amount of cash paid for insurance and wages and the amount of
cash received for fees during 2010.
LO5 Relationship of Expenses to Cash Paid
E 14. The income statement for Sahan Company included the following expenses
for 2011:
Rent expense $ 75,000
Interest expense 11,700
Salaries expense 121,000
132 CHAPTER 3 Measuring Business Income
Listed below are the related balance sheet account balances at year end for
last year and this year.
Last Year This Year
Prepaid rent — $ 1,350
Interest payable $1,500 —
Salaries payable 7,500 114,000
1. Compute the cash paid for rent during the year.
2. Compute the cash paid for interest during the year.
3. Compute the cash paid for salaries during the year.
Problems
LO3 Determining Adjustments
P 1. At the end of the first three months of operation, the trial balance of City
Answering Service appears as shown below. Tim Bass, the owner of City Answer-
ing Service, has hired an accountant to prepare financial statements to determine
how well the company is doing after three months. Upon examining the account-
ing records, the accountant finds the following items of interest:
a. An inventory of office supplies reveals supplies on hand of $150.
b. The Prepaid Rent account includes the rent for the first three months plus a
deposit for April’s rent.
c. Depreciation on the equipment for the first three months is $416.
d. The balance of the Unearned Answering Service Revenue account represents
a 12-month service contract paid in advance on February 1.
e. On March 31, accrued wages total $105.
City Answering Service
Trial Balance
March 31, 2010
Cash $ 3,582
Accounts Receivable 4,236
Office Supplies 933
Prepaid Rent 800
Equipment 4,700
Accounts Payable $ 2,673
Unearned Answering Service Revenue 888
T. Bass, Capital 5,933
T. Bass, Withdrawals 2,100
Answering Service Revenue 9,102
Wages Expense 1,900
Office Cleaning Expense 345
$18,596 $18,596
Required
All adjustments affect one balance sheet account and one income statement
account. For each of the above situations, show the accounts affected, the amount
Chapter Assignments 133
of the adjustment (using a (cid:3) or – to indicate an increase or decrease), and the
balance of the account after the adjustment in the following format:
Balance Amount of Income Amount of
Sheet Adjustment Balance After Statement Adjustment Balance After
Account ((cid:4) or (cid:2)) Adjustment Account ((cid:4) or (cid:2)) Adjustment
LO2 LO3 Preparing Adjusting Entries
P 2. On November 30, the end of the current fiscal year, the following infor-
mation is available to assist Caruso Company’s accountants in making adjusting
entries: |
a. Caruso Company’s Supplies account shows a beginning balance of $2,350.
Purchases during the year were $4,218. The end-of-year inventory reveals
supplies on hand of $1,397.
b. The Prepaid Insurance account shows the following on November 30:
Beginning balance $4,720
July 1 4,200
October 1 7,272
The beginning balance represents the unexpired portion of a one-year
policy purchased in September of the previous year. The July 1 entry repre-
sents a new one-year policy, and the October 1 entry represents additional
coverage in the form of a three-year policy.
c. The following table contains the cost and annual depreciation for buildings
and equipment, all of which Caruso Company purchased before the current
year:
Account Cost Annual Depreciation
Buildings $298,000 $16,000
Equipment 374,000 40,000
d. On September 1, the company completed negotiations with a client and
accepted an advance of $18,600 for services to be performed monthly in the
next year. The $18,600 was credited to Unearned Services Revenue.
e. The company calculated that as of November 30, it had earned $7,000 on
an $11,000 contract that would be completed and billed in January.
f. Among the liabilities of the company is a note payable in the amount of
$300,000. On November 30, the accrued interest on this note amounted to
$18,000.
g. On Saturday, December 2, the company, which is on a six-day workweek,
will pay its regular employees their weekly wages of $15,000.
h. On November 29, the company completed negotiations and signed a con-
tract to provide services to a new client at an annual rate of $23,000.
Required
1. Prepare adjusting entries for each item listed above.
User insight (cid:2) 2. Explain how the conditions for revenue recognition are applied to transac-
tions e and h.
134 CHAPTER 3 Measuring Business Income
LO3 LO4 Determining Adjusting Entries, Posting to T Accounts, and Preparing
an Adjusted Trial Balance
P 3. The trial balance for Prima Consultants Company on December 31, 2010,
appears below. The following information is also available:
a. Ending inventory of office supplies, $97
b. Prepaid rent expired, $500
c. Depreciation of office equipment for the period, $720
d. Interest accrued on the note payable, $600
e. Salaries accrued at the end of the period, $230
f. Service revenue still unearned at the end of the period, $1,410
g. Service revenue earned but not billed, $915
Required
1. Open T accounts for the accounts in the trial balance plus the following: Inter-
est Payable; Salaries Payable; Office Supplies Expense; Depreciation Expense–
Office Equipment; and Interest Expense. Enter the account balances.
2. Determine the adjusting entries and post them directly to the T accounts.
3. Prepare an adjusted trial balance.
User insight (cid:2) 4. Which financial statements do each of the above adjustments affect? What
financial statement is not affected by the adjustments?
Prima Consultants Company
Trial Balance
December 31, 2010
Cash $ 13,786
Accounts Receivable 24,840
Offi ce Supplies 991
Prepaid Rent 1,400
Offi ce Equipment 7,300
Accumulated Depreciation–Offi ce
Equipment $ 2,600
Accounts Payable 1,820
Notes Payable 10,000
Unearned Service Revenue 2,860
M. Sirot, Capital 30,387
M. Sirot, Withdrawals 15,000
Service Revenue 58,500
Salaries Expense 33,400
Utilities Expense 1,750
Rent Expense 7,700
$106,167 $106,167
Chapter Assignments 135
LO3 LO4 Determining Adjusting Entries and Tracing Their Effects
to Financial Statements
P 4. VIP Limo Service was organized to provide limousine service between the
airport and various suburban locations. It has just completed its second year of
business. Its trial balance is below.
VIP Limo Service
Trial Balance
June 30, 2010
Cash (111) $ 9,812
Accounts Receivable (113) 14,227
Prepaid Rent (117) 12,000
Prepaid Insurance (118) 4,900
Prepaid Maintenance (119) 12,000
Spare Parts (140) 11,310
Limousines (148) 220,000
Accumulated Depreciation–Limousines (149) $ 35,000
Notes Payable (211) 45,000
Unearned Passenger Service Revenue (213) 30,000
A. Pham, Capital (311) 88,211
A. Pham, Withdrawals (313) 20,000
Passenger Service Revenue (411) 428,498 |
Gas and Oil Expense (510) 89,300
Salaries Expense (511) 206,360
26,800
Advertising Expense (516)
$626,709 $626,709
The following information is also available:
a. To obtain space at the airport, VIP Limo paid two years’ rent in advance
when it began the business.
b. An examination of insurance policies reveals that $1,800 expired during the year.
c. To provide regular maintenance for the vehicles, VIP Limo deposited
$12,000 with a local garage. An examination of maintenance invoices reveals
charges of $10,944 against the deposit.
d. An inventory of spare parts shows $2,016 on hand.
e. VIP Limo depreciates all of its limousines at the rate of 12.5 percent per
year. No limousines were purchased during the year.
f. A payment of $10,500 for one full year’s interest on notes payable is now due.
g. Unearned Passenger Service Revenue on June 30 includes $17,815 for tick-
ets that employers purchased for use by their executives but which have not
yet been redeemed.
Required
1. Determine the adjusting entries and enter them in the general journal (Page 14).
2. Open ledger accounts for the accounts in the trial balance plus the following:
Interest Payable (213); Rent Expense (514); Insurance Expense (515); Spare
Parts Expense (516); Depreciation Expense–Limousines (517); Maintenance
Expense (518); and Interest Expense (519). Record the balances shown in
the trial balance.
136 CHAPTER 3 Measuring Business Income
3. Post the adjusting entries from the general journal to the ledger accounts,
showing proper references.
User insight (cid:2) 4. Prepare an adjusted trial balance, an income statement, a statement of o wner’s
equity, and a balance sheet. The owner made no investments during the period.
Alternate Problems
LO3 Determining Adjustments
P 5. At the end of its fiscal year, the trial balance for Andy’s Cleaners appears as
shown below:
Andy’s Cleaners
Trial Balance
September 30, 2010
Cash $ 11,788
Accounts Receivable 26,494
Prepaid Insurance 3,400
Cleaning Supplies 7,374
Land 18,000
Building 186,000
Accumulated Depreciation–Building $ 45,600
Accounts Payable 18,400
Unearned Cleaning Revenue 1,700
Mortgage Payable 110,000
A. Kopec, Capital 56,560
A. Kopec, Withdrawals 9,000
Cleaning Revenue 159,634
Wages Expense 101,330
Cleaning Equipment Rental Expense 6,100
Delivery Truck Expense 4,374
Interest Expense 11,000
Other Expenses 7,034
$391,894 $391,894
The following information is also available:
a. A study of the company’s insurance policies shows ssssthat $680 is unexpired at
the end of the year.
b. An inventory of cleaning supplies shows $1,150 on hand.
c. Estimated depreciation on the building for the year is $12,800.
d. Accrued interest on the mortgage payable is $1,000.
e. On September 1, the company signed a contract, effective immediately, with
Hope County Hospital to dry clean, for a fixed monthly charge of $425, the
uniforms used by doctors in surgery. The hospital paid for four months’ ser-
vice in advance.
f. Sales and delivery wages are paid on Saturday. The weekly payroll is $3,060.
September 30 falls on a Thursday, and the company has a six-day pay week.
Chapter Assignments 137
Required
All adjustments affect one balance sheet account and one income statement
account. For each of the above situations, show the accounts affected, the amount
of the adjustment (using a (cid:3) or (cid:4) to indicate an increase or decrease), and the
balance of the account after the adjustment in the following format:
Balance Amount of Income Amount of
Sheet Adjustment Balance After Statement Adjustment Balance After
Account ((cid:4) or (cid:2)) Adjustment Account ((cid:4) or (cid:2)) Adjustment
LO2 LO3 Preparing Adjusting Entries
P 6. On June 30, the end of the current fiscal year, the following information is
available to Conti Company’s accountants for making adjusting entries:
a. Among the liabilities of the company is a mortgage payable in the amount of
$260,000. On June 30, the accrued interest on this mortgage amounted to
$13,000.
b. On Friday, July 2, the company, which is on a five-day workweek and pays
employees weekly, will pay its regular salaried employees $18,700. |
c. On June 29, the company completed negotiations and signed a contract to
provide monthly services to a new client at an annual rate of $7,200.
d. The Supplies account shows a beginning balance of $1,615 and purchases
during the year of $4,115. The end-of-year inventory reveals supplies on
hand of $1,318.
e. The Prepaid Insurance account shows the following entries on June 30:
Beginning balance $1,620
January 1 2,900
May 1 3,366
The beginning balance represents the unexpired portion of a one-year policy
purchased in April of the previous year. The January 1 entry represents a new
one-year policy, and the May 1 entry represents the additional coverage of a
three-year policy.
f. The following table contains the cost and annual depreciation for buildings
and equipment, all of which were purchased before the current year:
Account Cost Annual Depreciation
Buildings $170,000 $ 7,300
Equipment 218,000 20,650
g. On June 1, the company completed negotiations with another client and
accepted an advance of $21,600 for services to be performed in the next
year. The $21,600 was credited to Unearned Service Revenue.
h. The company calculates that as of June 30 it had earned $4,500 on a $7,500
contract that will be completed and billed in August.
Required
1. Prepare adjusting entries for each item listed above.
User insight (cid:2) 2. Explain how the conditions for revenue recognition are applied to transac-
tions c and h.
138 CHAPTER 3 Measuring Business Income
LO3 Determining Adjusting Entries, Posting to T Accounts, and Preparing
an Adjusted Trial Balance
P 7. The trial balance for Best Advisors Service on December 31, 2011, is as
follows:
Best Advisors Service
Trial Balance
December 31, 2011
Cash $ 18,500
Accounts Receivable 8,250
Offi ce Supplies 2,662
Prepaid Rent 1,320
Offi ce Equipment 9,240
Accumulated Depreciation–
Offi ce Equipment $ 1,540
Accounts Payable 5,940
Notes Payable 11,000
Unearned Service Revenue 2,970
M. Dabrowska, Capital 26,002
M. Dabrowska, Withdrawals 22,000
Service Revenue 72,600
Salaries Expense 49,400
Rent Expense 4,400
Utilities Expense 4,280
$120,052 $120,052
The following information is also available:
a. Ending inventory of office supplies, $300
b. Prepaid rent expired, $610
c. Depreciation of office equipment for the period, $526
d. Accrued interest expense at the end of the period, $570
e. Accrued salaries at the end of the period, $330
f. Service revenue still unearned at the end of the period, $1,166
g. Service revenue earned but unrecorded, $3,100
Required
1. Open T accounts for the accounts in the trial balance plus the following:
Interest Payable; Salaries Payable; Office Supplies Expense; Depreciation
Expense–Office Equipment; and Interest Expense. Enter the balances shown
on the trial balance.
2. Determine the adjusting entries and post them directly to the T accounts.
User insight (cid:2)
3. Prepare an adjusted trial balance.
4. Which financial statements do each of the above adjustments affect? Which
financial statement is not affected by the adjustments?
Chapter Assignments 139
LO3 LO4 Determining Adjusting Entries and Tracing Their Effects to Financial
Statements
P 8. Helen Ortega opened a small tax-preparation service. At the end of its
second year of operation, Ortega Tax Service had the trial balance that appears
below.
Ortega Tax Service
Trial Balance
December 31, 2010
Cash $ 3,700
Accounts Receivable 1,099
Prepaid Insurance 240
Offi ce Supplies 780
Offi ce Equipment 7,100
Accumulated Depreciation–
Offi ce Equipment $ 770
Accounts Payable 635
Unearned Tax Fees 219
H. Ortega, Capital 6,939
H. Ortega, Withdrawals 6,000
Tax Fees Revenue 21,926
Offi ce Salaries Expense 8,300
Advertising Expense 650
Rent Expense 2,400
220
Telephone Expense
$30,489 $30,489
The following information is also available:
a. Office supplies on hand, December 31, 2010, $225.
b. Insurance still unexpired, $100.
c. Estimated depreciation of office equipment, $795.
d. Telephone expense for December, $21; the bill was received but not recorded.
e. The services for all unearned tax fees had been performed by the end of the year.
Required |
1. Open T accounts for the accounts in the trial balance plus the following:
Office Supplies Expense; Insurance Expense; and Depreciation Expense–
Office Equipment. Record the balances shown in the trial balance.
2. Determine the adjusting entries and post them directly to the T accounts.
3. Prepare an adjusted trial balance, an income statement, a statement of owner’s
User insight (cid:2)
equity, and a balance sheet. The owner made no investments during the period.
4. Why is it not necessary to show the effects of the above transactions on the
statement of cash flows?
140 CHAPTER 3 Measuring Business Income
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 LO2 Importance of Adjustments
LO3 C 1. Never Flake Company, which operated in the northeastern part of the United
States, provided a rust-prevention coating for the underside of new automobiles.
The company advertised widely and offered its services through new car dealers.
When a dealer sold a new car, the salesperson attempted to sell the rust-preven-
tion coating as an option. The protective coating was supposed to make cars last
longer in the severe northeastern winters. A key selling point was Never Flake’s
warranty, which stated that it would repair any damage due to rust at no charge
for as long as the buyer owned the car.
For several years, Never Flake had been very successful in generating enough
cash to continue operations. But in 2011, the company suddenly declared bank-
ruptcy. Company officials said that the firm had only $5.5 million in assets against
liabilities of $32.9 million. Most of the liabilities represented potential claims
under the company’s lifetime warranty. It seemed that owners were keeping their
cars longer now than previously. Therefore, more damage was being attributed
to rust. Discuss what accounting decisions could have helped Never Flake survive
under these circumstances.
LO1 Earnings Management and Fraudulent Financial Reporting
C 2. In recent years, the Securities and Exchange Commission (SEC) has been
waging a public campaign against corporate accounting practices that manage or
manipulate earnings to meet the expectations of Wall Street analysts. Corpora-
tions engage in such practices in the hope of avoiding shortfalls that might cause
serious declines in their stock price. For each of the following cases that the SEC
challenged, tell why each is a violation of the matching rule and how it should be
accounted for:
a. Lucent Technologies sold telecommunications equipment to companies
from which there was no reasonable expectation of payment because of the
companies’ poor financial condition.
b. America Online (AOL) recorded advertising as an asset rather than as an
expense.
c. Eclipsys recorded software contracts as revenue even though it had not yet
rendered the services.
d. KnowledgeWare recorded revenue from sales of software even though it
told customers they did not have to pay until they had the software.
LO2 LO3 Analysis of an Asset Account
C 3. The Walt Disney Company is engaged in the financing, production,
and distribution of motion pictures and television programming. In Disney’s
2008 annual report, the balance sheet contained an asset called “film and tele-
vision costs.” Film and television costs, which consist of the costs associated
with producing films and television programs less the amount expensed, were
$5,394,000,000. The estimated amount of film and television costs expensed
(amortized) during the next year were $3,500,000,000. The amount estimated
to be spent for new film productions was $2,900,000,000.
1. What are film and television costs, and why would they be classified as an
asset?
2. Prepare an entry in T account form to record the amount the company spent
on new film and television productions during 2010 (assume all expenditures
are paid for in cash).
Chapter Assignments 141
3. Prepare an adjusting entry in T account form to record the expense for film
and television productions during 2009. Show the balance of the Film and
Television Costs account at the end of the next year. |
4. Suggest a method by which The Walt Disney Company might have deter-
mined the amount of the expense in 3 in accordance with the matching rule.
LO1 LO2 Importance of Adjustments
LO3
C 4. Main Street Service Co. has achieved fast growth in the St. Louis area by sell-
ing service contracts on large appliances, such as washers, dryers, and refrigera-
tors. For a fee, Main Street agrees to provide all parts and labor on an appliance
after the regular warranty runs out. For example, by paying a fee of $200, a person
who buys a dishwasher can add two years (years 2 and 3) to the regular one-year
(year 1) warranty on the appliance. In 2009, the company sold service contracts
in the amount of $1.8 million, all of which applied to future years. Management
wanted all the sales recorded as revenues in 2009, contending that the amount
of the contracts could be determined and the cash had been received. Discuss
whether you agree with this logic. How would you record the cash receipts?
What assumptions do you think Main Street should make? Would you consider
it unethical to follow management’s recommendation? Who might be hurt or
helped by this action?
LO3 Real-World Observation of Business Activities
C 5. Visit a company with which you are familiar and observe its opera-
tions. (The company can be where you work, where you eat, or where you
buy things.) Identify at least two sources of revenue for the company and
six types of expenses. For each type of revenue and each type of expense,
determine whether it is probable that an adjusting entry is required at the
end of the accounting period. Then specify the adjusting entry as a deferred
revenue, deferred expense, accrued revenue, or accrued expense. Design a
table with columns and rows that summarizes your results in an easy-to-
understand format.
LO3 Analysis of Balance Sheet and Adjusting Entries
C 6. In CVS Corporation’s annual report in the Supplement to Chapter 5, refer
to the balance sheet and the Summary of Significant Accounting Policies in the
notes to the financial statements.
a. Examine the accounts in the current assets, property and equipment, and
current liabilities sections of CVS’s balance sheet. Which are most likely to
have had year-end adjusting entries? Describe the nature of the adjusting
entries. For more information about the property and equipment section,
refer to the notes to the financial statements.
b. Where is depreciation (and amortization) expense disclosed in CVS’s finan-
cial statements?
c. CVS has a statement on the “Use of Estimates” in its Summary of Signifi-
cant Accounting Policies. Read this statement and tell how important esti-
mates are to the determination of depreciation expense. What assumptions
do accountants make that allow these estimates to be made?
C H A P T E R
4 Completing the
Accounting Cycle
Making a Statement A ll companies prepare financial statements annually, and
whether required by law or not, preparing them every quar-
INCOME STATEMENT
ter, or even every month, is a good idea because these interim
Revenues
reports give management an ongoing view of a company’s financial
– Expenses
performance. The preparation of financial statements requires not
= Net Income only adjusting entries, which we described in the last chapter, but
also closing entries, which we explain in this chapter.
STATEMENT OF
OWNER’S EQUITY
Beginning Balance
LEARNING OBJECTIVES
+ Net Income
– Withdrawals LO1 Describe the accounting cycle and the role of closing entries in
the preparation of financial statements. (pp. 144–146)
= Ending Balance
LO2 Prepare closing entries. (pp. 147–151)
BALANCE SHEET
Assets Liabilities LO3 Prepare reversing entries. (pp. 152–153)
Owner’s LO4 Prepare and use a work sheet. (pp. 154–158)
Equity
A = L + OE
STATEMENT OF CASH FLOWS
Operating activities
+ Investing activities
+ Financing activities
= Change in Cash
+ Beginning Balance
= Ending Cash Balance
Closing entries set the
accounts on the income
statement to zero and transfer
the resulting balance of net
income or loss to the owner’s
Capital account on the
balance sheet. Closing entries |
do not affect cash flows.
142
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) What steps must a company
follow to prepare its accounts for
WESTWOOD MOVERS
the next accounting period?
(cid:2) After following these steps,
Westwood Movers provides moving and storage services for the local how is the ending balance of
college and its students and employees. Westwood’s business tends the owner’s Capital account
determined?
to be seasonal; its busiest times are generally in the late spring and
early fall. Thus, to keep a careful eye on fluctuations in earnings and
cash flows, Westwood prepares financial statements each quarter.
As you know from Chapter 3, before a company prepares financial
statements, it must make adjusting entries to the income statement
and owner’s equity accounts. After those entries have been made,
an adjusted trial balance listing all the accounts and balances is pre-
pared. Accounts from the adjusted trial balance are then used to pre-
pare the financial statements. For example, in preparing its income
statement, Westwood Movers would use the revenue and expense
accounts from its adjusted trial balance, which appear on the follow-
ing page. (This adjusted trial balance is “partial” in that it omits all
balance sheet accounts except the owner’s equity accounts.) In addi-
tion, Westwood, like all other companies, must prepare its accounts
for the next accounting period by making closing entries. Doing all
this takes time and effort, but the results benefit both management
and external users of the company’s financial statements by provid-
ing important information about revenues and operating income.
To accomplish these tasks, Westwood Movers needs to be able
to answer the questions on the right.
114433
144 CHAPTER 4 Completing the Accounting Cycle
From Transactions
To interpret and analyze a company’s performance requires an understanding
to Financial of how transactions are recognized and eventually end up in financial state-
ments. Two concepts that foster this understanding are the accounting cycle
Statements
and closing entries.
LO1 Describe the accounting The Accounting Cycle
cycle and the role of closing
As Figure 4-1 shows, the accounting cycle is a series of steps whose ultimate pur-
entries in the preparation of
pose is to provide useful information to decision makers. These steps are as follows:
financial statements.
1. Analyze business transactions from source documents.
2. Record the transactions by entering them in the general journal.
3. Post the journal entries to the ledger, and prepare a trial balance.
4. Adjust the accounts, and prepare an adjusted trial balance.
5. Prepare financial statements.
6. Close the accounts, and prepare a post-closing trial balance.
You are already familiar with Steps 1 through 5 from previous chapters. In the
next section, we describe Step 6, which may be performed before or after Step 5.
Closing Entries
Balance sheet accounts, such as Cash and Accounts Payable, are considered
permanent accounts, or real accounts, because they carry their end-of-period
balances into the next accounting period. In contrast, revenue and expense
accounts, such as Revenues Earned and Wages Expense, are considered tempo-
rary accounts, or nominal accounts, because they begin each accounting period
with a zero balance, accumulate a balance during the period, and are then cleared
by means of closing entries.
Closing entries are journal entries made at the end of an accounting period.
They have two purposes:
1. They set the stage for the next accounting period by clearing revenue and
expense accounts and the Withdrawals account of their balances.
From
Transactions
to
Financial
Statements
145
Decisions and Actions
THE ACCOUNTING CYCLE
PROCESSING
2. Record the entries 3. Post the journal entries
in the journal. to the ledger and
prepare a trial balance.
General Journal
Post. Date Description Ref. Debit Credit 20xx July 3 Prepaid Rent 3,200 Cash 3,200 Paid two months’ rent in advance 5 Office Supplies 5,200 Accounts Payable 5,200 Purchased office supplies
on credit
A
F
AUNN
AICNANI
TROPER
L
L |
FIGURE 4-1 Overview of the Accounting Cycle
BUSINESS ACTIVITIES DECISION MAKERS
Purchase
Order
MEASUREMENT COMMUNICATION
1. Analyze business 5. Prepare financial
transactions from statements.
source documents.
SALES INVOICE
$5,200
4. Adjust the accounts 6. Close the accounts and
and prepare an prepare a post-closing
adjusted trial balance. trial balance.
General Journal
Date Description PRoesft.. Debit Credit
2 JA u0c D lx yc xao tu en 3t 359 0s Pay Ia teb mle CAOPOAc r ca f fef fG P c cs i iR cpco oJJJ J hoe e eau ue 111 2sn in nf SdEt.e t t u q. s sRr p u a R Pep ipl n ael i m1 tL yceD a, es ee 0e bi nd v0b lta eg 0i bte lM er ilC l35 er ,, TJr22e ru 700d Dilay000i elt 3Bs 1iag ,A l a21nDc n0, c 0e Scxo 0 exb tB u0u ia t dn l it a o nN $C 35 12co r 62453,,e. 22e ,,,,, 346222 700d 280001 000i 00000t2 $6,280 REx ep vee nn use e 1 4 . . c o p u eA Ro r e n al e l s r r rmo ci e nt oc s oo c eda g or db st e nA ri e .n d r iF at ezs g ew io c vs n dr e c eu e e g ,oe ntr c un uoT n er ty twd sip n .e oe gds of Adju 2 3 s . . t u e u bi R An n x n eleg lpr e toc we e acE o c en ragn oL n es tn r it ei e nndar i dz s i geb te i . w n rdis r el eg , oi vt ci y n e ooc n rr u ud mr eer osde r ,d e 2J0uxlyx3 Prep 2Ia Jn 0i ucd D xlo y xar me ten e 33t 11S C AOP OA— Aum c r c ca f fe Of fCC c c cs i im cp cI o u ollh ft oo e e faa e u m uiss c ir m n nii Sd Ey uenn t t u qgg l s sR aE p u tR Pe qep ipn ae udli mt yce i G P pR DJJ aes eo me 44 be4 i ens vn f l1 eptt a e.e .1 P nrbr ea to le cl s i3ML D at ,3 e - 2 tei, C id l 12 oblg e 0l0 J ni ote r0 us r D li ynCe 43gsr ,4 8e 1 i, T 0gd ,8 0rin 20 t ia 0 0S l xA tB xuDc ac de lo biaB ou i na tn $l ct a 12enN C 531 6241co ,,, ,,r ,,e 066 34. 85e 3 06009 28d1 00i 000 00t4 $ 6 , 23 80 00
accounting periods.
$60,080 $60,080 $49,060 $49,060
146 CHAPTER 4 Completing the Accounting Cycle
FIGURE 4-2 Overview of the Closing Process
Expense Accounts Revenue Accounts
xxx xxx
Step 2: Step 1:
To close the To close the
expense revenue
accounts Income Summary accounts
xxx xxx
xx
Step 3:
To close
Income Summary
Withdrawals Capital
Step 4:
xx To close xx xx
Withdrawals
2. They summarize a period’s revenues and expenses by transferring the bal-
ances of revenue and expense accounts to the Income Summary account.
The Income Summary account is a temporary account that summarizes all
revenues and expenses for the period. It is used only in the closing process—
never in the financial statements. Its balance equals the net income or loss
reported on the income statement. The net income or loss is then transferred
to the owner’s Capital account.
Figure 4-2 shows an overview of the closing process. The net income or loss is
transferred from the Income Summary account to the owner’s Capital account
because even though revenues and expenses are recorded in individual accounts,
they represent increases and decreases in owner’s Capital. Closing entries transfer
the net effect of increases (revenues) and decreases (expenses) to owner’s Capi-
tal. For corporations like Netflix, the net income or loss is transferred from the
Income Summary account to the Retained Earnings account, which is part of the
stockholders’ (owner’s) equity of a corporation.
STOP
& APPLY
In each of the following pairs of activities, tell which activity is done first in the accounting cycle:
1. Close the accounts or adjust the accounts 3. Record the transactions in the journal or
2. Analyze the transactions or post the entries prepare the initial trial balance
to the ledger 4. Prepare the post-closing trial balance or
prepare the adjusted trial balance
SOLUTION
1. Adjust the accounts 3. Record the transactions in the journal
2. Analyze the transactions 4. Prepare the adjusted trial balance
Preparing Closing Entries 147
Preparing
The steps involved in making closing entries are as follows:
Closing Entries
Step 1. Close the credit balances on the income statement accounts to the
Income Summary account.
LO2 Prepare closing entries.
Step 2. Close the debit balances on the income statement accounts to the
Income Summary account. |
Study Note Step 3. Close the Income Summary account balance to the owner’s Capital
account.
Although it is not absolutely
necessary to use the Income Step 4. Close the Withdrawals account balance to the owner’s Capital account.
Summary account when
As you will learn in later chapters, not all revenue accounts have credit bal-
preparing closing entries, doing
ances and not all expense accounts have debit balances. For that reason, when
so simplifies the procedure.
referring to closing entries, we often use the term credit balances instead of rev-
enue accounts and the term debit balances instead of expense accounts.
An adjusted trial balance provides all the data needed to record the closing
entries. Exhibit 4-1 shows the relationships of the four kinds of closing entries to
Miller Design Studio’s adjusted trial balance.
Step 1: Closing the Credit Balances
On the credit side of the adjusted trial balance in Exhibit 4-1, Design Revenue shows
Study Note a balance of $13,600. To close this account, a journal entry must be made debiting
the account in the amount of its balance and crediting it to the Income Summary
After Step 1 has been completed,
account. Exhibit 4-2 shows how the entry is posted. Notice that the entry sets the
the Income Summary account
balance of the revenue account to zero and transfers the total revenues to the credit
reflects the account balance of
the Design Revenue account side of the Income Summary account.
before it was closed.
Step 2: Closing the Debit Balances
Several expense accounts show balances on the debit side of the adjusted trial bal-
ance in Exhibit 4-1. A compound entry is needed to credit each of these expense
accounts for its balance and to debit the Income Summary account for the total.
Exhibit 4-3 shows the effect of posting the closing entry. Notice how the entry
reduces the expense account balances to zero and transfers the total of the account
balances to the debit side of the Income Summary account.
Step 3: Closing the Income Summary
Account Balance
After the entries closing the revenue and expense accounts have been posted, the
Study Note
balance of the Income Summary account equals the net income or loss for the
period. A credit balance in the Income Summary account represents a net income
After Step 3 has been completed,
(i.e., revenues exceed expenses), and a debit balance represents a net loss (i.e.,
the credit balance of the Income
Summary account ($3,960) expenses exceed revenues).
represents net income—the key At this point, the balance of the Income Summary account, whatever its nature,
measure of performance. When a is closed to the owner’s Capital account, as shown in Exhibit 4-1. Exhibit 4-4
net loss occurs, debit the owner’s shows how the closing entry is posted when a company has a net income. Notice
Capital account (to reduce it) the dual effect of closing the Income Summary account and transferring the bal-
and credit the Income Summary ance to owner’s Capital.
account (to close it).
Step 4: Closing the Withdrawals Account Balance
The Withdrawals account shows the amount by which owner’s Capital decreased
during an accounting period. The debit balance of the Withdrawals account is
closed to the owner’s Capital account, as illustrated in Exhibit 4-1. Exhibit 4-5
148 CHAPTER 4 Completing the Accounting Cycle
EXHIBIT 4-1 Preparing Closing Entries from the Adjusted Trial Balance
Miller Design Studio
Entry 1:
Adjusted Trial Balance
July 31, 2011 July 31 Design Revenue 411 13,600
Income Summary 314 13,600
Cash $22,480
To close the
Accounts Receivable 5,000 revenue
Office Supplies 3,660 account
Prepaid Rent 1,600
Office Equipment 16,320 Entry 2:
Accumulated Depreciation–
July 31 Income Summary 314 9,640
Office Equipment $ 300
Wages Expense 511 5,520
Accounts Payable 6,280 Utilities Expense 512 680
Unearned Design Revenue 600 Rent Expense 514 1,600
Wages Payable 720 Office Supplies
Expense 517 1,540
J. Miller, Capital 40,000
Depreciation
J. Miller, Withdrawals 2,800
Expense–Office
Design Revenue 13,600
Equipment 520 300
Wages Expense 5,520 To close the
Utilities Expense 680 expense |
Rent Expense 1,600 accounts
Office Supplies Expense 1,540
Depreciation Expense– INCOME SUMMARY
Office Equipment 300 July 31 9,640 July 31 13,600
$61,500 $61,500
July 31 3,960 Bal. —
Entry 3:
July 31 Income Summary 314 3,960
J. Miller, Capital 312 3,960
To close the
Income Summary
account
Entry 4:
July 31 J. Miller, Capital 312 2,800
J. Miller,
Withdrawals 313 2,800
To close the
Withdrawals
account
shows the posting of the closing entry and the transfer of the balance of the With-
Study Note
drawals account to the owner’s Capital account. In a corporation like Netflix,
payments to owners are called dividends, and they are closed to the Retained
Note that the Withdrawals
account is closed to the owner’s Earnings account.
Capital account, not to the
Income Summary account. The Accounts After Posting
After all the steps in the closing process have been completed and all closing
entries have been posted, everything is ready for the next accounting period.
Preparing Closing Entries 149
EXHIBIT 4-2
Posting the Closing Entry of a Design Revenue Account No. 411
Credit Balance to the Income
Balance
Summary Account Post.
Date Item Ref. Debit Credit Debit Credit
July 10 J2 2,800 2,800
15 J2 9,600 12,400
31 Adj. J3 800 13,200
31 Adj. J3 400 13,600
31 Closing J4 13,600 —
Income Summary Account No. 314
Balance
Post.
Date Item Ref. Debit Credit Debit Credit
July 31 Closing J4 13,600 13,600
The revenue, expense, and Withdrawals accounts (temporary accounts) have zero
balances. The owner’s Capital account has been increased or decreased to reflect
net income or net loss (net income in our example) and has been decreased for
withdrawals. The balance sheet accounts (permanent accounts) show the correct
balances, which are carried into the next period.
EXHIBIT 4-3 Posting the Closing Entry of Debit Balances to the Income Summary Account
Wages Expense Account No. 511 Office Supplies Expense Account No. 517
Balance Balance
Post. Post.
Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit
July 26 J2 4,800 4,800 July 31 Adj. J3 1,540 1,540
31 Adj. J3 720 5,520 31 Closing J4 1,540 —
31 Closing J4 5,520 —
Depreciation Expense–Office
Utilities Expense Account No. 512 Equipment Account No. 520
Balance Balance
Post. Post.
Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit
July 30 J2 680 680 July 31 Adj. J3 300 300
31 Closing J4 680 — 31 Closing J4 300 —
Rent Expense Account No. 514 Income Summary Account No. 314
Balance Balance
Post. Post.
Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit
July 31 Adj. J3 1,600 1,600 July 31 Closing J4 13,600 13,600
31 Closing J4 1,600 — 31 Closing J4 9,640* 3,960
*Total of all credit closing entries to expense accounts is debited to the Income Summary account.
150 CHAPTER 4 Completing the Accounting Cycle
EXHIBIT 4-4 Posting the Closing Entry of the Income Summary Account Balance to the Owner’s Equity Account
Income Summary Account No. 314 J. Miller, Capital Account No. 312
Balance Balance
Post. Post.
Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit
July 31 Closing J4 13,600 13,600 July 1 J1 40,000 40,000
31 Closing J4 9,640 3,960 31 Closing J4 3,960 43,960
31 Closing J4 3,960 —
EXHIBIT 4-5 Posting the Closing Entry of the Withdrawals Account Balance to the Owner’s Capital Account
J. Miller, Withdrawals Account No. 313 J. Miller, Capital Account No. 312
Balance Balance
Post. Post.
Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit
July 31 J2 2,800 2,800 July 1 J1 40,000 40,000
31 Closing J4 2,800 — 31 Closing J4 3,960 43,960
31 Closing J4 2,800 41,160
The Post-Closing Trial Balance
Because errors can be made in posting closing entries to the ledger accounts, it is
necessary to prepare a post-closing trial balance. As you can see in Exhibit 4-6,
a post-closing trial balance contains only balance sheet accounts because the
income statement accounts and the Withdrawals account have been closed
and now have zero balances. It is a final check that total debits equal total
credits. |
EXHIBIT 4-6
Miller Design Studio
Post-Closing Trial Balance
Post-Closing Trial Balance
July 31, 2011
Cash $22,480
Accounts Receivable 5,000
Office Supplies 3,660
Prepaid Rent 1,600
Office Equipment 16,320
Accumulated Depreciation–Office Equipment $ 300
Accounts Payable 6,280
Unearned Design Revenue 600
Wages Payable 720
J. Miller, Capital 41,160
$49,060 $49,060
Preparing Closing Entries 151
STOP
& APPLY
Prepare the necessary closing entries from the following partial adjusted trial balance for Fountas
Recreational Park, and compute the ending balance of the owner’s Capital account. (Except for K.
Fountas, Capital, balance sheet accounts have been omitted.)
Fountas Recreational Park
Partial Adjusted Trial Balance
June 30, 2010
K. Fountas, Capital $93,070
K. Fountas, Withdrawals $36,000
Campsite Rentals 88,200
Wages Expense 23,850
Insurance Expense 3,784
Utilities Expense 1,800
Supplies Expense 1,320
Depreciation Expense–Building 6,000
SOLUTION
Closing entries prepared:
June 30 Campsite Rentals 88,200
Income Summary 88,200
To close the credit balance account
30 Income Summary 36,754
Wages Expense 23,850
Insurance Expense 3,784
Utilities Expense 1,800
Supplies Expense 1,320
Depreciation Expense–Building 6,000
To close the debit balance accounts
30 Income Summary 51,446
K. Fountas, Capital 51,446
To close the Income Summary account
$88,200 (cid:4) $36,754 (cid:2) $51,446
30 K. Fountas, Capital 36,000
K. Fountas, Withdrawals 36,000
To close the Withdrawals account
Ending balance of the K. Fountas, Capital account computed:
K. FOUNTAS, CAPITAL
June 30 36,000 Beg. Bal. 93,070
June 30 51,446
End. Bal. 108,516
152 CHAPTER 4 Completing the Accounting Cycle
Reversing Entries:
A reversing entry is an optional journal entry made on the first day of an account-
An Optional ing period. It has the opposite effect of an adjusting entry made at the end of the
previous period—that is, it debits the credits and credits the debits of an ear-
First Step
lier adjusting entry. The sole purpose of reversing entries is to simplify routine
bookkeeping procedures, and they apply only to certain adjusting entries. Defer-
LO3 Prepare reversing
rals should not be reversed because doing so would not simplify bookkeeping in
entries.
future accounting periods. As used in this text, reversing entries apply only to
accruals (accrued revenues and expenses).
To see how reversing entries can be helpful, consider this adjusting entry
Study Note
made in the records of Miller Design Studio to accrue wages expense:
Reversing entries are the
opposite of adjusting entries
and are dated the first day of
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
the new period. They apply only
to certain adjusting entries and WAGES PAYABLE WAGES EXPENSE
are never required. Dr. Cr. Dr. Cr.
July 31 720 July 31 720
Entry in Journal Form:
Dr. Cr.
July 31 Wages Expense 720
Wages Payable 720
Accrued unrecorded wages
When the company pays its assistant on the next regular payday, its accountant
would make this entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH WAGES PAYABLE WAGES EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
Aug. 23 4,800 Aug. 23 720 Aug. 23 4,080
Entry in Journal Form:
Dr. Cr.
Aug. 23 Wages Payable 720
Wages Expense 4,080
Cash 4,800
Paid four weeks wages to assistant, $720
of which accrued in the previous period
If no reversing entry is made at the time of payment, the accountant would
have to look in the records to find out how much of the $4,800 applies to the
current accounting period and how much applies to the previous period. That
may seem easy in our example, but think how difficult and time-consuming it
would be if a company had hundreds of employees working on different sched-
ules. A reversing entry helps solve the problem of applying revenues and expenses
to the correct accounting period.
Reversing Entries: An Optional First Step 153
For example, consider the following sequence of entries and their effects on
the Wages Expense account:
1. Adjusting Entry Dr. Cr. Wages Expense Account No. 511
July 31 Wages Expense 720
Balance
Wages Payable 720 Post.
2. Closing Entry Date Ref. Debit Credit Debit Credit |
July 31 Income Summary 5,520
Wages Expense 5,520 July 26 J2 4,800 4,800
3. Reversing Entry 31 J3 720 5,520
Aug. 1 Wages Payable 720 31 J4 5,520 —
Wages Expense 720 Aug. 1 J5 720 720
4. Payment Entry 23 J6 4,800 4,080
Aug. 23 Wages Expense 4,800
Cash 4,800
Entry 1 adjusted Wages Expense to accrue $720 in the July accounting period.
Entry 2 closed the $5,520 in Wages Expense for July to Income Summary, leav-
ing a zero balance.
Entry 3, the reversing entry, set up a credit balance of $720 on August 1 in
Wages Expense, which is the expense recognized through the adjusting entry
in July (and also reduced the liability account Wages Payable to a zero balance).
The reversing entry always sets up an abnormal balance in the income statement
account and produces a zero balance in the balance sheet account.
Entry 4 recorded the $4,800 payment of wages as a debit to Wages Expense,
automatically leaving a balance of $4,080, which represents the correct wages
expense to date in August. The reversing entry simplified the process of making
the payment entry on August 23.
Reversing entries apply to any accrued expenses or revenues. Miller Design Stu-
dio’s only accrued expense was wages expense. An adjusting entry for the company’s
accrued revenue (Design Revenue) would require the following reversing entry:
Dr. Cr.
Aug. 1 Design Revenue 400
Accounts Receivable 400
Reversed the adjusting entry
for accrued revenue earned
STOP
& APPLY
Which of the following accounts after adjustment will most likely require reversing entries:
a. Salaries Payable d. Supplies
b. Accumulated Depreciation e. Taxes Payable
c. Interest Payable
SOLUTION
a., c., and e.
154 CHAPTER 4 Completing the Accounting Cycle
The Work Sheet:
To organize data and avoid omitting important information that might affect the
An Accountant’s financial statements, accountants use working papers. Because working papers
provide evidence of past work, they enable accountants to retrace their steps when
Tool
they need to verify information in the financial statements.
A work sheet is a special kind of working paper. The work sheet is extremely
LO4 Prepare and use a work
useful when a company prepares financial statements on both an annual and seasonal
sheet.
basis, as Netflix does, and when an accountant must make numerous adjustments.
It is often used as a preliminary step in preparing financial statements. Using a work
sheet lessens the possibility of omitting an adjustment and helps the accountant check
Study Note
the arithmetical accuracy of the accounts. The work sheet is never published and is
The work sheet is not a financial rarely seen by management. It is a tool for the accountant. Because preparing a work
statement, it is not required, and sheet is a mechanical process, many accountants use a computer for this purpose.
it is not made public.
Preparing the Work Sheet
A work sheet often has one column for account names and multiple columns with
headings like the ones shown in Exhibit 4-7. A heading that includes the name of the
company and the period of time covered (as on the income statement) identifies the
work sheet. As Exhibit 4-7 shows, preparation of a work sheet involves five steps.
Step 1. Enter and Total the Account Balances in the Trial Balance
Study Note Columns The debit and credit balances of the accounts on the last day of an
accounting period are copied directly from the ledger into the Trial Balance col-
The Trial Balance columns of a
umns (the green columns in Exhibit 4-7). When accountants use a work sheet,
work sheet take the place of a
they do not have to prepare a separate trial balance.
trial balance.
Step 2. Enter and Total the Adjustments in the Adjustments Columns
The required adjustments are entered in the Adjustments columns of the work
sheet (the purple columns in Exhibit 4-7). As each adjustment is entered, a let-
ter is used to identify its debit and credit parts. For example, in Exhibit 4-7,
the letter (a) identifies the adjustment made for the rent that Miller Design
Studio prepaid on July 3, which results in a debit to Rent Expense and a credit |
to Prepaid Rent. These identifying letters may be used to reference supporting
computations or documentation for the related adjusting entries and can sim-
plify the recording of adjusting entries in the general journal.
A trial balance includes only accounts that have balances. If an adjustment
involves an account that does not appear in the trial balance, the new account is
added below the accounts listed on the work sheet. For example, Rent Expense
has been added to Exhibit 4-7. Accumulated depreciation accounts, which have a
zero balance only in the initial period of operation, are the sole exception to this
rule. They are listed immediately after their associated asset accounts. For exam-
ple, in Exhibit 4-7, the Accumulated Depreciation–Office Equipment account is
listed immediately after Office Equipment.
When all the adjustments have been made, the two Adjustments columns
must be totaled. This procedure proves that the debits and credits of the adjust-
ments are equal, and it generally reduces errors in the work sheet.
Step 3. Enter and Total the Adjusted Account Balances in the
Adjusted Trial Balance Columns The adjusted trial balance in the work sheet
is prepared by combining the amount of each account in the Trial Balance columns
with the corresponding amount in the Adjustments columns and entering each
result in the Adjusted Trial Balance columns (the yellow columns in Exhibit 4-7).
Exhibit 4-7 contains examples of crossfooting, or adding and subtracting
a group of numbers horizontally. The first line shows Cash with a debit balance
The Work Sheet: An Accountant’s Tool 155
EXHIBIT 4-7 The Work Sheet
Miller Design Studio
Work Sheet
For the Month Ended July 31, 2011
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Name Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 22,480 22,480 22,480
Accounts Receivable 4,600 (f) 400 5,000 5,000
Office Supplies 5,200 (b) 1,540 3,660 3,660
Prepaid Rent 3,200 (a) 1,600 1,600 1,600
Office Equipment 16,320 16,320 16,320
Accumulated
Depreciation–Office
Equipment (c) 300 300 300
Accounts Payable 6,280 6,280 6,280
Unearned Design
Revenue 1,400 (e) 800 600 600
J. Miller, Capital 40,000 40,000 40,000
J. Miller, Withdrawals 2,800 2,800 2,800
Design Revenue 12,400 (e) 800 13,600 13,600
(f) 400
Wages Expense 4,800 (d) 720 5,520 5,520
Utilities Expense 680 680 680
60,080 60,080
Rent Expense (a) 1,600 1,600 1,600
Office Supplies
Expense (b) 1,540 1,540 1,540
Depreciation Expense–
Office Equipment (c) 300 300 300
Wages Payable (d) 720 720 720
5,360 5,360 61,500 61,500 9,640 13,600 51,860 47,900
Net Income 3,960 3,960
13,600 13,600 51,860 51,860
Note: The columns of the work sheet are prepared in the following order: (1) Trial Balance, (2) Adjustments, (3) Adjusted Trial
Balance, and (4) Income Statement and Balance Sheet columns. In the fifth step, the Income Statement and Balance Sheet
columns are totaled.
of $22,480. Because there are no adjustments to the Cash account, $22,480
is entered in the debit column of the Adjusted Trial Balance columns. On the
second line, Accounts Receivable shows a debit of $4,600 in the Trial Balance
columns. Because there is a debit of $400 from adjustment f in the Adjustments
columns, it is added to the $4,600 and carried over to the debit column of the
Adjusted Trial Balance columns at $5,000. On the next line, Office Supplies
shows a debit of $5,200 in the Trial Balance columns and a credit of $1,540
156 CHAPTER 4 Completing the Accounting Cycle
from adjustment b in the Adjustments columns. Subtracting $1,540 from $5,200
results in a $3,660 debit balance in the Adjusted Trial Balance columns. This
process is followed for all the accounts, including those added below the trial bal-
ance totals. The Adjusted Trial Balance columns are then footed (totaled) to check
the accuracy of the crossfooting.
Step 4. Extend the Account Balances from the Adjusted Trial Bal-
ance Columns to the Income Statement or Balance Sheet Columns
Every account in the adjusted trial balance is an income statement account or a |
balance sheet account. Each account is extended to its proper place as a debit
or credit in either the Income Statement columns or the Balance Sheet col-
umns (the blue columns in Exhibit 4-7). As shown in Exhibit 4-7, revenue and
expense accounts are extended to the Income Statement columns, and asset,
liability, Capital, and Withdrawals accounts are extended to the Balance Sheet
columns.
To avoid overlooking an account, the accounts are extended line by line,
beginning with the first line (Cash) and not omitting any subsequent lines. For
instance, the Cash debit balance of $22,480 is extended to the debit column
of the Balance Sheet columns; then, the Accounts Receivable debit balance of
$5,000 is extended to the debit column of the Balance Sheet columns; and
so forth.
Step 5. Total the Income Statement Columns and the Balance Sheet
Columns. Enter the Net Income or Net Loss in Both Pairs of Columns
as a Balancing Figure, and Recompute the Column Totals This fifth
and last step, shown in the brown columns at the bottom of Exhibit 4-7, is neces-
sary to compute net income or net loss and to prove the arithmetical accuracy of
the work sheet.
Net income (or net loss) is equal to the difference between the total debits
and credits of the Income Statement columns. It is also equal to the difference
between the total debits and credits of the Balance Sheet columns.
Revenues (Income Statement credit column total) $13,600
Expenses (Income Statement debit column total) (9,640)
Net Income $ 3,960
In this case, revenues (credit column) exceed expenses (debit column). Thus,
Miller Design Studio has a net income of $3,960. The same difference occurs
between the total debits and credits of the Balance Sheet columns.
The $3,960 is entered in the debit side of the Income Statement columns
and in the credit side of the Balance Sheet columns to balance the columns.
Remember that the excess of revenues over expenses (net income) increases own-
er’s equity and that increases in owner’s equity are recorded by credits.
When a net loss occurs, the opposite rule applies. The excess of expenses over
revenues—net loss—is placed in the credit side of the Income Statement columns
as a balancing figure. It is then placed in the debit side of the Balance Sheet col-
umns because a net loss decreases owner’s equity, and decreases in owner’s equity
are recorded by debits.
As a final check, the four columns are totaled again. If the Income Statement
columns and the Balance Sheet columns do not balance, an account may have
been extended or sorted to the wrong column, or an error may have been made
in adding the columns. Of course, equal totals in the two pairs of columns are not
absolute proof of accuracy. If an asset has been carried to the Income Statement
debit column (or an expense has been carried to the Balance Sheet debit column)
The Work Sheet: An Accountant’s Tool 157
or a similar error with revenues or liabilities has been made, the work sheet will
balance, but the net income figure will be wrong.
Study Note
Theoretically, adjusting
Using the Work Sheet
entries can be recorded in the
accounting records before Accountants use the completed work sheet in performing three principal tasks.
the financial statements are These tasks are as follows:
prepared or even before the
1. Recording the adjusting entries in the general journal. Because the
work sheet is completed.
However, they always precede information needed to record the adjusting entries can be copied from
the preparation of closing the work sheet, entering the adjustments in the journal is an easy step,
entries. as shown in Exhibit 4-8. The adjusting entries are then posted to the
general ledger.
EXHIBIT 4-8
Adjustments from the Work General Journal Page 3
Sheet Entered in the General
Journal Post.
Date Description Ref. Debit Credit
2011
(a) July 31 Rent Expense 514 1,600
Prepaid Rent 117 1,600
To recognize expiration of one
month’s rent
(b) 31 Office Supplies Expense 517 1,540
Office Supplies 116 1,540
To recognize office supplies used
during the month
(c) 31 Depreciation Expense–Office |