Warren Reeve Duchac - E-Learning

Warren Reeve Duchac

ACCOUNTING 23e Carl S. Warren Professor Emeritus of Accounting University of Georgia, Athens

James M. Reeve Professor Emeritus of Accounting University of Tennessee, Knoxville

Jonathan E. Duchac Professor of Accounting Wake Forest University

Accounting, 23e Warren Reeve Duchac VP/Editorial Director: Jack W. Calhoun Editor in Chief: Rob Dewey Executive Editor: Sharon Oblinger Developmental Editor: Aaron Arnsparger Editorial Assistant: Heather McAuliffe Marketing Manager: Steven E. Joos Marketing Coordinator: Gretchen Wildauer Senior Media Editor: Scott Hamilton Senior Content Project Manager: Cliff Kallemeyn Art Director: Stacy Shirley Senior Frontlist Buyer: Doug Wilke Production: LEAP Publishing Services, Inc.

© 2009, 2007 South-Western, a part of Cengage Learning ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced, transmitted, stored or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, Web distribution, information networks, or information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the publisher. For permission to use material from this text or product, submit all requests online at www.cengage.com/permissions Further permission questions can be emailed to [email protected]

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Student Edition ISBN 13: 978-0-324-66296-2 ISBN 10: 0-324-66296-3 Instructor Edition ISBN 13: 978-0-324-66377-8 ISBN 10: 0-324-66377-3 Softbound Chapters 14–26 ISBN 13: 978-0-324-66390-7 ISBN 10: 0-324-66390-0 South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Cengage Learning products are represented in Canada by Nelson Education, Ltd. For your course and learning solutions, visit academic.cengage.com Purchase any of our products at your local college store or at our preferred online store www.ichapters.com

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The Author Team Carl S. Warren Dr. Carl S. Warren is Professor Emeritus of Accounting at the University of Georgia, Athens. Dr. Warren has taught classes at the University of Georgia, University of Iowa, Michigan State University, and University of Chicago. Professor Warren focused his teaching efforts on principles of accounting and auditing. He received his Ph.D. from Michigan State University and his B.B.A. and M.A. from the University of Iowa. During his career, Dr. Warren published numerous articles in professional journals, including The Accounting Review, Journal of Accounting Research, Journal of Accountancy, The CPA Journal, and Auditing: A Journal of Practice & Theory. Dr. Warren has served on numerous committees of the American Accounting Association, the American Institute of Certified Public Accountants, and the Institute of Internal Auditors. He has also consulted with numerous companies and public accounting firms. Warren’s outside interests include playing handball, golfing, skiing, backpacking, and fly-fishing.

James M. Reeve Dr. James M. Reeve is Professor Emeritus of Accounting and Information Management at the University of Tennessee. Professor Reeve taught on the accounting faculty for 25 years, after graduating with his Ph.D. from Oklahoma State University. His teaching effort focused on undergraduate accounting principles and graduate education in the Master of Accountancy and Senior Executive MBA programs. Beyond this, Professor Reeve is also very active in the Supply Chain Certification program, which is a major executive education and research effort of the College. His research interests are varied and include work in managerial accounting, supply chain management, lean manufacturing, and information management. He has published over 40 articles in academic and professional journals, including the Journal of Cost Management, Journal of Management Accounting Research, Accounting Review, Management Accounting Quarterly, Supply Chain Management Review, and Accounting Horizons. He has consulted or provided training around the world for a wide variety of organizations, including Boeing, Procter and Gamble, Norfolk Southern, Hershey Foods, Coca-Cola, and Sony. When not writing books, Professor Reeve plays golf and is involved in faith-based activities.

Jonathan Duchac Dr. Jonathan Duchac is the Merrill Lynch and Co. Professor of Accounting and Director of the Program in Enterprise Risk Management at Wake Forest University. He earned his Ph.D. in accounting from the University of Georgia and currently teaches introductory and advanced courses in financial accounting. Dr. Duchac has received a number of awards during his career, including the Wake Forest University Outstanding Graduate Professor Award, the T.B. Rose award for Instructional Innovation, and the University of Georgia Outstanding Teaching Assistant Award. In addition to his teaching responsibilities, Dr. Duchac has served as Accounting Advisor to Merrill Lynch Equity Research, where he worked with research analysts in reviewing and evaluating the financial reporting practices of public companies. He has testified before the U.S. House of Representatives, the Financial Accounting Standards Board, and the Securities and Exchange Commission; and has worked with a number of major public companies on financial reporting and accounting policy issues. In addition to his professional interests, Dr. Duchac is the Treasurer of The Special Children’s School of Winston-Salem; a private, nonprofit developmental day school serving children with special needs. Dr. Duchac is an avid long-distance runner, mountain biker, and snow skier. His recent events include the Grandfather Mountain Marathon, the Black Mountain Marathon, the Shut-In Ridge Trail run, and NO MAAM (Nocturnal Overnight Mountain Bike Assault on Mount Mitchell). iii

Leading by Example For nearly 80 years, Accounting has been used effectively to teach generations of businessmen and women. The text has been used by millions of business students. For many, this book provides the only exposure to accounting principles that they will ever receive. As the most successful business textbook of all time, it continues to introduce students to accounting through a variety of time-tested ways. The previous edition, 22e, started a new journey into learning more about the changing needs of accounting students through a variety of new and innovative research and development methods. Our Blue Sky Workshops brought accounting faculty from all over the country into our book development process in a very direct and creative way. Many of the features and themes present in this text are a result of the collaboration and countless conversations we’ve had with accounting instructors over the last several years. 23e continues to build on this philosophy and strives to be reflective of the suggestions and feedback we receive from instructors and students on an ongoing basis. We’re very happy with the results, and think you’ll be pleased with the improvements we’ve made to the text. The original author of Accounting, James McKinsey, could not have imagined the success and influence this text has enjoyed or that his original vision would continue to lead the market into the twenty-first century. As the current authors, we appreciate the responsibility of protecting and enhancing this vision, while continuing to refine it to meet the changing needs of students and instructors. Always in touch with a tradition of excellence but never satisfied with yesterday’s success, this edition enthusiastically embraces a changing environment and continues to proudly lead the way. We sincerely thank our many colleagues who have helped to make it happen.

“The teaching of accounting is no longer designed to train professional accountants only. With the growing complexity of business and the constantly increasing difficulty of the problems of management, it has become essential that everyone who aspires to a position of responsibility should have a knowledge of the fundamental principles of accounting.” — James O. McKinsey, Author, first edition, 1929

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Leading by Example Textbooks continue to play an invaluable role in the teaching and learning environment. Continuing our focus from previous editions, we reached out to accounting teachers in an effort to improve the textbook presentation. New for this edition, we have extended our discussions to reach out to students directly in order to learn what they value in a textbook. Here’s a preview of some of the improvements we’ve made to this edition based on student input:

Guiding Principles System

NEW!

Students can easily locate the information they need to master course concepts with the new “Guiding Principles System (GPS).” At the beginning of every chapter, this innovative system plots a course through the chapter content by displaying the chapter objectives, major topics, and related Example Exercises. The GPS reference to the chapter “At a Glance” summary completes this proven system.

After studying this chapter, you should be able to: 1

2

Describe the characteristics of an account and a chart of accounts.

Describe and illustrate journalizing transactions using the doubleentry accounting system.

3

Using Accounts to Record Transactions

Double-Entry Accounting System

Chart of Accounts

Balance Sheet Accounts Income Statement Accounts

Describe and illustrate the journalizing and posting of transactions to accounts.

Posting Journal Entries to Accounts 2-3

EE (page 63) 2-4 EE (page 66) 2-5 EE (page 66)

Owner Withdrawals

4 Prepare an unadjusted trial balance and explain how it can be used to discover errors.

Trial Balance Errors Affecting the Trial Balance

EE 2-6 (page 70) Errors Not Affecting the Trial Balance 2-7 EE (page 71)

Normal Balances 2-1 EE (page 54) Journalizing 2-2 EE (page 58)

At a Glance

NEW!

Menu

Turn to pg 72

Written for Today’s Students

Designed for today’s students, the 23rd edition has been extensively revised using an innovative, high-impact writing style that emphasizes topics in a concise and clearly written manner. Direct sentences, concise paragraphs, numbered lists, and step-by-step calculations provide students with an easy-to-follow structure for learning accounting. This is achieved without sacrificing content or rigor. v

Leading by Example NEW!

Mornin’ Joe Financial Statements

Beginning after “Accounting for Merchandising Businesses” and continuing through Chapter 15, “Investments and Fair Value Accounting,” each chapter contains an excerpt from the full financial statements for Mornin’ Joe, a coffee company. The addition of this new example shows students the big picture of accounting by providing a consistent reference point for users who want to see an entire set of financial statements and the way each chapter topic fits within them. The financial statements were crafted by the authors to be consistent with the presentation in each chapter.

NEW!

Revised Coverage of Investments

A new chapter on investments and fair value accounting has been written to consolidate coverage of both dept and equity investments. The chapter also contains a conceptual discussion of fair value accounting and its increasing role in defining today’s modern accounting methods.

NEW!

Modern User-Friendly Design

Based on students’ testimonials of what they find most useful, this streamlined presentation includes a wealth of helpful resources without the clutter. To update the look of the material, some exhibits use computerized spreadsheets to better reflect the changing environment of business. Visual learners will appreciate the generous number of exhibits and illustrations used to convey concepts and procedures.

Exhibit 4 Statement of Owner’s Equity for Merchandising Business

NetSolutions Statement of Owner’s Equity For the Year Ended December 31, 2011 $153,800

Chris Clark, capital, January 1, 2011 Net income for the year Less withdrawals Increase in owner’s equity Chris Clark, capital, December 31, 2011

$75,400 18,000 57,400 $211,200

Journal Date

Description

Page 25 Post. Ref.

Debit

Credit

2011

Jan.

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3

Cash Sales To record cash sales.

1,800 1,800

Leading by Example Chapter Updates and Enhancements The following includes some of the specific content changes that can be found in Accounting, 23e.

Chapter 1: Introduction to Accounting and Business • Starbucks replaces DaimlerChrysler in opening lead-in example. • Discussion of “types of business organizations” has been moved to later in the chapter. Proprietorships, partnerships, corporations, and limited liability companies (LLC) are now discussed with the business entity concept. • “General-purpose financial statements” has been added as a new key term. • New Exhibit 3 provides guidelines for ethical conduct. • Discussion on career opportunities for accountants has been updated. • Improved formatting of transaction discussion for NetSolutions for greater clarity. • International Accounting Standards Board (IASB) and International Financial Reporting Standards are now mentioned in the discussion of generally accepted accounting principles. • New Financial Analysis and Interpretation (FAI) box has been added that introduces the ratio for liabilities to owner’s equity.

Chapter 2: Analyzing Transactions • New chapter opener features Apple. • New section on the double-entry accounting system (Objective 2) provides improved coverage of the rules of debit and credit for balance sheet, income statement, and owner drawing account. This discussion includes normal balances of accounts. In addition, Exhibit 3 was revised so that it better summarizes the rules of debits and credits for students to refer to when working end-of-chapter homework. • Discussion of recording transactions in accounts has been streamlined by including the discussion of the rules of debits and credits earlier in the chapter. Also, a new more simplified format for the journal and accounts is used. • Each illustrated transaction now includes the following sections: “Transaction, Analysis, and Journal Entry.” In addition, new line art design improves the presentation of journal entries and accounts. • Discussion of discovery and correction of errors has been revised and is now integrated into the discussion of the unadjusted trial balance. • New FAI feature has been added that discusses horizontal analysis of financial statements.

Chapter 3: The Adjusting Process • Discussion of the adjusting process has been revised to list the reasons for updating some accounts in the ledger under accrual accounting. • A new Exhibit 6 on Summary of Adjustments has been developed to include the reason for each adjustment, the adjusting entry, example adjusting entries from NetSolutions, and the financial statement impact if adjusting is omitted. • New FAI feature has been added that discusses vertical analysis of financial statements.

Chapter 4: Completing the Accounting Cycle • New spreadsheet format provides row and column labels that are more consistent with Microsoft Excel to reflect what students will see in practice. • Integrated all accounts necessary to complete the spreadsheet directly into the spreadsheet rather than adding them at the bottom of the spreadsheet. As reviewer feedback notes, this is consistent with using Microsoft Excel where new rows (accounts) can be directly inserted into the spreadsheet at their appropriate place. • New acetate for preparing the work sheet (spreadsheet) has been added that separates the individual adjustments from the adjusted trial balance totals. • Added stepwise approach to preparing the work sheet (spreadsheet).

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Leading by Example • Added “closing the books” as a key term. Added (permanent) descriptor to real accounts key term. • New FAI feature covers working capital and the current ratio.

Chapter 5: Accounting Systems • Added stepwise approach to journalizing and posting transactions to special journal and subsidiary ledgers. • Updated QuickBooks illustration to QuickBooks 2008 and tied better (using steps) into the chapter illustrations of a manual accounting system. • New FAI feature covers horizontal and vertical analyses as they relate to how accounting systems can provide analysis of business segments.

Chapter 6: Accounting for Merchandising Businesses • New chapter opener features Dollar Tree, Inc. • For added clarity, “transportation” terminology has been changed to “freight.” For example, instead of transportation costs, we use freight costs or simply freight. • For added clarity, this edition provides a fuller definition of debit (credit) memorandums. For efficiency, they are usually referenced as just debit memo or credit memo. • In Appendix 2 (The Periodic Inventory System), “Transportation In” was switched to “Freight In” for consistency with the chapter presentation.

Chapter 7: Inventories • Begin financial reporting illustrations using Mornin’ Joe to reinforce the importance of financial statements to a business and as a framework to learn accounting. • Significantly revised section on “Effect of Inventory Errors on the Financial Statements.” Added new Exhibits 9, 10, and 11. The section begins with a list of reasons that inventory errors can occur. Further illustrations get into the effects on the income statement and balance sheet. Exhibit 9 depicts the inventory error and whether the effect is understated or overstated in terms of COMS, gross profit, and net income. Exhibit 10 shows the effects of inventory errors on two years of income statements. Exhibit 11 shows the ending error and whether it is overstated or understated as it relates to merchandise inventory, current assets, total assets, and owner’s equity (capital). • Moved the “Estimating Inventory Cost” section from the chapter to an appendix at the end of the chapter. This section describes and illustrates “retail” and the “gross profit” methods of estimating inventory. The end-of-chapter materials still include exercises and one problem (A and B) for this appendix.

Chapter 8: Sarbanes-Oxley, Internal Control, and Cash • New illustration and journal entry for “Cash Short and Over” provides a visual presentation to reinforce this concept. • For added clarity, “Depositor” terminology has change to “Company” in the bank reconciliations. • Added check numbers to Exhibit 5, illustration of a bank statement. This is done based on user feedback and reflects that most banks do not return checks but simply list the cleared checks (by check number) on the bank statement. • Added stepwise illustration of how to prepare the bank statement (see Exhibit 7). • Used Mornin’ Joe as the financial statement reporting illustration to reinforce the importance of financial statements to a business and as a framework to learn accounting.

Chapter 9: Receivables • New chapter opener features Oakley, Inc. • Illustrations for allowance methods revised to use the same data to facilitate comparisons of the percent of sales and aging of receivables methods.

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Leading by Example • New Exhibit 2 comparing percent of sales and aging of receivables methods. • New illustration of promissory note (Exhibit 4) provides a visual reference to reinforce this concept. • Used Mornin’ Joe as the financial statement reporting illustration to reinforce the importance of financial statements to a business and as a framework to learn accounting.

Chapter 10: Fixed Assets and Intangible Assets • New Exhibit 7, Comparing Depreciation Methods, compares depreciation methods using chapter illustration. • Exchanging of similar fixed assets moved to end of chapter appendix (Appendix 2). Related end-ofchapter materials are still included. • Used Mornin’ Joe as the financial statement reporting illustration to reinforce the importance of financial statements to a business and as a framework to learn accounting.

Chapter 11: Current Liabilities and Payroll • Updated federal withholding table and revised chapter illustrations. • Revised “Contingent Liabilities” section including Exhibit 10. • Used Mornin’ Joe as the financial statement reporting illustration to reinforce the importance of financial statements to a business and as a framework to learn accounting.

Chapter 12: Accounting for Partnerships and Limited Liability Companies • New chapter opener features AgentBlaze, LLC. • Revised Exhibit 1 to be consistent with chapter discussion using parallel terminology. • New illustration of a partner not paying capital deficiency in liquidation visually reinforces this concept.

Chapter 13: Corporations: Organization, Stock Transactions, and Dividends • New chapter opener features Hasbro, Inc. • Added discussion of cumulative preferred stock with dividends in arrears. • Used Mornin’ Joe as the financial statement reporting illustration to reinforce the importance of financial statements to a business and as a framework to learn accounting.

Chapter 14: Long-Term Liabilities: Bonds and Notes This chapter was based on Chapter 15 in 22e. Objectives for this chapter are: • • • • •

Objective 1: Compute the potential impact of long-term borrowing on earnings per share. Objective 2: Describe the characteristics and terminology of bonds payable. Objective 3: Journalize entries for bonds payable. Objective 4: Describe and illustrate the accounting for installment notes. Objective 5: Describe and illustrate the reporting of long-term liabilities including bonds and notes payable. • A new objective has been added that includes discussion of installment notes. • Discussion of pricing of bonds using present values moved to Appendix 1 at the end of the chapter. Related end-of-chapter is still included. • “Effective Interest Rate Method of Amortization” is now Appendix 2 at the end of the chapter. Related end-of-chapter is still included.

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Leading by Example NOTE: Chapter 14 from the prior edition no longer exists. The material from Chapter 14 of 22e has been redistributed as follows: 22e Chapter

Topic

23e Chapter

Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter

Deferred Taxes Reporting Unusual Items on the Income Statement Earnings Per Common Share Comprehensive Income Accounting for Investments in Stocks Characteristics of Bonds Payable Payment and Redemption of Bonds Payable Investments in Bonds Appendix: Effective Interest Rate Method of Amortization

Appendix D (back of text) Chapter 17 (FSA Appendix) Chapters 14, 17 Chapter 15 (Appendix 2) Chapter 15 Chapter 14 Chapter 14 Chapter 15 Chapter 14

14 14 14 14 14 15 15 15 15

Chapter 15: Investments and Fair Value Accounting NEW!

A new chapter on “Investments and Fair Value Accounting” has been written for this edition, consolidating all investments-related topics into one chapter based on market feedback. The objectives for this chapter are: • • • • • • • •

Objective 1: Describe why companies invest in debt and equity securities. Objective 2: Describe and illustrate the accounting for debt investments. Objective 3: Describe and illustrate the accounting for equity investments. Objective 4: Describe and illustrate valuing and reporting investments in the financial statements. Objective 5: Describe fair value accounting and its implications for the future. Chapter opener features News Corporation. Appendix 1 covers accounting for held-to-maturity investments. Appendix 2 covers the topic of comprehensive income.

Chapter 16: Statement of Cash Flows • Revised beginning section discussing the statement of cash flows (SCF) and illustrating the format for the SCF under the direct and indirect methods. • Revised beginning discussion of direct method to emphasize conversion of accrual income statement to cash flows from operations (on an item-by-item basis). New graphic for conversion of interest expense to cash payments for interest provides visual reinforcement for this topic. • Used stepwise format for preparing the statement of cash flows under indirect and direct methods. • Used stepwise format for preparing the work sheet for the indirect method in the end-of-chapter appendix.

Chapter 17: Financial Statement Analysis • New chapter opener features Nike, Inc. • Real world financial statement analysis problem features data from the Nike, Inc. 2007 10K, which can be found in Appendix E in the back of the text. • Each ratio is highlighted in a boxed screen for easier review. • Appendix on “Unusual Items on the Income Statement” was added.

Chapter 18: Managerial Accounting Concepts and Principles • Added a new section at the beginning of the chapter on the uses of managerial accounting, which references subsequent chapters where the uses are described and illustrated. • Added an illustration of comparing merchandising and manufacturing income statements.

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Leading by Example • Added format for the cost of goods manufactured statement. • Added stepwise preparation of the cost of goods manufactured.

Chapter 19: Job Order Costing • Added format for the entries used to dispose of overapplied or underapplied factory overhead. • Changed order of entries so that entries for sales and cost of goods sold are shown separately from the finished goods entry for completed units.

Chapter 20: Process Cost Systems • Revised Exhibit 2 and accompanying narrative so that Exhibit 2 ties into Exhibit 8, which illustrates entries for Frozen Delights. • Revised illustration of cost of production report so that units are classified into groups consisting of beginning work in process units (Group 1), started and completed units (Group 2), and ending work in process units (Group 3). This aids students in computing unit costs and assigning costs to groups using first-in, first-out inventory cost flow. Accompanying exhibits and art also classify units by these groups. • Revised and expanded the section on using the cost of production report for decision making to include an example from Frozen Delights.

Chapter 21: Cost Behavior and Cost-Volume-Profit Analysis • • • • • • • • •

Supplemented the mixed cost discussion by adding an equation for determining fixed costs. Added contribution margin equation to cost-volume-profit discussion. Added unit contribution margin equation to cost-volume-profit discussion. Added “change in income from operations” equation based on unit contribution margin to costvolume-profit discussion. Incorporated a discussion of computing break-even in sales dollars using contribution margin ratio. Added a stepwise approach to discussion of preparing cost-volume-profit and profit-volume charts. Added equation for computing the percent change in income from operations using “operating leverage.” Expanded discussion of margin of safety so that margin of safety may be expressed in sales dollars, units, or percent of current sales. Revised appendix on variable costing to include format for variable costing income statement.

Chapter 22: Budgeting • • • •

Made minor changes to chapter objectives. Added stepwise approach to preparing a flexible budget. Modified the definition of the master budget. Added new classifications of budget components of the master budget as operating, investing, and financing budget components. • Added format for determining “total units to be produced.” • Added format for determining “direct materials to be purchased.”

Chapter 23: Performance Evaluation Using Variances from Standard Costs • Added a 2nd level heading for Objective 1, “Criticisms of Standard Costs.” • Added several new headings for Objective 2, “Budget Performance Report” and “Manufacturing Cost Variances.”

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Leading by Example • Revised discussion of “Manufacturing Cost Variances” to better tie into subsequent discussion of standard cost variances. • Utilized a new equation format for computing standard cost variances. Using these equations, a positive amount indicates an unfavorable variance while a negative amount indicates a favorable variance. Later in the chapter, positive variance amounts are recorded as debits and negative variance amounts are recorded as credits. • Revised the factory overhead variance discussion to include equations for computing total, variable, and fixed factory overhead rates. These rates are then used to explain and illustrate the computation of the controllable factory overhead variance and the volume factory overhead variance. • Revised the factory overhead variance discussion to use equations for computing the controllable and volume variances. • Revised the discussion of how the total factory overhead cost variance is related to overapplied or underapplied overhead balance. Further explanation is provided to show how the overapplied or underapplied overhead balance can be separated into the controllable and volume variances. • Added new key terms for budgeted variable factory overhead, favorable cost variance, unfavorable cost variance, and standards.

Chapter 24: Performance Evaluation for Decentralized Operations • Modified the chapter objectives slightly. • Added equations for computing service department charge rates. • Presented equations for allocating service department charges to decentralized operations (divisions). • Added example format for determining residual income. • Added equations for computing increases and decreases in divisional income using different negotiated transfer prices.

Chapter 25: Differential Analysis and Product Pricing • Added section on managerial decision making. Objective 1 now includes a new flowchart depicting the steps that define the decision-making process. • Added equations (e.g., markup percentages, desired profit) to “Setting Normal Product Selling Prices” Section. • Adopted a stepwise approach to setting normal prices for each cost-plus (total, product, variable) concept. • Added Exhibit 11 to summarize cost-plus approaches to setting normal prices. • Added equation to determine “contribution margin per bottleneck constraint.” • Presented equations for assessing product pricing and cost decisions related to bottlenecks. • Added equation for determining “activity rate” in Activity-Based Costing appendix.

Chapter 26: Capital Investment Analysis • Replaced XM Satellite Radio with Carnival Corporation as the opener vignette. • Revised the learning objectives so that the nonpresent value (average rate of return and cash payback) methods have a separate learning objective from the present value (net present value and internal rate of return) methods. • Added an equation for determining the “average investment” for use in the average rate of return method. • Added an equation for determining the “cash payback period.” • Added a graphic for determining the present value of $1 along with additional explanations of present values. • Added format for using the net present value method that is consistent with that shown in the solutions manual. • Added an equation for determining the present value index.

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Leading by Example Accounting, 23e, is unparalleled in pedagogical innovation. Our constant dialogue with accounting faculty continues to affect how we refine and improve the text to meet the needs of today’s students. Our goal is to provide a logical framework and pedagogical system that caters to how students of today study and learn.

Clear Objectives and Key Learning Outcomes To help guide students, the authors provide clear chapter objectives and important learning outcomes. All aspects of the chapter materials relate back to these key points and outcomes, which keeps students focused on the Describe the most important topics and concepts in order to succeed in the course. nature of a

1

business, the role of accounting, and ethics in business.

EX 6-1

Determining gross profit

obj. 1

During the current year, merchandise is sold for $795,000. The cost of the merchandise sold is $477,000. a. What is the amount of the gross profit? b. Compute the gross profit percentage (gross profit divided by sales). c. Will the income statement necessarily report a net income? Explain.

Example Exercises Example Exercises were developed to reinforce concepts and procedures in a bold, new way. Like a teacher in the classroom, students follow the authors’ example to see how to complete accounting applications as they are presented in the text. This feature also provides a list of Practice Exercises that parallel the Example Exercises so students get the practice they need. In addition, the Practice Exercises also include references to the chapter Example Exercises so that students can easily cross-reference when completing homework. See the example of the application being presented. Follow along as the authors work through the Example Exercise.

Example Exercise 2-2

Follow My Example 2-2 June 3

Try these corresponding end-of-chapter exercises for practice!

2

Journal Entry for Asset Purchase

Prepare a journal entry for the purchase of a truck on June 3 for $42,500, paying $8,500 cash and the remainder on account.

Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

42,500 8,500 34,000

For Practice: PE 2-2A, PE 2-2B

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Leading by Example “At a Glance” Chapter Summary The “At a Glance” summary grid ties everything together and helps students stay on track. First, the Key Points recap the chapter content for each chapter objective. Second, the related Key Learning Outcomes list all of the expected student performance capabilities that come from completing each objective. In case students need further practice on a specific outcome, the last two columns reference related Example Exercises and their corresponding Practice Exercises. In addition, the “At a Glance” grid guides struggling students from the assignable Practice Exercises to the resources in the chapter that will help them complete their homework. Through this intuitive grid, all of the chapter pedagogy links together in one cleanly integrated summary.

1

Describe the nature of the adjusting process. Key Points The accrual basis of accounting requires that revenues are reported in the period in which they are earned and expenses matched with the revenues they generate. The updating of accounts at the end of the accounting period is called the adjusting process. Each adjusting entry affects an income statement and balance sheet account. The four types of accounts requiring adjusting entries are prepaid expenses, unearned revenues, accrued revenues, and accrued expenses.

Provides a conceptual review of each objective.

Example Exercises

Practice Exercises

• List accounts that do and do NOT require adjusting entries at the end of the accounting period.

3-1

3-1A, 3-1B

• Give an example of a prepaid expense, unearned revenue, accrued revenue, and accrued expense.

3-2

3-2A, 3-2B

Key Learning Outcomes • Explain why accrual accounting requires adjusting entries.

Creates a checklist of skills to help review for a test.

Real-World Chapter Openers

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H

A

P

T

E

R

Analyzing Transactions

© AP Photo/Paul Sakuma

Building on the strengths of past editions, these openers continue to relate the accounting and business concepts in the chapter to students’ lives. These openers employ examples of real companies and provide invaluable insight into real practice. Several of the openers created especially for this edition focus on interesting companies such as Apple; Dollar Tree; Hasbro; and News Corporation (Fox), the parent company of the hit television shows American Idol and The Simpsons.

C

Directs the student to this helpful feature!

A P P L E,

E

veryday it seems like we get an incredible amount of incoming e-mail messages; you get them from your friends, relatives, subscribed e-mail lists, and even spammers! But how do you organize all of these messages? You might create folders to sort messages by sender, topic, or project. Perhaps you use keyword search utilities. You might even use filters/rules to automatically delete spam or send messages from your best friend to a special folder. In any case, you are organizing information so that it is simple to retrieve and allows you to understand, respond, or refer to the messages. In the same way that you organize your e-mail, companies develop an organized method for processing, recording, and summarizing financial transactions. For example, Apple, Inc., has a huge volume of financial transactions, resulting from sales of its innovative computers, digital media (like iPod music and video players), and iPhone mobile phones. When Apple sells an iPhone online or at The Apple Store, a customer has the option of paying with credit card, a debit

I N C.™ or check card, an Apple gift card, a financing arrangement, or cash (using a cashier’s check, a money order, or a wire transfer). In order to analyze only the information related to Apple’s cash transactions, the company must record or summarize all these similar sales using a single category or “cash” account. This is comparable to how you summarize cash in the check register of your checkbook. Similarly, Apple will record credit card payments for iPhones and sales from financing arrangements in different accounts (records). While Chapter 1 uses the accounting equation (Assets = Liabilities + Owner’s Equity) to analyze and record financial transactions, this chapter presents more practical and efficient recording methods that most companies use. In addition, this chapter discusses possible accounting errors that may occur, along with methods to detect and correct them.

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Leading by Example Financial Analysis and Interpretation The “Financial Analysis and Interpretation” section at the end of each accounting chapter introduces relevant key ratios used throughout the textbook. Students connect with the business environment as they learn how stakeholders interpret financial reports. This section covers basic analysis tools that students will use again in Chapter 17, “Financial Statement Analysis.” Furthermore, students get to test their proficiency with these tools through special activities and exercises at the end of each chapter. To ensure a consistent presentation, a unique icon is used for both the section and related end-of-chapter materials.

Financial Analysis and Interpretation Comparing each item in a current statement with a total amount within that same statement is useful in analyzing relationships within a financial statement. Vertical analysis is the term used to describe such comparisons. In vertical analysis of a balance sheet, each asset item is stated as a percent of the total assets. Each liability and owner’s equity item is stated as a percent of the total liabilities and owner’s equity. In vertical analysis of an income statement, each item is stated as a percent of revenues or fees earned. Vertical analysis may be prepared for several periods to analyze changes in relationships over time. Vertical analysis of two years of income statements for J. Holmes, Attorneyat-Law, is shown below. J. Holmes, Attorney-at-Law Income Statements For the Years Ended December 31, 2010 and 2009 2010 Amount Fees earned $187,500 __________ Operating expenses: Wages expense $ 60,000 Rent expense 15,000 Utilities expense 12,500 Supplies expense 2,700 Miscellaneous expense 2,300 __________ Total operating expenses $ 92,500 __________ Net income $ 95,000 __________ __________

The preceding vertical analysis indicates both favorable and unfavorable trends affecting the income statement of J. Holmes, Attorney-at-Law. The increase in wages expense of 2% (32% 30%) is an unfavorable trend, as is the increase in utilities expense of 0.7% (6.7% 6.0%). A favorable trend is the decrease in supplies expense of 0.6% (2.0% 1.4%). Rent expense and miscellaneous expense as a percent of fees earned were constant. The net result of these trends was that net income decreased as a percent of fees earned from 52.8% to 50.7%. The analysis of the various percentages shown for J. Holmes, Attorney-at-Law, can be enhanced by comparisons with industry averages. Such averages are published by trade associations and financial information services. Any major differences between industry averages should be investigated.

2009

Percent Amount Percent 100.0% ______

$150,000 __________ 100.0% ______

32.0% $ 45,000 8.0% 12,000 6.7% 9,000 1.4% 3,000

30.0%* 8.0% 6.0% 2.0%

1.2% ______

1,800 ______ 1.2% __________

49.3% ______

$ 70,800 ______ 47.2% __________

50.7% ______ ______

$ 79,200 ______ 52.8% __________ __________ ______

*$45,000 ÷ $150,000

Business Connection and Comprehensive Real-World Notes Students get a close-up look at how accounting operates in the marketplace through a variety of items in the margins and in the “Business Connection” boxed features. In addition, a variety of end-ofchapter exercises and problems employ reallargest business, such as Ford Motor Company, compaTHE ACCOUNTING EQUATION nies use the accounting equation. Some examples taken world data to give stuThe accounting equation serves as the basic foundation for from recent financial reports of well-known companies are the accounting systems of all companies. From the small- shown below. dents a feel for the materiest business, such as the local convenience store, to the al that accountants see Company Assets* Liabilities Owner’s Equity daily. No matter where The Coca-Cola Company $ 29,963 $13,043 $16,920 Circuit City Stores, Inc. 4,007 2,216 1,791 they are found, elements Dell Inc. 25,635 21,196 4,439 eBay Inc. 13,494 2,589 10,905 that use material from real Google 18,473 1,433 17,040 McDonald’s 29,024 13,566 15,458 companies are indicated Microsoft Corporation 63,171 32,074 31,097 Southwest Airlines Co. 13,460 7,011 6,449 with a unique icon for a Wal-Mart 151,193 89,620 61,573 consistent presentation. *Amounts are shown in millions of dollars.

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Leading by Example Integrity, Objectivity, and Ethics in Business In each chapter, these cases help students develop their ethical compass. Often coupled with related end-of-chapter activities, these cases can be discussed in class or students can consider the cases as they read the chapter. Both the section and related end-ofchapter materials are indicated with a unique icon for a consistent presentation.

ACCOUNTING REFORM The financial accounting and reporting failures of Enron, WorldCom, Tyco, Xerox, and others shocked the investing public. The disclosure that some of the nation’s largest and best-known corporations had overstated profits and misled investors raised the question: Where were the CPAs? In response, Congress passed the Investor Protection, Auditor Reform, and Transparency Act of 2002, called the

Sarbanes-Oxley Act. The Act establishes a Public Company Accounting Oversight Board to regulate the portion of the accounting profession that has public companies as clients. In addition, the Act prohibits auditors (CPAs) from providing certain types of nonaudit services, such as investment banking or legal services, to their clients, prohibits employment of auditors by clients for one year after they last audited the client, and increases penalties for the reporting of misleading financial statements.

Continuing Case Study Students follow a fictitious company, NetSolutions, throughout Chapters 1–6, which demonstrates a variety of transactions. The continuity of using the same company facilitates student learning especially for Chapters 1–4, which cover the accounting cycle. Also, using the same company allows students to follow the transition of the company from a service business in Chapters 1–4 to a merchandising business in Chapters 5 and 6.

Summaries Within each chapter, these synopses draw special attention to important points and help clarify difficult concepts.

Self-Examination Questions Five multiple-choice questions, with answers at the end of the chapter, help students review and retain chapter concepts.

Illustrative Problem and Solution A solved problem models one or more of the chapter’s assignment problems so that students can apply the modeled procedures to end-of-chapter materials.

Market Leading End-of-Chapter Material Students need to practice accounting so that they can understand and use it. To give students the greatest possible advantage in the real world, Accounting, 23e, goes beyond presenting theory and procedure with comprehensive, time-tested, end-of-chapter material. xvi

Online Solutions South-Western, a division of Cengage Learning, offers a vast array of online solutions to suit your course needs. Choose the product that best meets your classroom needs and course goals. Please check with your Cengage representative for more details or for ordering information.

Aplia Founded in 2000 by economist and Stanford professor Paul Romer, Aplia is an educational technology company dedicated to improving learning by increasing student effort and engagement. Currently, our products support college-level courses and have been used by more than 650,000 students at over 750 institutions. For students, Aplia offers a way to stay on top of coursework with regularly scheduled homework assignments. Interactive tools and content further increase engagement and understanding. For professors, Aplia offers high-quality, auto-graded assignments, which ensure that students put forth effort on a regular basis throughout the term. These assignments have been developed for a range of textbooks and are easily customized for individual teaching schedules. Every day, we develop our products by responding to the needs and concerns of the students and professors who use Aplia in their classrooms. As you explore the features and benefits Aplia has to offer, we hope to hear from you as well. Welcome to Aplia.

CengageNOW Express CengageNOW Express™ for Warren/Reeve/Duchac Accounting, 23e, is an online homework solution that delivers better student outcomes—NOW! CengageNOW Express focuses on the textbook homework that is central to success in accounting with streamlined course start-up, straightforward assignment creation, automatic grading and tracking student progress, and instant feedback for students. • Streamlined Course Start-Up: All Brief Exercises, Exercises, Problems, and Comprehensive Problems are available immediately for students to practice. • Straightforward Assignment Creation: Select required exercises and problems, and CengageNOW Express automatically applies faculty approved, Accounting Homework Options. • Automatic grading and tracking student progress: CengageNOW Express grades and captures students’ scores to easily monitor their progress. Export the grade book to Excel for easy data management. • Instant feedback for students: Students stay on track with instructor-written hints and immediate feedback with every assignment. Links to the e-book, animated exercise demonstrations, and Excel spreadsheets from specific assignments are ideal for student review.

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Online Solutions CengageNOW CengageNOW for Warren/Reeve/Duchac Accounting, 23e, is a powerful and fully integrated online teaching and learning system that provides you with flexibility and control. This complete digital solution offers a comprehensive set of digital tools to power your course. CengageNOW offers the following: • Homework, including algorithmic variations • Integrated E-book • Personalized Study Plans, which include a variety of multimedia assets (from exercise demonstrations to video to iPod content) for students as they master the chapter materials • Assessment options which include the full test bank, including algorithmic variations • Reporting capability based on AACSB, AICPA, and IMA competencies and standards • Course Management tools, including grade book • WebCT and Blackboard Integration

WebTutor™! Available packaged with Warren/Reeve/Duchac Accounting, 23e, or for individual student purchase Jumpstart your course with customizable, rich, textspecific content within your Course Management System. • Jumpstart—Simply load a WebTutor cartridge into your Course Management System. • Customizable—Easily blend, add, edit, reorganize, or delete content. • Content—Rich, text-specific content, media assets, quizzing, test bank, weblinks, discussion topics, interactive games and exercises, and more. Visit academic.cengage.com for more information. xviii

For the Instructor When it comes to supporting instructors, South-Western is unsurpassed. Accounting, 23e, continues the tradition with powerful print and digital ancillaries aimed at facilitating greater course successes.

Instructor’s Manual This manual contains a number of resources designed to aid instructors as they prepare lectures, assign homework, and teach in the classroom. For each chapter, the instructor is given a brief synopsis and a list of objectives. Then each objective is explored, including information on Key Terms, Ideas for Class Discussion, Lecture Aids, Demonstration Problems, Group Learning Activities, Exercises and Problems for Reinforcement, and Internet Activities. Also, Suggested Approaches are included that incorporate many of the teaching initiatives being stressed in higher education today, including active learning, collaborative learning, critical thinking, and writing across the curriculum.

Solutions Manual The Solutions Manual contains answers to all exercises, problems, and activities that appear in the text. As always, the solutions are author-written and verified multiple times for numerical accuracy and consistency with the core text. Solutions transparencies are also available. Test Bank For each chapter, the Test Bank includes True/False questions, MultipleChoice questions, and Problems, each marked with a difficulty level, chapter objective association, and a tie-in to standard course outcomes. Along with the normal update and upgrade of the 2,800 test bank questions, variations of the new Example Exercises have been added to this bank for further quizzing and better integration with the textbook. In addition, the bank provides a grid for each chapter that compiles the correlation of each question to the individual chapter’s objectives, as well as a ranking of difficulty based on a clearly described categorization. Through this helpful grid, making a test that is comprehensive and well-balanced is a snap!

ExamView® Pro Testing Software This intuitive software allows you to easily customize exams, practice tests, and tutorials and deliver them over a network, on the Internet, or in printed form. In addition, ExamView comes with searching capabilities that make sorting the wealth of questions from the printed test bank easy. The software and files are found on the IRCD.

PowerPoint® Each presentation, which is included on the IRCD and on the product support site, enhances lectures and simplifies class preparation. Each chapter contains objectives followed by a thorough outline of the chapter that easily provide an entire lecture model. Also, exhibits from the chapter, such as the new Example Exercises, have been recreated as colorful PowerPoint slides to create a powerful, customizable tool.

Instructor Excel® Templates These templates provide the solutions for the problems and exercises that have Enhanced Excel® templates for students. Through these files, instructors can see the solutions in the same format as the students. All problems with accompanying templates are marked in the book with an icon and are listed in the information grid in the solutions manual. These templates are available for download on academic.cengage.com/accounting/warren or on the IRCD.

Instructor’s Resource CD-ROM This convenient resource includes the PowerPoint® Presentations, Instructor’s Manual, Solutions Manual, Test Bank, ExamView®, An Instructor’s Guide to Online Resources, and Excel Application Solutions. Lively demonstrations of support technology are also included. All the basic material an instructor would need is available in one place on this IRCD.

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For the Student Students come to accounting with a variety of learning needs. Accounting, 23e, offers a broad range of supplements in both printed form and easy-touse technology. We continue to refine our entire supplement package around the comments instructors have provided about their courses and teaching needs.

Study Guide This author-written guide provides students Quiz and Test Hints, Matching questions, Fill-in-the-Blank questions (Parts A & B), Multiple-Choice questions, True/False questions, Exercises, and Problems for each chapter. Designed to assist students in comprehending the concepts and principles in the text, solutions for all of these items are available in the guide for quick reference. Working Papers for Exercises and Problems The traditional working papers include problem-specific forms for preparing solutions for Exercises, A & B Problems, the Continuing Problem, and the Comprehensive Problems from the textbook. These forms, with preprinted headings, provide a structure for the problems, which helps students get started and saves them time. Additional blank forms are included.

Blank Working Papers These Working Papers are available for completing exercises and problems either from the text or prepared by the instructor. They have no preprinted headings. A guide at the front of the Working Papers tells students which form they will need for each problem. Enhanced Excel® Templates These templates are provided for selected long or complicated end-of-chapter exercises and problems and provide assistance to the student as they set up and work the problem. Certain cells are coded to display a red asterisk when an incorrect answer is entered, which helps students stay on track. Selected problems that can be solved using these templates are designated by an icon.

Klooster & Allen General Ledger Software Prepared by Dale Klooster and Warren Allen, this best-selling, educational, general ledger package introduces students to the world of computerized accounting through a more intuitive, user-friendly system than the commercial software they’ll use in the future. In addition, students have access to general ledger files with information based on problems from the textbook and practice sets. The program is enhanced with a problem checker that enables students to determine if their entries are correct and emulates commercial general ledger packages more closely than other educational packages. Problems that can be used with Klooster/Allen are highlighted by an icon. A free Network Version is available to schools whose students purchase Klooster/Allen GL.

Product Support Web Site academic.cengage.com/accounting/warren. This site provides students with a wealth of introductory accounting resources, including quizzing and supplement downloads and access to the Enhanced Excel® Templates.

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Acknowledgments Many of the enhancements made to Accounting, 23e, are a direct result of countless conversations we’ve had with principles of accounting students over the past several years. We want to take this opportunity to thank them for their perspectives and feedback on textbook use; we think that 23e represents our finest edition yet! Bucks County Community College Instructors: Lori Grady, Judy Toland Bernadette Allen Matarazzo Vikas Patel Erica Olsen Eric Goldner Shelly Rushbrook Eamon Coleman Tracy Bunsick Baltimore City Community College Instructors: Jeff Hillard, John Wiley Sulaimon Adeyemi Udeya Diour Dwain White Debra Witherspoon Jacqueline Tuggle Mabono Soumahoo Des Moines Area Community College Instructors: Shea Mears, Patty Holmes Zach Schmidt Angie Lee Tim Hoffman Richard Palmer Sharon Beattie Joseph J. Johnson Armina Kahrimanovic Ryan Wisnousky Lindsay Tripp Tiffany Shuey Jenny Leonard Susann Shaffner Cori Shanahan Nicholas Wallace Kyle Melohn Wendy Doolittle LaRue Brannan Nicholas Christopher Yaeger Jason Aitchison Kean University Instructor: Gary Schader Margherita Marjotta Hugo Prado Marta Domanska

Nicole Foy Andrea Colbert Khatija Bibi Houston Community College Instructor: Linda Flowers Yildirim Kocoglu Ana Zelaya Seungkyu Kim Mohammad Arsallan Bakali Vanessa K. Rangel Cher Lay Sherika Gibson Ulsi Ramos Muhammad Shaikha Hong Yang Pamela Ruiz Yvonne Ngo Lansing Community College Instructor: Patricia Walczak Ana Topor John Barrett Brandon Smithwick Bradley L. Moore Cassandra DeVos Elizabeth C. Escalera Clara Powers Lance Spencer Jennifer Jones Aristoteles Paiva Lopes Oakland Community College Instructor: Deborah Niemer Paul Boker Tracie M. Leitner Thetnia Lynette Cobb Vera Kolaj Olivia Burke Thomas J. Zuchowski Ryan Shead Austen Michaels Michaele Jones Bradlee J. VanAlstine Tim Doherty Vanya Jelezarova Nilda Dervishaj Maja Lulgjuraj

Pierce Radtke Butler Community College Instructors: Jennifer Brewer, Janice Akao Sarah Kirkwood Kimberly Brothers Christine Brown Chelsey Perkins Thomas Mackay Tucker Stewart Austin Birkholtz Santa Monica College Instructors: Greg Brookins, Terri Bernstein, and Pat Halliday Julieta Loreto Noah Johnson Matthew Nyby Anitha Guna Wijaya Jovani Rodriguez Michelle Sharma Marisol Granele Prashila Sharma Karlie Bryant Wing San Kwong Anthony Mitchell Metropolitan Community College Instructor: Idalene Williams Suquett Saunders Danette Cook Ewokem Akohachere Ivina Washington Queen Esther Tucker Jamie Rusch Daisuke Motomura Comlanri S. Zannou Melissa Brunious Marc Anderson Keith Costello Robyn Adler Kelly Fitzgerald Volunteer State Community College Instructor: Brent Trentham Kris Anderson Jasmine Cox

Wendy Nabors Patrick Farmer Justin Gill Kathryn Gambrell Dana Mihalko Kavitha Sudheendra April Jeffries Ray Mefford Ashlee Kilpatrick Cedar Valley Instructor: S.T. Desai Tiffany King Kareem Aziz Ebony Wingard Cheryl Boyd Dwevelyn Jennings Kal Takieddin Lazari Vanly Adrian McKinney Tanya Hubbard Angela Fulbright Tenisha Blair Jamie Riley Roshunda Webb Porsha Espie Keisha Murrell Dawn Smith Sinclair Community College Instructor: Donna Chadwick Emanuel Gena Victoria Wiseman Daniel Hulet Naaman Beck Eric Pedro Kathy Ernest Jessica Weiss Jessica Baker Champer Murtery Steve Huffman Regis Allison Hiba Ligawad Cara Scott Tammy Baughman Kevin Ricketts Nora Hatlab Mary Kasper

Nicole Sutherland, Grossmont College Katie Longo, Southern Adventist University Joel Hughes, Southern Adventist University Lisa Hubbard, Mid-State Technical College Amanda Baker, Davenport University Phillipe Bouzy, Southern Adventist University Barbara Bryant, DeKalb Technical College Charisse Dolina, Maharishi School of Management Amanda Worrell, Southern Adventist University Angela Snider, Cardinal Stritch University Star Maddox, DeKalb Technical College Charles Balliet, Lehigh Carbon CC Ashley Heath, Buena Vista University Brianna Miller, Southern Adventist University John Varga, Orange Coast College Roger Montero, East Los Angeles College Terry Thorpe, Irvine Valley Jim Sugden, Orange Coast College

WebEx Focus Group Participants April Wakefield, Northcentral Technical College

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The following instructors are members of our Blue Sky editorial board, whose helpful comments and feedback continue to have a profound impact on the presentation and core themes of this text:

Ana M. Cruz Miami Dade College

Gloria Worthy Southwest Tennessee Community College

Walter DeAguero Saddleback College

Lee Smart Southwest Tennessee Community College Rick Andrews Sinclair Community College Donna Chadwick Sinclair Community College Warren Smock Ivy Tech Community College

Terry Dancer Arkansas State University David L. Davis Tallahassee Community College

Robert Dunlevy Montgomery County Community College Richard Ellison Middlesex County College W. Michael Fagan Raritan Valley Community College Carol Flowers Orange Coast College

Shirly A. Kleiner Johnson County Community College

Carol Welsh Rowan University

Patrick Borja Citrus College

Michael M. Landers Middlesex College

Chris Widmer Tidewater Community College

Robert Adkins Clark State Community College

Phillip Lee Nashville State Community College

Lynnette Mayne Yerbury Salt Lake Community College

Melvin Williams College of the Mainland

Denise Leggett Middle Tennessee State University

The following instructors have participated in the review process, focus groups, and marketing events for this new edition:

Patrick Rogan Consumes River College

Lynne Luper Ocean County College Maria C. Mari Miami Dade College Thomas S. Marsh Northern Virginia Community College— Annandale Cynthia McCall Des Moines Area Community College

Gary Schader Kean University

Linda S. Flowers Houston Community College

Priscilla Wisner Montana State University

Mike Foland Southwest Illinois College

Andrea Murowski Brookdale Community College

Audrey Hunter Broward Community College

Anthony Fortini Camden Community College

Rachel Pernia Essex County College

Renee Rigoni Monroe Community College Terry Thorpe Irvine Community College Patricia Walczak Lansing Community College Judith Zander Grossmont College Gilda M. Agacer Monmouth University Irene C. Bembenista Davenport University Laurel L. Berry Bryant & Stratton College Bill Black Raritan Valley Community College Gregory Brookins Santa Monica College

Barbara M. Gershowitz Nashville State Community College Angelina Gincel Middlesex County College Lori Grady Bucks County Community College Joseph R. Guardino Kingsborough Community College Amy F. Haas Kingsborough Community College Betty Habershon Prince George’s Community College Patrick A. Haggerty Lansing Community College

Rebecca Carr Arkansas State University

Becky Hancock El Paso Community College

James L. Cieslak Cuyahoga Community College

Paul Harris Camden County College

Sue Cook Tulsa Community College

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Patricia H. Holmes Des Moines Area Community College

Brenda Fowler Alamance Community College

James Cieslaks Cuyahoga Community College

Shelia Ammons Austin Community College

Felicia Baldwin Daley College

Peggy Smith Baker College—Auburn Hills

Debra Kiss Davenport University

Christopher Mayer Bergen Community College

Dawn Peters Southwest Illinois College Gary J. Pieroni Diablo Valley College

Audrey Hunter Broward Community College

Debra Prendergast Northwestern Business College

Cathy Montesarchio Broward Community College

Lou Rosamillia Hudson Valley Community College

Laurel L. Berry Bryant and Stratton College

Eric Rothernburg Kingsborough Community College

Judy Toland Bucks County Community College

Gerald Savage Essex Community College Janice Stoudemire Midlands Technical College Linda H. Tarrago Hillsborough Community College

Lawrence Roman Cuyahoga Community College

Darlene B. Lindsey Hinds Community College

Michelle Grant Bossier Parish Community College

Richard Sarkisian Camden Community College

Sandee Cohen Columbia College—Chicago

Lori Grady Bucks County Community College Rafik Elias California State University —Los Angeles Norris Dorsey California State University —Northridge

Judy Toland Buck Community College

Angela Siedel Cambria-Rowe Business College

Bob Urell Irvine Valley College

Suryakant Desai Cedar Valley College

Marilyn Ciolino Delgado Community College Patti Holmes Des Moines Area Community College Gary J. Pieroni Diablo Valley College Rebecca Brown DMACC—Carroll Campus Chris Gilbert East Los Angeles College Satoshi K. Kojima East Los Angeles College Ron Ozur East Los Angeles College Lorenzo Ybarra East Los Angeles College Carol Dutchover Eastern New Mexico University—Roswell Peter VanderWeyst Edmonds Community College Debbie Luna El Paso Community College Lee Cannell El Paso Community College

Kenneth O’Brien Farmingdale State College Lynn Clements Florida Southern College Sara Seyedin Foothill College Aaron Reeves Forest Park Community College Ron Dustin Fresno City College Christy Kloezman Glendale Community College Scott Stroher Glendale Community College Brenda Bindschatel Green River Community College Judith Zander Grossmont College

Susan Logorda Lehigh Carbon Community College Kirk Canzano Long Beach City College Frank Iazzetta Long Beach City College Anothony Dellarte Luzerne County Community College Bruce England Massasoit Community College Idalene Williams Metropolitan Community College Cathy Larson Middlesex Community College Janice Stoudemire Midlands Technical College

Dick Ahrens Pierce College Catherine Jeppson Pierce College Al Partington Pierce College Mercedes Martinez Rio Hondo College Michael Chaks Riverside Community College Cheryl Honore Riverside Community College Frank Stearns Riverside Community College Patricia Worsham Riverside Community College Leonard Cronin Rochester Community College

Dominque Svarc Harper College

Renee Rigoni Monroe Community College

Jennifer Finley Hill College

Janice Feingold Moorpark College

Michelle Powell Dancy Holmes Community College

Yaw Mensah Rutgers University

Patricia Feller Nashville State Community College

David Juriga Saint Louis Community College

Terry Thorpe Irvine Community College

Ray Wurzburger New River Community College

Doug Larson Salem State College

Leslie Thysell John Tyler Community College

Desta Damtew Norfolk State University

Carol Welsh Rowan University

David L. Davis Tallahassee Community College Chris Widmer Tidewater Community College Julie Gilbert Triton College Stephanie Farewell U of Arkansas— Little Rock Sanford Kahn University of Cincinnati Suzanne McCaffrey University of Mississippi Pete Rector Victor Valley College Daniel Gibbons Waubonsee Community College The following instructors created content for the supplements that accompany the text: Christine Jonick Gainesville State College CengageNOW Janice Stoudemire Midlands Technical College CengageNOW

Greg Brookins Santa Monica College

Angie LaTourneau Winthrop University CengageNOW

Dan King Shoreline Community College

Ann Martel Marquette University CengageNOW

Ann Gregory South Plains College

Robin Turner Rowan-Cabarrus Community College CengageNOW

Shirly A. Kleiner Johnson County Community College

Andrew McKee North Country Community College

Alex Clifford Kennebec Valley Technical College

Greg Lauer North Iowa Area Community College

Eric Rothenburg Kingsborough Community College

Debra Prendergast Northwestern Business College

John Dudley La Harbor College

Lynne Luper Ocean County College

Abdul Qastin Lakeland College

Audrey Morrison Pensacola Junior College

John Teter St. Petersburg College

Patricia Walczak Lansing Community College

Judy Grotrian Peru State College

Bonnie Scrogham Sullivan University

Gloria Worthy Southwest Tennessee Community College Beatrice Garcia Southwest Texas Junior College

Sheila Ammons Austin Community College CengageNOW Tracie Nobles Austin Community College CengageNOW

Patti Lopez Valencia Community College General Ledger Software LuAnn Bean Florida Institute of Technology Test Bank Barbara Durham University of Central Florida Test Bank Doug Cloud Pepperdine University PowerPoint Presentations Kirk Lynch Sandhills Community College Instructor’s Manual Lori Grady Bucks County Community College JoinIN/Turning Point Kevin McFarlane Front Range Community College Achievement Tests, Web Quizzes L.L. Price Pierce College Leaping Lizards Lawn Care Practice Set Don Lucy Indian River Community College Bath Designs, Danielle’s Dog Care Practice Sets Jose Luis Hortensi Miami Dade College Fitness City Merchandise Practice Set Edward Krohn, Miami Dade, College Star Computer Sales and Services Practice Set Ana Cruz & Blanca Ortega, Miami Dade College Artistic Décor Practice Set

Craig Pence Highland Community College Spreadsheets

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BRIEF CONTENTS

CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

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

A APPENDIX B APPENDIX C APPENDIX

D APPENDIX E APPENDIX

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Introduction to Accounting and Business . . . . . . . . . . . . . . . . . . . . Analyzing Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Adjusting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Completing the Accounting Cycle . . . . . . . . . . . . . . . . . . . . . . . . . Accounting Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounting for Merchandising Businesses . . . . . . . . . . . . . . . . . . Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sarbanes-Oxley, Internal Control, and Cash . . . . . . . . . . . . . . . . . . Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Assets and Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . Current Liabilities and Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounting for Partnerships and Limited Liability Companies . . . . . Corporations: Organization, Stock Transactions, and Dividends . . . Long-Term Liabilities: Bonds and Notes . . . . . . . . . . . . . . . . . . . . Investments and Fair Value Accounting. . . . . . . . . . . . . . . . . . . . . . Financial Statements for Mornin’ Joe . . . . . . . . . . . . . . . . . . . . . . Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Statement Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . Managerial Accounting Concepts and Principles . . . . . . . . . . . . . Job Order Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Process Cost Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost Behavior and Cost-Volume-Profit Analysis . . . . . . . . . . . . . Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Performance Evaluation Using Variances from Standard Costs . . Performance Evaluation for Decentralized Operations . . . . . . . . . Differential Analysis and Product Pricing . . . . . . . . . . . . . . . . . . Capital Investment Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1 49 99 143 201 251 311 352 397 440 484 532 574 617 657 707 710 762 817 854 896 947 996 1042 1086 1131 1179

Interest Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reversing Entries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . End-of-Period Spreadsheet (Work Sheet) for a Merchandising Business . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounting for Deferred Income Taxes . . . . . . . . . . . . . . . . . . . . Nike, Inc., Annual Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subject Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Company Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A-2 B-1 C-1 D-1 E-1 G-1 I-1 I-18

Contents

CHAPTER

1

Introduction to Accounting and Business ................................................1

Nature of Business and Accounting 2 Types of Businesses 2 The Role of Accounting in Business 3 Role of Ethics in Accounting and Business 4 Opportunities for Accountants 6

Generally Accepted Accounting Principles 7 Business Entity Concept 8 The Cost Concept 8

The Accounting Equation 9 Business Transactions and the Accounting Equation 10 Business Connection: The Accounting Equation 10 Financial Statements 15 Income Statement 16 Statement of Owner’s Equity 17 Balance Sheet 17 Statement of Cash Flows 19 Interrelationships Among Financial Statements 21

Financial Analysis and Interpretation 21 CHAPTER

2

Analyzing Transactions.....................49

Using Accounts to Record Transactions 50 Chart of Accounts 52

Business Connection: The Hijacking Receivable 52 Double-Entry Accounting System 53 Balance Sheet Accounts 53 Income Statement Accounts 54 Owner Withdrawals 54 Normal Balances 54 Journalizing 55

Posting Journal Entries to Accounts 59 Trial Balance 68 Errors Affecting the Trial Balance 68 Errors Not Affecting the Trial Balance 70

Financial Analysis and Interpretation 71 CHAPTER

3

The Adjusting Process ......................99

Nature of the Adjusting Process 100 The Adjusting Process 101 Types of Accounts Requiring Adjustment 102

Recording Adjusting Entries 104 Prepaid Expenses 105 Unearned Revenues 107

Accrued Revenues 108 Accrued Expenses 109 Depreciation Expense 111

Summary of Adjustment Process 113 Business Connection: Microsoft Corporation 116 Adjusted Trial Balance 118 Financial Analysis and Interpretation 120 CHAPTER

4

Completing the Accounting Cycle...................................................143

Flow of Accounting Information 144 Financial Statements 146 Income Statement 146 Statement of Owner’s Equity 148 Balance Sheet 149

Business Connection: International Differences 150 Closing Entries 150 Journalizing and Posting Closing Entries 152 Post-Closing Trial Balance 155

Accounting Cycle 156 Illustration of the Accounting Cycle 157 Step 1. Analyzing and Recording Transactions in the Journal 158 Step 2. Posting Transactions to the Ledger 159 Step 3. Preparing an Unadjusted Trial Balance 160 Step 4. Assembling and Analyzing Adjustment Data 160 Step 5. Preparing an Optional End-of-Period Spreadsheet (Work Sheet) 161 Step 6. Journalizing and Posting Adjusting Entries 161 Step 7. Preparing an Adjusted Trial Balance 163 Step 8. Preparing the Financial Statements 163 Step 9. Journalizing and Posting Closing Entries 165 Step 10. Preparing a Post-Closing Trial Balance 165

Fiscal Year 168 Financial Analysis and Interpretation 168A Appendix: End-of-Period Spreadsheet (Work Sheet) 168A Step 1. Enter the Title 168C Step 2. Enter the Unadjusted Trial Balance 168C Step 3. Enter the Adjustments 168C Step 4. Enter the Adjusted Trial Balance 168D Step 5. Extend the Accounts to the Income Statement and Balance Sheet Columns 168D Step 6. Total the Income Statement and Balance Sheet Columns, Compute the Net Income or Net Loss, and Complete the Spreadsheet 168D Preparing the Financial Statements from the Spreadsheet 169 xxv

Comprehensive Problem 1 196 Practice Set: Leaping Lizards Lawn Care

This set is a service business operated as a proprietorship. It includes a narrative of transactions and instructions for an optional solution with no debits and credits. This set can be solved manually or with the Klooster/Allen software.

CHAPTER

5

Accounting Systems........................201

Basic Accounting Systems 202 Manual Accounting System 203 Subsidiary Ledgers 203 Special Journals 204 Revenue Journal 205 Cash Receipts Journal 208 Accounts Receivable Control Account and Subsidiary Ledger 210 Purchases Journal 211 Cash Payments Journal 214 Accounts Payable Control Account and Subsidiary Ledger 216

Adapting Manual Accounting Systems 217 Additional Subsidiary Ledgers 217 Modified Special Journals 217

Computerized Accounting Systems 218 Business Connection: Accounting Systems and Profit Measurement 219 E-Commerce 222 Financial Analysis and Interpretation 223 CHAPTER

6

Accounting for Merchandising Businesses........................................251

Nature of Merchandising Businesses 252 Financial Statements for a Merchandising Business 253 Multiple-Step Income Statement 254 Single-Step Income Statement 258 Statement of Owner’s Equity 258 Balance Sheet 258

Business Connection: H&R Block Versus The Home Depot 260 Merchandising Transactions 260 Chart of Accounts for a Merchandising Business 260 Sales Transactions 260 Purchase Transactions 266 Freight, Sales Taxes, and Trade Discounts 269 Dual Nature of Merchandise Transactions 272

The Adjusting and Closing Process 273 Adjusting Entry for Inventory Shrinkage 273 Closing Entries 274

Financial Analysis and Interpretation 275 Appendix: Accounting Systems for Merchandisers 276 Manual Accounting System 276 Computerized Accounting Systems 278 xxvi

Appendix: The Periodic Inventory System 279 Cost of Merchandise Sold Using the Periodic Inventory System 279 Chart of Accounts Under the Periodic Inventory System 280 Recording Merchandise Transactions Under the Periodic Inventory System 281 Adjusting Process Under the Periodic Inventory System 281 Financial Statements Under the Periodic Inventory System 282 Closing Entries Under the Periodic Inventory System 282

Comprehensive Problem 2 306 Practice Set: Fitness City Merchandise

This set is a merchandising business operated as a proprietorship. It includes business documents, and it can be solved manually or with the Klooster/Allen software.

CHAPTER

7

Inventories ........................................311

Control of Inventory 312 Safeguarding Inventory 312 Reporting Inventory 313

Inventory Cost Flow Assumptions 313 Inventory Costing Methods Under a Perpetual Inventory System 316 First-In, First-Out Method 316 Last-In, First-Out Method 318 Average Cost Method 319 Computerized Perpetual Inventory Systems 319

Inventory Costing Methods Under a Periodic Inventory System 320 First-In, First-Out Method 320 Last-In, First-Out Method 321 Average Cost Method 322

Comparing Inventory Costing Methods 323 Reporting Merchandise Inventory in the Financial Statements 324 Valuation at Lower of Cost or Market 325 Valuation at Net Realizable Value 326 Merchandise Inventory on the Balance Sheet 326 Effect of Inventory Errors on the Financial Statements 327

Business Connection: Rapid Inventory at Costco 330 Financial Analysis and Interpretation 330 Appendix: Estimating Inventory Cost 331 Retail Method of Inventory Costing 331 Gross Profit Method of Inventory Costing 332 CHAPTER

8

Sarbanes-Oxley, Internal Control, and Cash............................................352

Sarbanes-Oxley Act of 2002 353 Internal Control 355 Objectives of Internal Control 355 Elements of Internal Control 355 Control Environment 356 Risk Assessment 357

Control Procedures 357 Monitoring 359 Information and Communication 360 Limitations of Internal Control 360

Cash Controls Over Receipts and Payments 360 Control of Cash Receipts 361 Control of Cash Payments 363

Bank Accounts 364 Bank Statement 364 Using the Bank Statement as a Control Over Cash 366

Bank Reconciliation 367 Special-Purpose Cash Funds 371 Financial Statement Reporting of Cash 372 Financial Analysis and Interpretation 373 Business Connection: Microsoft Corporation 374 CHAPTER

9

Accounts Receivable 398 Notes Receivable 398 Other Receivables 399

Uncollectible Receivables 399 Direct Write-Off Method for Uncollectible Accounts 400 Allowance Method for Uncollectible Accounts 401 Write-Offs to the Allowance Account 402 Estimating Uncollectibles 403

Comparing Direct Write-Off and Allowance Methods 408 Notes Receivable 410 Characteristics of Notes Receivable 410 Accounting for Notes Receivable 411

Reporting Receivables on the Balance Sheet 413 Financial Analysis and Interpretation 414 Business Connection: Delta Air Lines 415 Appendix: Discounting Notes Receivable 415

10

Discarding Fixed Assets 454 Selling Fixed Assets 455

Natural Resources 456 Intangible Assets 457 Patents 457 Copyrights and Trademarks 458 Goodwill 459

Financial Reporting for Fixed Assets and Intangible Assets 460 Business Connection: Hub-and-Spoke or Point-to-Point? 461 Financial Analysis and Interpretation 462 Appendix: Sum-of-the-Years-Digits Depreciation 462 Appendix: Exchanging Similar Fixed Assets 463 Gain on Exchange 464 Loss on Exchange 464 Practice Set: Danielle’s Dog Care

Receivables.......................................397

Classification of Receivables 398

CHAPTER

Disposal of Fixed Assets 454

Fixed Assets and Intangible Assets.................................................440

Nature of Fixed Assets 441 Classifying Costs 442 The Cost of Fixed Assets 443 Capital and Revenue Expenditures 444 Leasing Fixed Assets 445

Accounting for Depreciation 446 Factors in Computing Depreciation Expense 447 Straight-Line Method 448 Units-of-Production Method 449 Double-Declining-Balance Method 450 Comparing Depreciation Methods 451 Depreciation for Federal Income Tax 452 Revising Depreciation Estimates 452

This set includes payroll transactions for a merchandising business operated as a proprietorship. It includes business documents, and it can be solved manually or with the Klooster/Allen software.

CHAPTER

11

Current Liabilities and Payroll ................................................484

Current Liabilities 485 Accounts Payable 485 Current Portion of Long-Term Debt 486 Short-Term Notes Payable 486

Payroll and Payroll Taxes 489 Liability for Employee Earnings 489 Deductions from Employee Earnings 489 Computing Employee Net Pay 492 Liability for Employer’s Payroll Taxes 492

Business Connection: The Most You Will Ever Pay 493 Accounting Systems for Payroll and Payroll Taxes 493 Payroll Register 494 Employee’s Earnings Record 497 Payroll Checks 497 Payroll System Diagram 498 Internal Controls for Payroll Systems 499

Employees’ Fringe Benefits 501 Vacation Pay 501 Pensions 502 Postretirement Benefits Other than Pensions 503 Current Liabilities on the Balance Sheet 504

Contingent Liabilities 504 Probable and Estimable 504 Probable and Not Estimable 505 Reasonably Possible 505 Remote 505

Financial Analysis and Interpretation 507 Comprehensive Problem 3 526 xxvii

CHAPTER

12

Accounting for Partnerships and Limited Liability Companies............532

Proprietorships, Partnerships, and Limited Liability Companies 533 Proprietorships 533 Partnerships 534 Limited Liability Companies 535 Comparing Proprietorships, Partnerships, and Limited Liability Companies 536

Business Connection: Organizational Forms in the Accounting and Consulting Industry 536 Forming and Dividing Income of a Partnership 536 Forming a Partnership 537 Dividing Income 538

Partner Admission and Withdrawal 540 Admitting a Partner 540 Withdrawal of a Partner 545 Death of a Partner 545

Liquidating Partnerships 546 Gain on Realization 547 Loss on Realization 548 Loss on Realization—Capital Deficiency 550 Errors in Liquidation 553

Statement of Partnership Equity 553 Financial Analysis and Interpretation 554

Practice Set: Artistic Décor

This set is a service and merchandising business operated as a corporation. It includes narrative for six months of transactions, which are to be recorded in a general journal. The set can be solved manually or with the Klooster/Allen software. Practice Set: Star Computer Sales and Services

This set is a departmentalized merchandising business operated as a corporation. It includes a narrative of transactions, which are to be recorded in special journals. The set can be solved manually or with the Klooster/Allen software. CHAPTER

14

Long-Term Liabilities: Bonds and Notes ..................................................617

Financing Corporations 618 Nature of Bonds Payable 621 Bond Characteristics and Terminology 621 Proceeds from Issuing Bonds 621

Accounting for Bonds Payable 622 Bonds Issued at Face Amount 622 Bonds Issued at a Discount 623 Amortizing a Bond Discount 624 Bonds Issued at a Premium 625 Amortizing a Bond Premium 626

Business Connection: Ch-Ch-Ch-Changes in Bond Trends 627 Bond Redemption 627

Installment Notes 629 CHAPTER

13

Corporations: Organization, Stock Transactions, and Dividends .........574

Nature of a Corporation 575 Characteristics of a Corporation 575 Forming a Corporation 576

Stockholders’ Equity 578 Paid-In Capital from Issuing Stock 579 Characteristics of Stock 579 Classes of Stock 579 Issuing Stock 581 Premium on Stock 582 No-Par Stock 582

Business Connection: Cisco Systems, Inc. 583 Accounting for Dividends 584 Cash Dividends 584 Stock Dividends 586

Treasury Stock Transactions 587 Reporting Stockholders’ Equity 589 Stockholders’ Equity in the Balance Sheet 589 Reporting Retained Earnings 591 Statement of Stockholders’ Equity 592 Reporting Stockholders’ Equity for Mornin’ Joe 593

Stock Splits 594 Financial Analysis and Interpretation 595 xxviii

Issuing an Installment Note 629 Annual Payments 629

Reporting Long-Term Liabilities 631 Financial Analysis and Interpretation 632 Appendix: Present Value Concepts and Pricing Bonds Payable 632 Present Value Concepts 633 Pricing Bonds 635

Appendix: Effective Interest Rate Method of Amortization 637 Amortization of Discount by the Interest Method 637 Amortization of Premium by the Interest Method 638 CHAPTER

15

Investments and Fair Value Accounting........................................657

Why Companies Invest 658 Investing Cash in Current Operations 658 Investing Cash in Temporary Investments 659 Investing Cash in Long-Term Investments 659

Accounting for Debt Investments 660 Purchase of Bonds 660 Interest Revenue 660 Sale of Bonds 661

Accounting for Equity Investments 662 Less Than 20% Ownership 662 Between 20%–50% Ownership 664 More Than 50% Ownership 666

Valuing and Reporting Investments 667 Trading Securities 667 Held-to-Maturity Securities 670 Available-for-Sale Securities 671 Summary 674

Business Connection: Warren Buffett: The Sage of Omaha 676 Fair Value Accounting 676 Trend to Fair Value Accounting 676 Effect of Fair Value Accounting on the Financial Statements 677 Future of Fair Value Accounting 678

Financial Analysis and Interpretation 678 Appendix: Accounting for Held-to-Maturity Investments 678 Purchase of Bonds 678 Amortization of Premium or Discount 679 Receipt of Maturity Value of Bond 680

Appendix: Comprehensive Income 681 Comprehensive Problem 4 703

Financial Statements for Mornin’ Joe 707 CHAPTER

16

Statement of Cash Flows................710

Reporting Cash Flows 711 Cash Flows from Operating Activities 712 Cash Flows from Investing Activities 714 Cash Flows from Financing Activities 714 Noncash Investing and Financing Activities 714

Business Connection: Too Much Cash! 714 No Cash Flow per Share 715

Statement of Cash Flows—The Indirect Method 715 Retained Earnings 717 Adjustments to Net Income 717 Dividends 722 Common Stock 722 Bonds Payable 723 Building 723 Land 724 Preparing the Statement of Cash Flows 724

Statement of Cash Flows—The Direct Method 725 Cash Received from Customers 726 Cash Payments for Merchandise 727 Cash Payments for Operating Expenses 728 Gain on Sale of Land 728 Interest Expense 728 Cash Payments for Income Taxes 729 Reporting Cash Flows from Operating Activities—Direct Method 729

Financial Analysis and Interpretation 730 Appendix: Spreadsheet (Work Sheet) for Statement of Cash Flows—The Indirect Method 731 Analyzing Accounts 731 Retained Earnings 731 Other Accounts 733 Preparing the Statement of Cash Flows 733

CHAPTER

17

Financial Statement Analysis ........762

Basic Analytical Methods 763 Horizontal Analysis 764 Vertical Analysis 766 Common-Sized Statements 767 Other Analytical Measures 769

Solvency Analysis 769 Current Position Analysis 770 Accounts Receivable Analysis 772 Inventory Analysis 773 Ratio of Fixed Assets to Long-Term Liabilities 775 Ratio of Liabilities to Stockholders’ Equity 775 Number of Times Interest Charges Earned 776

Profitability Analysis 777 Ratio of Net Sales to Assets 777 Rate Earned on Total Assets 778 Rate Earned on Stockholders’ Equity 779 Rate Earned on Common Stockholders’ Equity 780 Earnings Per Share on Common Stock 781 Price-Earnings Ratio 782 Dividends Per Share 783 Dividend Yield 783 Summary of Analytical Measures 783

Corporate Annual Reports 785 Management Discussion and Analysis 785 Report on Internal Control 785 Report on Fairness of the Financial Statements 786

Business Connection: Investing Strategies 786 Appendix: Unusual Items on the Income Statement 787 Unusual Items Affecting the Current Period’s Income Statement 787 Unusual Items Affecting the Prior Period’s Income Statement 789

Nike, Inc., Problem 813 CHAPTER

18

Managerial Accounting Concepts and Principles.................817

Managerial Accounting 818 Differences Between Managerial and Financial Accounting 819 The Management Accountant in the Organization 820 Managerial Accounting in the Management Process 821

Manufacturing Operations: Costs and Terminology 823 Direct and Indirect Costs 824 Manufacturing Costs 825

Financial Statements for a Manufacturing Business 829 Balance Sheet for a Manufacturing Business 829 Income Statement for a Manufacturing Company 830

Uses of Managerial Accounting 832 Business Connection: Navigating the Information Highway 835 xxix

CHAPTER

19

Job Order Costing ............................854

Cost Accounting System Overview 855 Job Order Cost Systems for Manufacturing Businesses 856 Materials 857 Factory Labor 859 Factory Overhead Cost 861 Work in Process 866 Finished Goods 867 Sales and Cost of Goods Sold 868 Period Costs 868 Summary of Cost Flows for Legend Guitars 868

Job Order Costing for Decision Making 870 Job Order Cost Systems for Professional Service Businesses 870 Business Connection: Making Money in the Movie Business 872 Practice Set: Bath Designs, Inc.

This set is a manufacturing business operated as a corporation that uses a job order cost system. The set can be solved manually or with the Klooster/Allen software. CHAPTER

20

Process Cost Systems ....................896

Comparing Job Order and Process Cost Systems 898 Cost Flows for a Process Manufacturer 900

Cost of Production Report 903 Step 1: Determine the Units to Be Assigned Costs 903 Step 2: Compute Equivalent Units of Production 905 Step 3: Determine the Cost per Equivalent Unit 908 Step 4: Allocate Costs to Units Transferred Out and Partially Completed Units 910 Preparing the Cost of Production Report 912

Journal Entries for a Process Cost System 913 Using the Cost of Production Report for Decision Making 916 Frozen Delight 916 Holland Beverage Company 917 Yield 917

Just-in-Time Processing 918 Business Connection: Radical Improvement: Just in Time for Pulaski’s Customers 920 Appendix: Average Cost Method 920 Determining Costs Using the Average Cost Method 920 The Cost of Production Report 922

21

Cost Behavior and Cost-VolumeProfit Analysis...................................947

Cost Behavior 948 Variable Costs 949 Fixed Costs 950 Mixed Costs 950 Summary of Cost Behavior Concepts 953 xxx

Contribution Margin 954 Contribution Margin Ratio 954 Unit Contribution Margin 955

Mathematical Approach to Cost-Volume-Profit Analysis 957 Break-Even Point 957

Business Connection: Breaking Even on Howard Stern 960 Target Profit 960

Graphic Approach to Cost-Volume-Profit Analysis 962 Cost-Volume-Profit (Break-Even) Chart 962 Profit-Volume Chart 964 Use of Computers in Cost-Volume-Profit Analysis 965 Assumptions of Cost-Volume-Profit Analysis 965

Special Cost-Volume-Profit Relationships 966 Sales Mix Considerations 967 Operating Leverage 968 Margin of Safety 970

Appendix: Variable Costing 971 CHAPTER

22

Budgeting ..........................................996

Nature and Objectives of Budgeting 997

Process Cost Systems 897

CHAPTER

Cost-Volume-Profit Relationships 953

Objectives of Budgeting 998 Human Behavior and Budgeting 998

Budgeting Systems 1000 Static Budget 1001 Flexible Budget 1001

Business Connection: Build Versus Harvest 1002 Computerized Budgeting Systems 1003

Master Budget 1004 Income Statement Budgets 1005 Sales Budget 1005 Production Budget 1006 Direct Materials Purchases Budget 1007 Direct Labor Cost Budget 1008 Factory Overhead Cost Budget 1009 Cost of Goods Sold Budget 1010 Selling and Administrative Expenses Budget 1012 Budgeted Income Statement 1012

Balance Sheet Budgets 1012 Cash Budget 1013 Capital Expenditures Budget 1016 Budgeted Balance Sheet 1017 CHAPTER

23

Performance Evaluation Using Variances from Standard Costs.................................................1042

Standards 1043 Setting Standards 1044 Types of Standards 1044 Reviewing and Revising Standards 1045 Criticisms of Standard Costs 1045

Business Connection: Making the Grade in the Real World—The 360-Degree Review 1045 Budgetary Performance Evaluation 1046 Budget Performance Report 1047 Manufacturing Cost Variances 1048

Direct Materials and Direct Labor Variances 1049 Direct Materials Variances 1049 Direct Labor Variances 1051

Factory Overhead Variances 1054 The Factory Overhead Flexible Budget 1054 Variable Factory Overhead Controllable Variance 1055 Fixed Factory Overhead Volume Variance 1056 Reporting Factory Overhead Variances 1058 Factory Overhead Account 1058

Recording and Reporting Variances from Standards 1060 Nonfinancial Performance Measures 1063 Comprehensive Problem 5 1081 CHAPTER

24

Performance Evaluation for Decentralized Operations.............1086

Centralized and Decentralized Operations 1087 Advantages of Decentralization 1088 Disadvantages of Decentralization 1088 Responsibility Accounting 1088

Responsibility Accounting for Cost Centers 1089 Responsibility Accounting for Profit Centers 1091 Service Department Charges 1091 Profit Center Reporting 1094

Responsibility Accounting for Investment Centers 1095 Rate of Return on Investment 1096

Business Connection: Return on Investment 1099 Residual Income 1099 The Balanced Scorecard 1101

Variable Cost Concept 1147 Choosing a Cost-Plus Approach Cost Concept 1149 Activity-Based Costing 1150 Target Costing 1150

Production Bottlenecks, Pricing, and Profits 1151 Production Bottlenecks and Profits 1151 Production Bottlenecks and Pricing 1152

Business Connection: What Is a Product? 1153 Appendix: Activity-Based Costing 1154 CHAPTER

26

Nature of Capital Investment Analysis 1180 Methods Not Using Present Values 1181 Average Rate of Return Method 1181 Cash Payback Method 1182

Methods Using Present Values 1184 Present Value Concepts 1184 Net Present Value Method 1187 Internal Rate of Return Method 1189

Business Connection: Panera Bread Store Rate of Return 1191 Factors that Complicate Capital Investment Analysis 1192 Income Tax 1192 Unequal Proposal Lives 1192 Lease versus Capital Investment 1194 Uncertainty 1194 Changes in Price Levels 1194 Qualitative Considerations 1195

Capital Rationing 1195

A APPENDIX B APPENDIX C APPENDIX

Transfer Pricing 1102 Market Price Approach 1103 Negotiated Price Approach 1104 Cost Price Approach 1106

CHAPTER

25

Differential Analysis and Product Pricing...............................1131

Differential Analysis 1132 Lease or Sell 1134 Discontinue a Segment or Product 1135 Make or Buy 1137 Replace Equipment 1139 Process or Sell 1140 Accept Business at a Special Price 1141

Capital Investment Analysis.........1179

APPENDIX

D

Interest Tables .................................A-2 Reversing Entries.............................B-1 End-of-Period Spreadsheet (Work Sheet) for a Merchandising Business ............................................C-1 Accounting for Deferred Income Taxes..................................................D-1

Temporary Differences D-1 Reporting Deferred Taxes D-3 Permanent Differences D-3 APPENDIX

E

Nike, Inc., Annual Report................E-1

Glossary G-1 Subject Index I-1 Company Index I-18

Setting Normal Product Selling Prices 1143 Total Cost Concept 1143 Product Cost Concept 1146 xxxi

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© AP Photo/Paul Sakuma

Introduction to Accounting and Business

G O O G L E™

W

hen two teams pair up for a game of football, there is often a lot of noise. The band plays, the fans cheer, and fireworks light up the scoreboard. Obviously, the fans are committed and care about the outcome of the game. Just like fans at a football game, the owners of a business want their business to “win” against their competitors in the marketplace. While having our football team win can be a source of pride, winning in the marketplace goes beyond pride and has many tangible benefits. Companies that are winners are better able to serve customers, to provide good jobs for employees, and to make more money for the owners. One such successful company is Google, one of the most visible companies on the Internet. Many of us cannot visit the Web without first stopping at Google to power your search. As one writer said, “Google is the closest thing the Web has

to an ultimate answer machine.” And yet, Google is a free tool—no one asks for your credit card when you use any of Google’s search tools. So, do you think Google has been a successful company? Does it make money? How would you know? Accounting helps to answer these questions. Google’s accounting information tells us that Google is a very successful company that makes a lot of money, but not from you and me. Google makes its money from advertisers. In this textbook, we will introduce you to accounting, the language of business. In this chapter, we begin by discussing what a business is, how it operates, and the role that accounting plays.

2

Chapter 1

Introduction to Accounting and Business

After studying this chapter, you should be able to: 1

2

3

4

Describe the nature of a business, the role of accounting, and ethics in business.

Summarize the development of accounting principles and relate them to practice.

Nature of Business and Accounting

Generally Accepted Accounting Principles

The Accounting Equation

Types of Businesses

Business Entity Concept

1-2 EE (page 9)

The Role of Accounting in Business

The Cost Concept

Role of Ethics in Accounting and Business

State the accounting equation and define each element of the equation.

5 Describe and illustrate how business transactions can be recorded in terms of the resulting change in the elements of the accounting equation.

Business Transactions and the Accounting Equation 1-3

EE (page 15)

Describe the financial statements of a proprietorship and explain how they interrelate.

Financial Statements Income Statement 1-4 EE (page 16) Statement of Owner’s Equity

1-1 EE (page 9)

1-5 EE (page 17) Balance Sheet

Opportunities for Accountants

1-6 EE (page 19) Statement of Cash Flows 1-7 EE (page 20) Interrelationships Among Financial Statements

At a Glance

1

Describe the nature of a business, the role of accounting, and ethics in business.

Menu

Turn to pg 22

Nature of Business and Accounting A business1 is an organization in which basic resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (outputs) to customers. Businesses come in all sizes, from a local coffee house to Starbucks, which sells over $9 billion of coffee and related products each year. The objective of most businesses is to earn a profit. Profit is the difference between the amounts received from customers for goods or services and the amounts paid for the inputs used to provide the goods or services. In this text, we focus on businesses operating to earn a profit. However many of the same concepts and principles also apply to not-forprofit organizations such as hospitals, churches, and government agencies.

Types of Businesses Three types of businesses operated for profit include service, merchandising, and manufacturing businesses. 1 A complete glossary of terms appears at the end of the text.

Chapter 1

Introduction to Accounting and Business

3

Each type of business and some examples are described below. Service businesses provide services rather than products to customers. Roughly eight out of every ten workers in the United States are service providers.

Delta Air Lines (transportation services) The Walt Disney Company (entertainment services) Merchandising businesses sell products they purchase from other businesses to customers. Wal-Mart (general merchandise) Amazon.com (Internet books, music, videos) Manufacturing businesses change basic inputs into products that are sold to customers. General Motors Corporation (cars, trucks, vans) Dell Inc. (personal computers)

The Role of Accounting in Business What is the role of accounting in business? The simplest answer is that accounting provides information for managers to use in operating the business. In addition, accounting provides information to other users in assessing the economic performance and condition of the business. Thus, accounting can be defined as an information system that provides reports to users about the economic activities and conAccounting is an information sysdition of a business. You may think of accounting as the “language tem that provides reports to users of business.” This is because accounting is the means by which about the economic activities and businesses’ financial information is communicated to users. condition of a business. The process by which accounting provides information to users is as follows: 1. Identify users. 2. Assess users’ information needs. 3. Design the accounting information system to meet users’ needs. 4. Record economic data about business activities and events. 5. Prepare accounting reports for users. As illustrated in Exhibit 1, users of accounting information can be divided into two groups: internal users and external users.

Exhibit 1 Users of Accounting Information

Providing Accounting Information to Users

Identify users

Internal users: Managers, employees

Users

External users: Customers, creditors, investors, government

Assess users’ information needs

Prepare accounting reports for users

Record economic data about business activities and events

Design the accounting information system to meet users’ needs

4

Chapter 1

Introduction to Accounting and Business

Internal users of accounting information include managers and employees. These users are directly involved in managing and operating the business. The area of accounting that provides internal users with information is called managerial accounting or management accounting. The objective of managerial accounting is to provide relevant and timely information for managers’ and employees’ decision-making needs. Often times, such information is sensitive and is not distributed outside the business. Examples of sensitive information might include information about customers, prices, and plans to expand the business. Managerial accountants employed by a business are employed in private accounting. External users of accounting information include customers, creditors, and the government. These users are not directly involved in managing and operating the business. The area of accounting that provides external users with information is called financial accounting. The objective of financial accounting is to provide relevant and timely information for the decision-making needs of users outside of the business. For example, financial reports on the operations and condition of the business are useful for banks and other creditors in deciding whether to lend money to the business. General-purpose financial statements are one type of financial accounting report that is distributed to external users. The term general-purpose refers to the wide range of decision-making needs that these reports are designed to serve. Later in this chapter, we describe and illustrate general-purpose financial statements.

Role of Ethics in Accounting and Business The objective of accounting is to provide relevant, timely information for user decision making. Accountants must behave in an ethical manner so that the information they provide will be trustworthy and, thus, useful for decision making. Managers and employees must also behave in an ethical manner in managing and operating a business. Otherwise, no one will be willing to invest in or loan money to the business. Ethics are moral principles that guide the conduct of individuals. Unfortunately, business managers and accountants sometimes behave in an unethical manner. A number of managers of the companies listed in Exhibit 2 engaged in accounting or business fraud. These ethical violations led to fines, firings, and lawsuits. In some cases, managers were criminally prosecuted, convicted, and sent to prison. What went wrong for the managers and companies listed in Exhibit 2? The answer normally involved one or both of the following two factors: Failure of Individual Character. An ethical manager and accountant is honest and fair. However, managers and accountants often face pressures from supervisors to meet company and investor expectations. In many of the cases in Exhibit 2, managers and accountants justified small ethical violations to avoid such pressures. However, these small violations became big violations as the company’s financial problems became worse. Culture of Greed and Ethical Indifference. By their behavior and attitude, senior managers set the company culture. In most of the companies listed in Exhibit 2, the senior managers created a culture of greed and indifference to the truth.

DOING THE RIGHT THING

Time Magazine named three women as “Persons of the Year 2002.” Each of these not-so-ordinary women had the courage, determination, and integrity to do the right thing. Each risked their personal careers to expose shortcomings in their organizations. Sherron Watkins, an Enron vice president, wrote a letter to Enron’s chairman, Kenneth Lay, warning him of improper accounting that eventually led to Enron’s collapse. Cynthia Cooper,

an internal accountant, informed WorldCom’s Board of Directors of phony accounting that allowed WorldCom to cover up over $3 billion in losses and forced WorldCom into bankruptcy. Coleen Rowley, an FBI staff attorney, wrote a memo to FBI Director Robert Mueller, exposing how the Bureau brushed off her pleas to investigate Zacarias Moussaoui, who was indicted as a co-conspirator in the September 11 terrorist attacks.

Chapter 1

Introduction to Accounting and Business

Exhibit 2 Accounting and Business Fraud in the 2000s Nature of Accounting or Business Fraud

Company

Result

Adelphia Communications

Rigas family treated the company assets as their own.

Bankruptcy. Rigas family members found guilty of fraud and lost their investment in the company.

American International Group, Inc. (AIG)

Used sham accounting transactions to inflate performance.

CEO resigned. Executives criminally convicted. AIG paid $126 million in fines.

America Online, Inc. and PurchasePro

Artificially inflated their financial results.

Civil charges filed against senior executives of both companies. $500 million fine.

Computer Associates International, Inc.

Fraudulently inflated its financial results.

CEO and senior executives indicted. Five executives pled guilty. $225 million fine.

Enron

Fraudulently inflated its financial results.

Bankrupcty. Senior executives criminally convicted. Over $60 billion in stock market losses.

Fannie Mae

Improperly shifted financial performance between periods.

CEO and CFO fired. Company made a $9 billion correction to previously reported earnings.

HealthSouth

Overstated performance by $4 billion in false entries.

Senior executives criminally convicted.

Qwest Communications International, Inc.

Improperly recognized $3 billion in false receipts.

CEO and six other executives criminally convicted of “massive financial fraud.” $250 million SEC fine.

Tyco International, Ltd.

Failed to disclose secret loans to executives that were subsequently forgiven.

CEO forced to resign and subjected to frozen asset order and criminally convicted.

WorldCom

Misstated financial results by nearly $9 billion.

Bankruptcy. Criminal conviction of CEO and CFO. Over $100 billion in stock market losses. Directors forced to pay $18 million.

Xerox Corporation

Recognized $3 billion in revenue prior to when it should have been.

$10 million fine to SEC. Six executives forced to pay $22 million.

Exhibit 3 Guideline for Ethical Conduct

1. Identify an ethical decision by using your personal ethical standards of honesty and fairness. 2. Identify the consequences of the decision and its effect on others. 3. Consider your obligations and responsibilities to those that will be affected by your decision. 4 . Make a decision that is ethical and fair to those affected by it.

5

6

Chapter 1

Introduction to Accounting and Business

As a result of the accounting and business frauds shown in Exhibit 2, Congress passed new laws to monitor the behavior of accounting and business. For example, the Sarbanes-Oxley Act of 2002 (SOX) was enacted. SOX established a new oversight body for the accounting profession called the Public Company Accounting Oversight Board (PCAOB). In addition, SOX established standards for independence, corporate responsibility, and disclosure. How does one behave ethically when faced with financial or other types of pressure? A guideline for behaving ethically is shown in Exhibit 3. 2

Opportunities for Accountants Numerous career opportunities are available for students majoring in accounting. Currently, the demand for accountants exceeds the number of new graduates entering the job market. This is partly due to the increased regulation of business caused by the accounting and business frauds shown in Exhibit 2. Also, more and more businesses have come to recognize the importance and value of accounting information. As we indicated earlier, accountants employed by a business are said to be employed in private accounting. Private accountants have a variety of possible career options within a company. Some of these career options are shown in Exhibit 4 along with their starting salaries. Accountants who provide audit services, called auditors, verify the accuracy of financial records, accounts, and systems. As shown in Exhibit 4, several private accounting careers have certification options.

Exhibit 4 Accounting Career Paths and Salaries Accounting Career Track Private Accounting

Public Accounting

Annual Starting Salaries1

Description

Career Options

Accountants employed by companies, government, and not-for-profit entities.

Bookkeeper

$34,875

Payroll clerk

$33,500

General accountant Budget analyst Cost accountant

$40,750 $42,875 $42,125

Internal auditor

$46,375

Information technology auditor

$54,625

Certified Information Systems Auditor (CISA)

Local firms

$43,625

Certified Public Accountant (CPA)

National firms

$52,500

Certified Public Accountant (CPA)

Accountants employed individually or within a public accounting firm in tax or audit services.

Certification

Certified Payroll Professional (CPP)

Certified Management Accountant (CMA) Certified Internal Auditor (CIA)

Source: Robert Half 2008 Salary Guide (Finance and Accounting), Robert Half International, Inc. 1 Median salaries of a reported range. Private accounting salaries are reported for large companies. Salaries may vary by region.

2 Many companies have ethical standards of conduct for managers and employees. In addition, the Institute of Management Accountants and the American Institute of Certified Public Accountants have professional codes of conduct.

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7

Accountants and their staff who provide services on a fee basis are said to be employed in public accounting. In public accounting, an accountant may practice as an individual or as a member of a public accounting firm. Public accountants who have met a state’s education, experience, and examination requirements may become Certified Public Accountants (CPAs). CPAs generally perform general accounting, audit, or tax services. As can be seen in Exhibit 4, CPAs have slightly better starting salaries than private accountants. Career statistics indicate, however, that these salary differences tend to disappear over time. Because all functions within a business use accounting information, experience in private or public accounting provides a solid foundation for a career. Many positions in industry and in government agencies are held by individuals with accounting backgrounds.

ACCOUNTING REFORM The financial accounting and reporting failures of Enron, WorldCom, Tyco, Xerox, and others shocked the investing public. The disclosure that some of the nation’s largest and best-known corporations had overstated profits and misled investors raised the question: Where were the CPAs? In response, Congress passed the Investor Protection, Auditor Reform, and Transparency Act of 2002, called the

2

Summarize the development of accounting principles and relate them to practice.

Sarbanes-Oxley Act. The Act establishes a Public Company Accounting Oversight Board to regulate the portion of the accounting profession that has public companies as clients. In addition, the Act prohibits auditors (CPAs) from providing certain types of nonaudit services, such as investment banking or legal services, to their clients, prohibits employment of auditors by clients for one year after they last audited the client, and increases penalties for the reporting of misleading financial statements.

Generally Accepted Accounting Principles If a company’s management could record and report financial data as it saw fit, comparisons among companies would be difficult, if not impossible. Thus, financial accountants follow generally accepted accounting principles (GAAP) in preparing reports. These reports allow investors and other users to compare one company to another. Accounting principles and concepts develop from research, accepted accounting practices, and pronouncements of regulators. Within the United States, the Financial Accounting Standards Board (FASB) has the primary responsibility for developing accounting principles. The FASB publishes Statements of Financial Accounting Standards as well as Interpretations of these Standards. In addition, the Securities and Exchange Commission (SEC), an agency of the U.S. government, has authority over the accounting and financial disclosures for companies whose shares of ownership (stock) are traded and sold to the public. The SEC normally accepts the accounting principles set forth by the FASB. However, the SEC may issue Staff Accounting Bulletins on accounting matters that may not have been addressed by the FASB. Many countries outside the United States use generally accepted accounting principles adopted by the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRSs). Significant differences currently exist between FASB and IASB accounting principles. However, the FASB and IASB are working together to reduce and eliminate these differences into a single set of accounting principles. Such a set of worldwide accounting principles would help facilitate investment and business in an increasingly global economy. In this chapter and text, we emphasize accounting principles and concepts. It is by this emphasis on the “why” as well as the “how” that you will gain an understanding of accounting.

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Business Entity Concept The business entity concept limits the economic data in an accounting system to data related directly to the activities of the business. In other words, the business is viewed as an entity separate from its owners, creditors, or other businesses. For example, the accountant for a business with Under the business entity concept, one owner would record the activities of the business only and the activities of a business are would not record the personal activities, property, or debts of recorded separately from the the owner. activities of its owners, creditors, A business entity may take the form of a proprietorship, partor other businesses. nership, corporation, or limited liability company (LLC). Each of these forms and their major characteristics are listed below. Form of Business Entity

Characteristics

Proprietorship is owned by one individual.

• • • •

Partnership is owned by two or more individuals.

• 10% of business organizations in the United States (combined with limited liability companies). • Combines the skills and resources of more than one person.

Corporation is organized under state or federal statutes as a separate legal taxable entity.

• • • • •

Limited liability company (LLC) combines the attributes of a partnership and a corporation.

• 10% of business organizations in the United States (combined with partnerships). • Often used as an alternative to a partnership. • Has tax and legal liability advantages for owners.

70% of business entities in the United States. Easy and cheap to organize. Resources are limited to those of the owner. Used by small businesses.

Generates 90% of business revenues. 20% of the business organizations in the United States. Ownership is divided into shares called stock. Can obtain large amounts of resources by issuing stock. Used by large businesses.

The three types of businesses we discussed earlier—service, merchandising, and manufacturing—may be organized as proprietorships, partnerships, corporations, or limited liability companies. Because of the large amount of resources required to operate a manufacturing business, most manufacturing businesses such as Ford Motor Company are corporations. Most large retailers such as Wal-Mart and Home Depot are also corporations.

The Cost Concept Under the cost concept, amounts are initially recorded in the accounting records at their cost or purchase price. To illustrate, assume that Aaron Publishers purchased the following building on February 20, 2008: Price listed by seller on January 1, 2008 Aaron Publishers’ initial offer to buy on January 31, 2008 Purchase price on February 20, 2008 Estimated selling price on December 31, 2010 Assessed value for property taxes, December 31, 2010

$160,000 140,000 150,000 220,000 190,000

Under the cost concept, Aaron Publishers records the purchase of the building on February 20, 2008, at the purchase price of $150,000. The other amounts listed above have no effect on the accounting records. The fact that the building has an estimated selling price on December 31, 2010, indicates that the building has increased in value. However, to use the $220,000 in the accounting records would be to record an illusory or unrealized profit. If Aaron Publishers sells the building on January 9, 2011, for $220,000, a profit of $70,000 is then realized and recorded. The new owner would record $220,000 as its cost of the building.

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The cost concept also involves the objectivity and unit of measure concepts. The objectivity concept requires that the amounts recorded in the accounting records be based on objective evidence. In exchanges between a buyer and a seller, both try to get the best price. Only the final agreed-upon amount is objective enough to be recorded in the accounting records. If amounts in the accounting records were constantly being revised upward or downward based on offers, appraisals, and opinions, accounting reports could become unstable and unreliable. The unit of measure concept requires that economic data be recorded in dollars. Money is a common unit of measurement for reporting financial data and reports.

Example Exercise 1-1

2

Cost Concept

On August 25, Gallatin Repair Service extended an offer of $125,000 for land that had been priced for sale at $150,000. On September 3, Gallatin Repair Service accepted the seller’s counteroffer of $137,000. On October 20, the land was assessed at a value of $98,000 for property tax purposes. On December 4, Gallatin Repair Service was offered $160,000 for the land by a national retail chain. At what value should the land be recorded in Gallatin Repair Service’s records?

Follow My Example 1-1 $137,000. Under the cost concept, the land should be recorded at the cost to Gallatin Repair Service.

For Practice: PE 1-1A, PE 1-1B

3

State the accounting equation and define each element of the equation.

The Accounting Equation The resources owned by a business are its assets. Examples of assets include cash, land, buildings, and equipment. The rights or claims to the assets are divided into two types: (1) the rights of creditors and (2) the rights of owners. The rights of creditors are the debts of the business and are called liabilities. The rights of the owners are called owner’s equity. The following equation shows the relationship among assets, liabilities, and owner’s equity: Assets  Liabilities  Owner’s Equity

Example Exercise 1-2

3

Accounting Equation

John Joos is the owner and operator of You’re A Star, a motivational consulting business. At the end of its accounting period, December 31, 2009, You’re A Star has assets of $800,000 and liabilities of $350,000. Using the accounting equation, determine the following amounts:

a. Owner’s equity, as of December 31, 2009. b. Owner’s equity, as of December 31, 2010, assuming that assets increased by $130,000 and liabilities decreased by $25,000 during 2010.

Follow My Example 1-2 a.

Assets  Liabilities  Owner’s Equity $800,000  $350,000  Owner’s Equity Owner’s Equity  $450,000

b. First, determine the change in Owner’s Equity during 2010 as follows:

Next, add the change in Owner’s Equity on December 31, 2009 to arrive at Owner’s Equity on December 31, 2010, as shown below. Owner’s Equity on December 31, 2010  $605,000  $450,000  $155,000

Assets  Liabilities  Owner’s Equity $130,000  $25,000  Owner’s Equity Owner’s Equity  $155,000

For Practice: PE 1-2A, PE 1-2B

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This equation is called the accounting equation. Liabilities usually are shown before owner’s equity in the accounting equation because creditors have first rights to the assets. Given any two amounts, the accounting equation may be solved for the third unknown amount. To illustrate, if the assets owned by a business amount to $100,000 and the liabilities amount to $30,000, the owner’s equity is equal to $70,000, as shown below. Assets  Liabilities  Owner’s Equity $100,000  $30,000  $70,000

4

Describe and illustrate how business transactions can be recorded in terms of the resulting change in the elements of the accounting equation.

Business Transactions and the Accounting Equation

Paying a monthly telephone bill of $168 affects a business’s financial condition because it now has less cash on hand. Such an economic event or condition that directly changes an entity’s financial condition or its results of operations is a business transaction. For example, purchasing land for $50,000 is a business transaction. In contrast, a change in a business’s credit rating does not directly affect cash or any other asset, liability, or owner’s equity amount. All business transactions can be stated in terms of changes in the elements of the accounting equation. We illustrate how business transactions affect the accounting equation by using some typical transactions. As a basis for illustration, we use a business organized by Chris Clark. Assume that on November 1, 2009, Chris Clark begins a business that will be known as NetSolutions. The first phase of Chris’s business plan is to operate NetSolutions as a service business assisting individuals and small businesses in developing Web pages and installing computer software. Chris expects this initial phase of the business to last one to two years. All business transactions can be During this period, Chris plans on gathering information on the stated in terms of changes in software and hardware needs of customers. During the second the elements of the accounting phase of the business plan, Chris plans to expand NetSolutions into equation. a personalized retailer of software and hardware for individuals and small businesses.

THE ACCOUNTING EQUATION The accounting equation serves as the basic foundation for the accounting systems of all companies. From the smallest business, such as the local convenience store, to the

largest business, such as Ford Motor Company, companies use the accounting equation. Some examples taken from recent financial reports of well-known companies are shown below.

Company

Assets*  Liabilities  Owner’s Equity

The Coca-Cola Company Circuit City Stores, Inc. Dell Inc. eBay Inc. Google McDonald’s Microsoft Corporation Southwest Airlines Co. Wal-Mart

$ 29,963 4,007 25,635 13,494 18,473 29,024 63,171 13,460 151,193

*Amounts are shown in millions of dollars.

        

$13,043 2,216 21,196 2,589 1,433 13,566 32,074 7,011 89,620

        

$16,920 1,791 4,439 10,905 17,040 15,458 31,097 6,449 61,573

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11

Each transaction during NetSolutions’ first month of operations is described in the following paragraphs. The effect of each transaction on the accounting equation is then shown. Transaction A Nov. 1, 2009 Chris Clark deposits $25,000 in a bank account in the name of NetSolutions.

This transaction increases the asset cash (on the left side of the equation) by $25,000. To balance the equation, the owner’s equity (on the right side of the equation) increases by the same amount. The equity of the owner is identified using the owner’s name and “Capital,” such as “Chris Clark, Capital.” The effect of this transaction on NetSolutions’ accounting equation is shown below.

a.

Assets



Owner’s Equity

Cash 25,000



Chris Clark, Capital 25,000

Since Chris Clark is the sole owner, NetSolutions is a proprietorship. Also, the accounting equation shown above is only for the business, NetSolutions. Under the business entity concept, Chris Clark’s personal assets, such as a home or personal bank account, and personal liabilities are excluded from the equation. Transaction B Nov. 5, 2009 NetSolutions paid $20,000 for the purchase of land as a future building site. The land is located in a business park with access to transportation facilities. Chris Clark plans to rent office space and equipment during the first phase of the business plan. During the second phase, Chris plans to build an office and a warehouse on the land. The purchase of the land changes the makeup of the assets, but it does not change the total assets. The items in the equation prior to this transaction and the effect of the transaction are shown below. The new amounts are called balances. Assets Cash  Land Bal. 25,000 b. 20,000 20,000 Bal. 5,000 20,000



Owner’s Equity



Chris Clark, Capital 25,000 25,000

Transaction C Nov. 10, 2009 NetSolutions purchased supplies for $1,350 and agreed to pay the supplier in the near future.

You have probably used a credit card to buy clothing or other merchandise. In this type of transaction, you received clothing for a promise to pay your credit card bill in the future. That is, you received an asset and incurred a liability to pay a future bill. NetSolutions entered into a similar transaction by purchasing supplies for $1,350 and agreeing to pay the supplier in the near future. This type of transaction is called a purchase on account and is often described as follows: Purchased supplies on account, $1,350.

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The liability created by a purchase on account is called an account payable. Items such as supplies that will be used in the business in the future are called prepaid expenses, which are assets. Thus, the effect of this transaction is to increase assets (Supplies) and liabilities (Accounts Payable) by $1,350, as follows: Other examples of common prepaid expenses include insurance and rent. Businesses often report these assets together as a single item, prepaid expenses.

Bal. c. Bal.

Assets



Cash  Supplies  Land 5,000 20,000 1,350 5,000 1,350 20,000



Liabilities  Owner’s Equity Accounts  Chris Clark, Payable Capital 25,000 1,350 1,350 25,000

Transaction D Nov. 18, 2009 NetSolutions received cash of $7,500 for providing services to customers. You may have earned money by painting houses or mowing lawns. If so, you received money for rendering services to a customer. Likewise, a business earns money by selling goods or services to its customers. This amount is called revenue. During its first month of operations, NetSolutions received cash of $7,500 for providing services to customers. The receipt of cash increases NetSolutions’ assets and also increases Chris Clark’s equity in the business. The revenues of $7,500 are recorded in a Fees Earned column to the right of Chris Clark, Capital. The effect of this transaction is to increase Cash and Fees Earned by $7,500, as shown below.

Bal. d. Bal.

Assets



Cash  Supplies  Land 5,000 1,350 20,000 7,500 12,500 1,350 20,000



Liabilities 

Owner’s Equity

Accounts Chris Clark, Fees Payable  Capital  Earned 1,350 25,000 7,500 1,350 25,000 7,500

Different terms are used for the various types of revenues. As illustrated above, revenue from providing services is recorded as fees earned. Revenue from the sale of merchandise is recorded as sales. Other examples of revenue include rent, which is recorded as rent revenue, and interest, which is recorded as interest revenue. Instead of receiving cash at the time services are provided or goods are sold, a business may accept payment at a later date. Such revenues are described as fees earned on account or sales on account. For example, if NetSolutions had provided services on account instead of for cash, transaction (d) would have been described as follows: Fees earned on account, $7,500. In such cases, the firm has an account receivable, which is a claim against the customer. An account receivable is an asset, and the revenue is earned and recorded as if cash had been received. When customers pay their accounts, Cash increases and Accounts Receivable decreases. Transaction E Nov. 30, 2009 NetSolutions paid the following expenses during the month: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275.

During the month, NetSolutions spent cash or used up other assets in earning revenue. Assets used in this process of earning revenue are called expenses. Expenses include supplies used and payments for employee wages, utilities, and other services.

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NetSolutions paid the following expenses during the month: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275. Miscellaneous expenses include small amounts paid for such items as postage, coffee, and newspapers. The effect of expenses is the opposite of revenues in that expenses reduce assets and owner’s equity. Like fees earned, the expenses are recorded in columns to the right of Chris Clark, Capital. However, since expenses reduce owner’s equity, the expenses are entered as negative amounts. The effect of this transaction is shown below.  Liabilities 

Assets

Cash Supplies  Land  Bal. 12,500 1,350 20,000 e. 3,650 Bal. 8,850 1,350 20,000

Owner’s Equity

Accounts Chris Clark, Fees Wages Rent Utilities Misc. Payable  Capital  Earned  Exp.  Exp.  Exp.  Exp. 1,350 25,000 7,500 2,125 800 450 275 1,350 25,000 7,500 2,125 800 450 275

Businesses usually record each revenue and expense transaction as it occurs. However, to simplify, we have summarized NetSolutions’ revenues and expenses for the month in transactions (d) and (e). Transaction F

Nov. 30, 2009

NetSolutions paid creditors on account, $950.

When you pay your monthly credit card bill, you decrease the cash in your checking account and decrease the amount you owe to the credit card company. Likewise, when NetSolutions pays $950 to creditors during the month, it reduces assets and liabilities, as shown below.



Assets

Cash Supplies Land Bal. 8,850 1,350 20,000 f. 950 Bal. 7,900 1,350 20,000



Liabilities  Accounts Chris Clark, Payable  Capital  1,350 25,000 950 400 25,000

Owner’s Equity Fees Wages Rent Utilities Misc. Earned  Exp.  Exp.  Exp.  Exp. 7,500 2,125 800 450 275 7,500

2,125

800

450

275

Paying an amount on account is different from paying an expense. The paying of an expense reduces owner’s equity, as illustrated in transaction (e). Paying an amount on account reduces the amount owed on a liability. Transaction G Nov. 30, 2009 Chris Clark determined that the cost of supplies on hand at the end of the month was $550.

The cost of the supplies on hand (not yet used) at the end of the month is $550. Thus, $800 ($1,350  $550) of supplies must have been used during the month. This decrease in supplies is recorded as an expense, as shown at the top of the next page.

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Assets

Bal. g. Bal.

Cash Supplies  Land 7,900 1,350 20,000 800 7,900 550 20,000



Liabilities

Owner’s Equity

Accounts Chris Clark, Fees Wages Rent Supplies Utilities Misc. Payable  Capital  Earned  Exp.  Exp.  Exp.  Exp.  Exp. 400 25,000 7,500 2,125 800 450 275 800 400 25,000 7,500 2,125 800 800 450 275

Transaction H

Nov. 30, 2009

Chris Clark withdrew $2,000 from NetSolutions for personal use.

At the end of the month, Chris Clark withdrew $2,000 in cash from the business for personal use. This transaction is the opposite of an investment in the business by the owner. Withdrawals by the owner should not be confused with expenses. Withdrawals do not represent assets or services used in the process of earning revenues. Instead, withdrawals are a distribution of capital to the owner. Owner withdrawals are identified by the owner’s name and Drawing. For example, Chris Clark’s withdrawal is identified as Chris Clark, Drawing. Like expenses, withdrawals are recorded in a column to the right of Chris Clark, Capital. The effect of the $2,000 withdrawal is shown as follows:

Assets

Cash  Supp.  Land Bal. 7,900 550 20,000 h. 2,000 Bal. 5,900 550 20,000





Liabilities 

Owner’s Equity

Accounts Chris Clark, Chris Clark, Payable  Capital  Drawing  400 25,000 2,000 400 25,000 2,000

Fees Wages Rent Supplies Utilities Misc. Earned  Exp.  Exp.  Exp.  Exp.  Exp. 7,500 2,125 800 800 450 275 7,500

2,125 800

800

450

275

Summary The transactions of NetSolutions are summarized below. Each transaction is identified by letter, and the balance of each item is shown after every transaction.

Assets Cash  Supp.  Land a. 25,000 b. 20,000 20,000 Bal. 5,000 20,000 c. 1,350 Bal. 5,000 1,350 20,000 d. 7,500 Bal. 12,500 1,350 20,000 e. 3,650 Bal. 8,850 1,350 20,000 f. 950 Bal. 7,900 1,350 20,000 g. 800 Bal. 7,900 550 20,000 h. 2,000 Bal. 5,900 550 20,000

 Liabilities  

Owner’s Equity

Accounts Chris Clark, Chris Clark, Fees Wages Rent Supplies Utilities Misc. Payable  Capital  Drawing  Earned  Exp.  Exp.  Exp.  Exp.  Exp. 25,000 25,000 1,350 1,350

25,000

1,350

25,000

7,500 7,500

1,350 950 400

25,000

7,500

2,125 800 2,125 800

25,000

7,500

2,125 800

400 400

25,000 25,000

2,000 2,000

7,500

2,125 800

800 800

7,500

2,125 800

800

450 450

275 275

450

275

450

275

450

275

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You should note the following in the preceding summary: 1. 2. 3.

The effect of every transaction is an increase or a decrease in one or more of the accounting equation elements. The two sides of the accounting equation are always equal. The owner’s equity is increased by amounts invested by the owner and is decreased by withdrawals by the owner. In addition, the owner’s equity is increased by revenues and is decreased by expenses.

The effects of these four types of transactions on owner’s equity are illustrated in Exhibit 5.

Exhibit 5 Effects of Transactions on Owner’s Equity

Example Exercise 1-3

Ow ne r's Eq ui ty

Increased by

Decreased by

• Owner’s investments • Revenues

• Owner’s withdrawals • Expenses

4

Transactions

Salvo Delivery Service is owned and operated by Joel Salvo. The following selected transactions were completed by Salvo Delivery Service during February: 1. 2. 3. 4. 5.

Received cash from owner as additional investment, $35,000. Paid creditors on account, $1,800. Billed customers for delivery services on account, $11,250. Received cash from customers on account, $6,740. Paid cash to owner for personal use, $1,000.

Indicate the effect of each transaction on the accounting equation elements (Assets, Liabilities, Owner’s Equity, Drawing, Revenue, and Expense) by listing the numbers identifying the transactions, (1) through (5). Also, indicate the specific item within the accounting equation element that is affected. To illustrate, the answer to (1) is shown below. (1) Asset (Cash) increases by $35,000; Owner’s Equity (Joel Salvo, Capital) increases by $35,000.

Follow My Example 1-3 (2) Asset (Cash) decreases by $1,800; Liability (Accounts Payable) decreases by $1,800. (3) Asset (Accounts Receivable) increases by $11,250; Revenue (Delivery Service Fees) increases by $11,250. (4) Asset (Cash) increases by $6,740; Asset (Accounts Receivable) decreases by $6,740. (5) Asset (Cash) decreases by $1,000; Drawing (Joel Salvo, Drawing) increases by $1,000.

For Practice: PE 1-3A, PE 1-3B

5

Describe the financial statements of a proprietorship and explain how they interrelate.

Financial Statements After transactions have been recorded and summarized, reports are prepared for users. The accounting reports providing this information are called financial statements. The primary financial statements of a proprietorship are the income statement, the statement of owner’s equity, the balance sheet, and the statement of cash flows. The order that the financial statements are prepared and the nature of each statement is described as follows.

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Order Prepared

Financial Statement

Description of Statement

1.

Income statement

2.

Statement of owner’s equity

3.

Balance sheet

4.

Statement of cash flows

A summary of the revenue and expenses for a specific period of time, such as a month or a year. A summary of the changes in the owner’s equity that have occurred during a specific period of time, such as a month or a year. A list of the assets, liabilities, and owner’s equity as of a specific date, usually at the close of the last day of a month or a year. A summary of the cash receipts and cash payments for a specific period of time, such as a month or a year.

The four financial statements and their interrelationships are illustrated in Exhibit 6, on page 18. The data for the statements are taken from the summary of transactions of NetSolutions on page 14. All financial statements are identified by the name of the business, the title of the statement, and the date or period of time. The data presented in the income statement, the statement of owner’s equity, and the statement of cash flows are for a period of time. The data presented in the balance sheet are for a specific date.

Income Statement When you buy something at a store, you may match the cash register total with the amount you paid the cashier and with the amount of change, if any, you received.

The income statement reports the revenues and expenses for a period of time, based on the matching concept. This concept is applied by matching the expenses with the revenue generated during a period by those expenses. The excess of the revenue over the expenses is called net income or net profit. If the expenses exceed the revenue, the excess is a net loss. The revenue and expenses for NetSolutions were shown in the equation as separate increases and decreases in each item. Net income for a period increases the owner’s equity (capital) for the period. A net loss decreases the owner’s equity (capital) for the period.

Example Exercise 1-4

5

Income Statement

The assets and liabilities of Chickadee Travel Service at April 30, 2010, the end of the current year, and its revenue and expenses for the year are listed below. The capital of the owner, Adam Cellini, was $80,000 at May 1, 2009, the beginning of the current year. Accounts payable Accounts receivable Cash Fees earned Land

$ 12,200 31,350 53,050 263,200 80,000

Miscellaneous expense Office expense Supplies Wages expense

$ 12,950 63,000 3,350 131,700

Prepare an income statement for the current year ended April 30, 2010.

Follow My Example 1-4 Chickadee Travel Service Income Statement For the Year Ended April 30, 2010 Fees earned . . . . . . . . . . Expenses: Wages expense . . . . . . Office expense . . . . . . Miscellaneous expense Total expenses . . . . . Net income . . . . . . . . . . .

.............. . . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

$263,200 $131,700 63,000 12,950 207,650 $ 55,550

For Practice: PE 1-4A, PE 1-4B

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The revenue, expenses, and the net income of $3,050 for NetSolutions are reported in the income statement in Exhibit 6, on page 18. The order in which the expenses are listed in the income statement varies among businesses. Most businesses list expenses in order of size, beginning with the larger items. Miscellaneous expense is usually shown as the last item, regardless of the amount.

Statement of Owner’s Equity The statement of owner’s equity reports the changes in the owner’s equity for a period of time. It is prepared after the income statement because the net income or net loss for the period must be reported in this statement. Similarly, it is prepared before the balance sheet, since the amount of owner’s equity at the end of the period must be reported on the balance sheet. Because of this, the statement of owner’s equity is often viewed as the connecting link between the income statement and balance sheet. Three types of transactions affected owner’s equity for NetSolutions during November: (1) the original investment of $25,000, (2) the revenue and expenses that resulted in net income of $3,050 for the month, and (3) a withdrawal of $2,000 by the owner. This information is summarized in the statement of owner’s equity in Exhibit 6.

Example Exercise 1-5

5

Statement of Owner’s Equity

Using the data for Chickadee Travel Service shown in Example Exercise 1-4, prepare a statement of owner’s equity for the current year ended April 30, 2010. Adam Cellini invested an additional $50,000 in the business during the year and withdrew cash of $30,000 for personal use.

Follow My Example 1-5 Chickadee Travel Service Statement of Owner’s Equity For the Year Ended April 30, 2010 Adam Cellini, capital, May 1, 2009 . . . . . . . . . . . . . . . Additional investment by owner during year . . . . . . . Net income for the year . . . . . . . . . . . . . . . . . . . . . . . Less withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in owner’s equity . . . . . . . . . . . . . . . . . . . . . Adam Cellini, capital, April 30, 2010 . . . . . . . . . . . . . .

$ 80,000 $ 50,000 55,550 $105,550 30,000 75,550 $155,550

For Practice: PE 1-5A, PE 1-5B

Balance Sheet Bank loan officers use a business’s financial statements in deciding whether to grant a loan to the business. Once the loan is granted, the borrower may be required to maintain a certain level of assets in excess of liabilities. The business’s financial statements are used to monitor this level.

The balance sheet in Exhibit 6 reports the amounts of NetSolutions’ assets, liabilities, and owner’s equity as of November 30, 2009. The asset and liability amounts are taken from the last line of the summary of transactions on page 14. Chris Clark, Capital as of November 30, 2009, is taken from the statement of owner’s equity. The form of balance sheet shown in Exhibit 6 is called the account form. This is because it resembles the basic format of the accounting equation, with assets on the left side and the liabilities and owner’s equity sections on the right side.3 The assets section of the balance sheet presents assets in the order that they will be converted into cash or used in operations. Cash is presented first, followed by receivables, supplies, prepaid insurance, and other assets. The assets of a more permanent nature are shown next, such as land, buildings, and equipment.

3 We illustrate an alternative form of balance sheet, called the report form, in Chapter 6. It presents the liabilities and owner’s equity sections below the assets section.

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Chapter 1

Introduction to Accounting and Business

Exhibit 6 Financial Statements for NetSolutions

NetSolutions Income Statement For the Month Ended November 30, 2009 Fees earned . . . . . . . . . Expenses: Wages expense . . . . . Rent expense . . . . . . . Supplies expense . . . . Utilities expense . . . . . Miscellaneous expense Total expense . . . . . Net income . . . . . . . . . .

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$7,500 $2,125 800 800 450 275 4,450 $3,050

NetSolutions Statement of Owner’s Equity For the Month Ended November 30, 2009 Chris Clark, capital, November 1, 2009. . . . . . . . . . . . . . . . . . Investment on November 1, 2009 . . . . . . . . . . . . . . . . . . . . . Net income for November . . . . . . . . . . . . . . . . . . . . . . . . . . Less withdrawals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in owner’s equity . . . . . . . . . . . . . . . . . . . . . . . . . . Chris Clark, capital, November 30, 2009 . . . . . . . . . . . . . . . . .

$

0

$25,000 3,050 $ 28,050 2,000 26,050 $26,050

NetSolutions Balance Sheet November 30, 2009

Cash . . . . . Supplies . . Land . . . . . Total assets

. . . .

Assets ...... ...... ...... ......

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$ 5,900 550 20,000 $26,450

Liabilities Accounts payable . . . . . . . . . . . . . . Owner’s Equity Chris Clark, capital . . . . . . . . . . . . . Total liabilities and owner’s equity . .

$

400

26,050 $26,450

NetSolutions Statement of Cash Flows For the Month Ended November 30, 2009 Cash flows from operating activities: Cash received from customers . . . . . . . . . . . . . . . Deduct cash payments for expenses and payments to creditors . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash flow from operating activities. . . . . . . . . . Cash flows from investing activities: Cash payments for purchase of land. . . . . . . . . . . . Cash flows from financing activities: Cash received as owner’s investment . . . . . . . . . . . Deduct cash withdrawal by owner . . . . . . . . . . . . . Net cash flow from financing activities . . . . . . . . . . Net cash flow and November 30, 2009, cash balance .

......

$ 7,500

...... ......

4,600 $ 2,900

...... . . . .

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(20,000) $ 25,000 2,000 23,000 $ 5,900

Chapter 1

19

Introduction to Accounting and Business

In the liabilities section of the balance sheet in Exhibit 6, accounts payable is the only liability. When there are two or more liabilities, each should be listed and the total amount of liabilities presented as follows: Liabilities Accounts payable Wages payable Total liabilities

Example Exercise 1-6

$12,900 2,570 $15,470

5

Balance Sheet

Using the data for Chickadee Travel Service shown in Example Exercises 1-4 and 1-5, prepare the balance sheet as of April 30, 2010.

Follow My Example 1-6 Chickadee Travel Service Balance Sheet April 30, 2010 Cash . . . . . . . . . . . . Accounts receivable Supplies . . . . . . . . . Land . . . . . . . . . . . . Total assets . . . . . . .

Assets ...... ...... ...... ...... ......

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$ 53,050 31,350 3,350 80,000 $167,750

Liabilities Accounts payable . . . . . . . . . . . . . .

$ 12,200

Owner’s Equity Adam Cellini, capital . . . . . . . . . . . . Total liabilities and owner’s equity . .

155,550 $167,750

For Practice: PE 1-6A, PE 1-6B

Statement of Cash Flows The statement of cash flows consists of three sections, as shown in Exhibit 6: (1) operating activities, (2) investing activities, and (3) financing activities. Each of these sections is briefly described below.

Cash Flows from Operating Activities This section reports a summary of cash receipts and cash payments from operations. The net cash flow from operating activities normally differs from the amount of net income for the period. In Exhibit 6, NetSolutions reported net cash flows from operating activities of $2,900 and net income of $3,050. This difference occurs because revenues and expenses may not be recorded at the same time that cash is received from customers or paid to creditors.

Cash Flows from Investing Activities This section reports the cash transactions for the acquisition and sale of relatively permanent assets. Exhibit 6 reports that NetSolutions paid $20,000 for the purchase of land during November. Cash Flows from Financing Activities This section reports the cash transactions related to cash investments by the owner, borrowings, and withdrawals by the owner. Exhibit 6 shows that Chris Clark invested $25,000 in the business and withdrew $2,000 during November. Preparing the statement of cash flows requires that each of the November cash transactions for NetSolutions be classified as operating, investing, or financing activities. Using the summary of transactions shown on page 14, the November cash transactions for NetSolutions are classified as follows: Transaction a. b. d. e. f. h.

Amount

Cash Flow Activity

$25,000 20,000 7,500 3,650 950 2,000

Financing (Investment by Chris Clark) Investing (Purchase of land) Operating (Fees earned) Operating (Payment of expenses) Operating (Payment of account payable) Financing (Withdrawal by Chris Clark)

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Chapter 1

Introduction to Accounting and Business

Transactions (c) and (g) are not listed above since they did not involve a cash receipt or payment. In addition, the payment of accounts payable in transaction (f) is classified as an operating activity since the account payable arose from the purchase of supplies, which are used in operations. Using the preceding classifications of November cash transactions, the statement of cash flows is prepared as shown in Exhibit 6.4 The ending cash balance shown on the statement of cash flows is also reported on the balance sheet as of the end of the period. To illustrate, the ending cash of $5,900 reported on the November statement of cash flows in Exhibit 6 is also reported as the amount of cash on hand in the November 30, 2009, balance sheet. Since November is NetSolutions’ first period of operations, the net cash flow for November and the November 30, 2009, cash balance are the same amount, $5,900, as shown in Exhibit 6. In later periods, NetSolutions will report in its statement of cash flows a beginning cash balance, an increase or a decrease in cash for the period, and an ending cash balance. For example, assume that for December NetSolutions has a decrease in cash of $3,835. The last three lines of NetSolutions’ statement of cash flows for December would be as follows: Decrease in cash Cash as of December 1, 2009 Cash as of December 31, 2009

Example Exercise 1-7

$3,835 5,900 $2,065

5

Statement of Cash Flows

A summary of cash flows for Chickadee Travel Service for the year ended April 30, 2010, is shown below. Cash receipts: Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . Cash received from additional investment of owner . . . . . . . . .

$251,000 50,000

Cash payments: Cash paid for expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid for land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid to owner for personal use . . . . . . . . . . . . . . . . . . . .

210,000 80,000 30,000

The cash balance as of May 1, 2009, was $72,050. Prepare a statement of cash flows for Chickadee Travel Service for the year ended April 30, 2010.

Follow My Example 1-7 Chickadee Travel Service Statement of Cash Flows For the Year Ended April 30, 2010 Cash flows from operating activities: Cash received from customers . . . . . . . . . Deduct cash payments for expenses . . . . Net cash flows from operating activities. . Cash flows from investing activities: Cash payments for purchase of land . . . . Cash flows from financing activities: Cash received from owner as investment . Deduct cash withdrawals by owner . . . . . Net cash flows from financing activities . . Net decrease in cash during year . . . . . . . . . . Cash as of May 1, 2009 . . . . . . . . . . . . . . . . . . Cash as of April 30, 2010 . . . . . . . . . . . . . . . . .

.............. .............. ..............

$251,000 210,000 $ 41,000

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(80,000) $ 50,000 30,000 20,000 $ (19,000) 72,050 $ 53,050

For Practice: PE 1-7A, PE 1-7B

4 This method of preparing the statement of cash flows is called the “direct method.” This method and the indirect method are discussed further in Chapter 16.

Chapter 1

Introduction to Accounting and Business

21

Interrelationships Among Financial Statements Financial statements are prepared in the order of the income statement, statement of owner’s equity, balance sheet, and statement of cash flows. This order is important because the financial statements are interrelated. These interrelationships for NetSolutions are shown in Exhibit 6 and are described below.5 Financial Statements

Interrelationship

NetSolutions Example (Exhibit 6)

Income Statement and Statement of Owner’s Equity

Net income or net loss reported on the income statement is also reported on the statement of owner’s equity as either an addition (net income) to or deduction (net loss) from the beginning owner’s equity and any additional investments by the owner during the period.

NetSolutions’ net income of $3,050 for November is added to Chris Clark’s investment of $25,000 in the statement of owner’s equity.

Statement of Owner’s Equity and Balance Sheet

Owner’s capital at the end of the period reported on the statement of owner’s equity is also reported on the balance sheet as owner’s capital.

Chris Clark, Capital of $26,050 as of November 30, 2009, on the statement of owner’s equity also appears on the November 30, 2009, balance sheet as Chris Clark, Capital.

Balance Sheet and Statement of Cash Flows

The cash reported on the balance sheet is also reported as the end-ofperiod cash on the statement of cash flows.

Cash of $5,900 reported on the balance sheet as of November 30, 2009, is also reported on the November statement of cash flows as the end-of-period cash.

The preceding interrelationships are important in analyzing financial statements and the impact of transactions on a business. In addition, these interrelationships serve as a check on whether the financial statements are prepared correctly. For example, if the ending cash on the statement of cash flows doesn’t agree with the balance sheet cash, then an error has occurred.

Financial Analysis and Interpretation Financial statements are useful to bankers, creditors, owners, and other users in analyzing and interpreting the financial performance and condition of a business. Throughout this text, we discuss various tools that are often used to analyze and interpret the financial performance and condition of a business. The first such tool we introduce is useful in analyzing the ability of a business to pay its creditors. The relationship between liabilities and owner’s equity, expressed as a ratio, is computed as follows: Total Liabilities Ratio of Liabilities to Owner’s Equity = Total Owner ,s Equity (or , Total Stockholders Equity)

$400 Ratio of Liabilities = = 0.015 , to Owner s Equity $26,050 Corporations refer to total owner’s equity as total stockholders’ equity. Thus, you should substitute total stockholders’ equity for total owner’s equity when computing this ratio for a corporation. The rights of creditors to a business’s assets take precedence over the rights of the owners or stockholders. Thus, the lower the ratio of liabilities to owner’s equity, the better able the business is to withstand poor business conditions and pay its obligations to creditors.

To illustrate, NetSolutions’ ratio of liabilities to owner’s equity at the end of November is 0.015, as calculated at the top of the next column.

5 Depending on the method of preparing the cash flows from operating activities section of the statement of cash flows, net income (or net loss) may also appear on the statement of cash flows. This interrelationship or method of preparing the statement of cash flows, called the “indirect method,” is described and illustrated in Chapter 16.

At a Glance

1

1

Describe the nature of a business, the role of accounting, and ethics in business. Key Points A business provides goods or services (outputs) to customers with the objective of earning a profit. Three types of businesses include service, merchandising, and manufacturing businesses. Accounting, called the “language of business,” is an information system that provides reports to users about the economic activities and condition of a business. Ethics are moral principles that guide the conduct of individuals. Good ethical conduct depends on individual character and firm culture. Accountants are engaged in private accounting or public accounting.

2

Key Learning Outcomes

Example Exercises

Practice Exercises

• Distinguish among service, merchandising, and manufacturing businesses. • Describe the role of accounting in business and explain why accounting is called the “language of business.” • Define ethics and list the two factors affecting ethical conduct. • Describe what private and public accounting means.

Summarize the development of accounting principles and relate them to practice. Key Points Generally accepted accounting principles (GAAP) are used in preparing financial statements so that users can compare one company to another. Accounting principles and concepts develop from research, practice, and pronouncements of authoritative bodies such as the Financial Accounting Standards Board (FASB), Securities and Exchange Commission (SEC), and the International Accounting Standards Board (IASB). The business entity concept views the business as an entity separate from its owners, creditors, or other businesses. Businesses may be organized as proprietorships, partnerships, corporations, and limited liability companies. The cost concept requires that properties and services bought by a business be recorded in terms of actual cost. The objectivity concept requires that the accounting records and reports be based on objective evidence. The unit of measure concept requires that economic data be recorded in dollars.

3

Key Learning Outcomes

Example Exercises

Practice Exercises

1-1

1-1A, 1-1B

Example Exercises

Practice Exercises

1-2

1-2A, 1-2B

• Explain what is meant by generally accepted accounting principles. • Describe how generally accepted accounting principles are developed. • Describe and give an example of what is meant by the business entity concept. • Describe the characteristics of a proprietorship, partnership, corporation, and limited liability company. • Describe and give an example of what is meant by the cost concept. • Describe and give an example of what is meant by the objectivity concept. • Describe and give an example of what is meant by the unit of measure concept.

State the accounting equation and define each element of the equation. Key Points

Key Learning Outcomes

The resources owned by a business and the rights or claims to these resources may be stated in the form of an equation, as follows:

• State the accounting equation.

Assets  Liabilities  Owner’s Equity

• Given two elements of the accounting equation, solve for the third element.

22

• Define assets, liabilities, and owner’s equity.

4

5

Describe and illustrate how business transactions can be recorded in terms of the resulting change in the elements of the accounting equation. Key Points

Key Learning Outcomes

All business transactions can be stated in terms of the change in one or more of the three elements of the accounting equation.

• Define a business transaction. • Using the accounting equation as a framework, record transactions.

Example Exercises

Practice Exercises

1-3

1-3A, 1-3B

Describe the financial statements of a proprietorship and explain how they interrelate. Key Points

Example Exercises

Practice Exercises

• Prepare an income statement.

1-4

1-4A, 1-4B

• Prepare a statement of owner’s equity.

1-5

1-5A, 1-5B

• Prepare a balance sheet.

1-6

1-6A, 1-6B

• Prepare a statement of cash flows.

1-7

1-7A, 1-7B

Key Learning Outcomes

The primary financial statements of a proprietorship are the income statement, the statement of owner’s equity, the balance sheet, and the statement of cash flows. The income statement reports a period’s net income or net loss, which is also reported on the statement of owner’s equity. The ending owner’s capital reported on the statement of owner’s equity is also reported on the balance sheet. The ending cash balance is reported on the balance sheet and the statement of cash flows.

• List and describe the financial statements of a proprietorship.

• Explain how the financial statements of a proprietorship are interrelated.

Key Terms account form (17) account payable (12) account receivable (12) accounting (3) accounting equation (10) assets (9) balance sheet (16) business (2) business entity concept (8) business transaction (10) Certified Public Accountant (CPA) (7) corporation (8) cost concept (8)

ethics (4) expenses (12) fees earned (12) financial accounting (4) Financial Accounting Standards Board (FASB) (7) financial statements (15) general-purpose financial statements (4) generally accepted accounting principles (GAAP) (7) income statement (16) interest revenue (12) International Accounting Standards Board (IASB) (7) liabilities (9)

limited liability company (LLC) (8) management (or managerial) accounting (4) manufacturing business (3) matching concept (16) merchandising business (3) net income (or net profit) (16) net loss (16) objectivity concept (9) owner’s equity (9) partnership (8) prepaid expenses (12) private accounting (4) profit (2) 23

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Chapter 1

Introduction to Accounting and Business

proprietorship (8) public accounting (7) rent revenue (12) revenue (12)

sales (12) Securities and Exchange Commission (SEC) (7) service business (3)

statement of cash flows (16) statement of owner’s equity (16) unit of measure concept (9)

Illustrative Problem Cecil Jameson, Attorney-at-Law, is a proprietorship owned and operated by Cecil Jameson. On July 1, 2009, Cecil Jameson, Attorney-at-Law, has the following assets and liabilities: cash, $1,000; accounts receivable, $3,200; supplies, $850; land, $10,000; accounts payable, $1,530. Office space and office equipment are currently being rented, pending the construction of an office complex on land purchased last year. Business transactions during July are summarized as follows: a. b. c. d. e. f. g. h.

Received cash from clients for services, $3,928. Paid creditors on account, $1,055. Received cash from Cecil Jameson as an additional investment, $3,700. Paid office rent for the month, $1,200. Charged clients for legal services on account, $2,025. Purchased supplies on account, $245. Received cash from clients on account, $3,000. Received invoice for paralegal services from Legal Aid Inc. for July (to be paid on August 10), $1,635. i. Paid the following: wages expense, $850; answering service expense, $250; utilities expense, $325; and miscellaneous expense, $75. j. Determined that the cost of supplies on hand was $980; therefore, the cost of supplies used during the month was $115. k. Jameson withdrew $1,000 in cash from the business for personal use.

Instructions 1. Determine the amount of owner’s equity (Cecil Jameson’s capital) as of July 1, 2009. 2. State the assets, liabilities, and owner’s equity as of July 1 in equation form similar to that shown in this chapter. In tabular form below the equation, indicate the increases and decreases resulting from each transaction and the new balances after each transaction. 3. Prepare an income statement for July, a statement of owner’s equity for July, and a balance sheet as of July 31, 2009. 4. (Optional). Prepare a statement of cash flows for July.

Solution 1. Assets  Liabilities  Owner’s Equity (Cecil Jameson, capital) ($1,000  $3,200  $850  $10,000)  $1,530  Owner’s Equity (Cecil Jameson, capital) $15,050  $1,530  Owner’s Equity (Cecil Jameson, capital) $13,520  Owner’s Equity (Cecil Jameson, capital)

Chapter 1

25

Introduction to Accounting and Business

2.  Liabilities 

Assets

Bal. a. Bal. b. Bal. c. Bal. d. Bal. e. Bal. f. Bal. g. Bal. h. Bal. i. Bal. j. Bal. k. Bal.

Owner’s Equity

Cecil Cecil Answering Accts. Accts. Jameson, Jameson, Fees Paralegal Wages Rent Utilities Service Cash  Rec.  Supp.  Land  Pay.  Capital  Drawing  Earned  Exp.  Exp.  Exp.  Exp.  Exp.  1,000 3,200 850 10,000 1,530 13,520 3,928 3,928 4,928 3,200 850 10,000 1,530 13,520 3,928 1,055 1,055 3,873 3,200 850 10,000 475 13,520 3,928 3,700  3,700 7,573 3,200 850 10,000 475 17,220 3,928 1,200 1,200 6,373 3,200 850 10,000 475 17,220 3,928 1,200 2,025 2,025 6,373 5,225 850 10,000 475 17,220 5,953 1,200  245  245 6,373 5,225 1,095 10,000 720 17,220 5,953 1,200 3,000 3,000 9,373 2,225 1,095 10,000 720 17,220 5,953 1,200 1,635 1,635 9,373 2,225 1,095 10,000 2,355 17,220 5,953 1,635 1,200 1,500 850 325 250 7,873 2,225 1,095 10,000 2,355 17,220 5,953 1,635 850 1,200 325 250  115 7,873 2,225 980 10,000 2,355 17,220 5,953 1,635 850 1,200 325 250 1,000 1,000 6,873 2,225 980 10,000 2,355 17,220 1,000 5,953 1,635 850 1,200 325 250

Supp. Misc. Exp.  Exp.

75 75 115 115

75

115

75

3. Cecil Jameson, Attorney-at-Law Income Statement For the Month Ended July 31, 2009 Fees earned . . . . . . . . . . . . . Expenses: Paralegal expense . . . . . . . . Rent expense . . . . . . . . . . . Wages expense . . . . . . . . . Utilities expense . . . . . . . . . Answering service expense . Supplies expense . . . . . . . . Miscellaneous expense . . . . Total expenses . . . . . . . . Net income . . . . . . . . . . . . . .

................................ . . . . . . . . .

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$5,953 $1,635 1,200 850 325 250 115 75 4,450 $1,503

Cecil Jameson, Attorney-at-Law Statement of Owner’s Equity For the Month Ended July 31, 2009 Cecil Jameson, capital, July 1, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional investment by owner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income for the month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in owner’s equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cecil Jameson, capital, July 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$13,520 $3,700 1,503 $5,203 1,000 4,203 $17,723

(continued)

26

Chapter 1

Introduction to Accounting and Business

Cecil Jameson, Attorney-at-Law Balance Sheet July 31, 2009

Cash . . . . . . . . . . . Accounts receivable Supplies . . . . . . . . Land . . . . . . . . . . . Total assets . . . . . .

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Assets ...... ...... ...... ...... ......

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Liabilities Accounts payable . . . . . . . . . . . . . . . Owner’s Equity Cecil Jameson, capital . . . . . . . . . . . Total liabilities and owner’s equity . . . . . . . . . . . . . . .

$ 6,873 2,225 980 10,000 $20,078

$ 2,355 17,723 $20,078

4. Optional. Cecil Jameson, Attorney-at-Law Statement of Cash Flows For the Month Ended July 31, 2009 Cash flows from operating activities: Cash received from customers. . . . . . . . . . . . Deduct cash payments for operating expenses Net cash flows from operating activities . . . . . Cash flows from investing activities . . . . . . . . . . Cash flows from financing activities: Cash received from owner as investment . . . . Deduct cash withdrawals by owner . . . . . . . . Net cash flows from financing activities . . . . . Net increase in cash during year . . . . . . . . . . . . Cash as of July 1, 2009. . . . . . . . . . . . . . . . . . . Cash as of July 31, 2009. . . . . . . . . . . . . . . . . .

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$6,928* 3,755**

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$3,700 1,000

$3,173 —

2,700 $5,873 1,000 $6,873

*$6,928  $3,928  $3,000 **$3,755  $1,055  $1,200  $1,500

Self-Examination Questions 1. A profit-making business operating as a separate legal entity and in which ownership is divided into shares of stock is known as a: A. proprietorship. C. partnership. B. service business. D. corporation. 2. The resources owned by a business are called: A. assets. C. the accounting equation. B. liabilities. D. owner’s equity. 3. A listing of a business entity’s assets, liabilities, and owner’s equity as of a specific date is a(n): A. balance sheet. B. income statement. C. statement of owner’s equity. D. statement of cash flows.

(Answers at End of Chapter) 4. If total assets increased $20,000 during a period and total liabilities increased $12,000 during the same period, the amount and direction (increase or decrease) of the change in owner’s equity for that period is a(n): A. $32,000 increase. C. $8,000 increase. B. $32,000 decrease. D. $8,000 decrease. 5. If revenue was $45,000, expenses were $37,500, and the owner’s withdrawals were $10,000, the amount of net income or net loss would be: A. $45,000 net income. C. $37,500 net loss. B. $7,500 net income. D. $2,500 net loss.

Eye Openers 1. What is the objective of most businesses? 2. What is the difference between a manufacturing business and a service business? Is a restaurant a manufacturing business, a service business, or both?

Chapter 1

Introduction to Accounting and Business

27

3. Name some users of accounting information. 4. What is the role of accounting in business? 5. Why are most large companies like Microsoft, PepsiCo, Caterpillar, and AutoZone organized as corporations? 6. Barry Bergan is the owner of Elephant Delivery Service. Recently, Barry paid interest of $3,000 on a personal loan of $40,000 that he used to begin the business. Should Elephant Delivery Service record the interest payment? Explain. 7. On April 2, Gremlin Repair Service extended an offer of $100,000 for land that had been priced for sale at $125,000. On May 10, Gremlin Repair Service accepted the seller’s counteroffer of $115,000. Describe how Gremlin Repair Service should record the land. 8. a. Land with an assessed value of $300,000 for property tax purposes is acquired by a business for $475,000. Ten years later, the plot of land has an assessed value of $500,000 and the business receives an offer of $900,000 for it. Should the monetary amount assigned to the land in the business records now be increased? b. Assuming that the land acquired in (a) was sold for $900,000, how would the various elements of the accounting equation be affected? 9. Describe the difference between an account receivable and an account payable. 10. A business had revenues of $600,000 and operating expenses of $715,000. Did the business (a) incur a net loss or (b) realize net income? 11. A business had revenues of $687,500 and operating expenses of $492,400. Did the business (a) incur a net loss or (b) realize net income? 12. What particular item of financial or operating data appears on both the income statement and the statement of owner’s equity? What item appears on both the balance sheet and the statement of owner’s equity? What item appears on both the balance sheet and the statement of cash flows?

Practice Exercises PE 1-1A Cost concept

obj. 2 EE 1-1

p. 9

PE 1-1B Cost concept

obj. 2 EE 1-1

p. 9

PE 1-2A Accounting equation

obj. 3 EE 1-2

p. 9

On February 7, Snap Repair Service extended an offer of $75,000 for land that had been priced for sale at $85,000. On February 21, Snap Repair Service accepted the seller’s counteroffer of $81,000. On April 30, the land was assessed at a value of $125,000 for property tax purposes. On August 30, Snap Repair Service was offered $130,000 for the land by a national retail chain. At what value should the land be recorded in Snap Repair Service’s records? On November 23, Terrier Repair Service extended an offer of $40,000 for land that had been priced for sale at $48,500. On December 2, Terrier Repair Service accepted the seller’s counteroffer of $44,000. On December 27, the land was assessed at a value of $50,000 for property tax purposes. On April 1, Terrier Repair Service was offered $75,000 for the land by a national retail chain. At what value should the land be recorded in Terrier Repair Service’s records? Paul Eberly is the owner and operator of You’re Great, a motivational consulting business. At the end of its accounting period, December 31, 2009, You’re Great has assets of $475,000 and liabilities of $115,000. Using the accounting equation, determine the following amounts: a. Owner’s equity, as of December 31, 2009. b. Owner’s equity, as of December 31, 2010, assuming that assets increased by $90,000 and liabilities increased by $28,000 during 2010.

28

Chapter 1

PE 1-2B Accounting equation

obj. 3 EE 1-2

p. 9

PE 1-3A Transactions

obj. 4 EE 1-3

p. 15

PE 1-3B Transactions

obj. 4 EE 1-3

p. 15

PE 1-4A Income statement

obj. 5 EE 1-4

p. 16

Introduction to Accounting and Business

Lynn Doyle is the owner and operator of Star LLC, a motivational consulting business. At the end of its accounting period, December 31, 2009, Star has assets of $750,000 and liabilities of $293,000. Using the accounting equation, determine the following amounts: a. Owner’s equity, as of December 31, 2009. b. Owner’s equity, as of December 31, 2010, assuming that assets increased by $75,000 and liabilities decreased by $30,000 during 2010.

Zany Delivery Service is owned and operated by Joey Bryant. The following selected transactions were completed by Zany Delivery Service during February: 1. Received cash from owner as additional investment, $15,000. 2. Paid advertising expense, $900. 3. Purchased supplies on account, $600. 4. Billed customers for delivery services on account, $9,000. 5. Received cash from customers on account, $5,500. Indicate the effect of each transaction on the accounting equation elements (Assets, Liabilities, Owner’s Equity, Drawing, Revenue, and Expense) by listing the numbers identifying the transactions, (1) through (5). Also, indicate the specific item within the accounting equation element that is affected. To illustrate, the answer to (1) is shown below. (1) Asset (Cash) increases by $15,000; Owner’s Equity (Joey Bryant, Capital) increases by $15,000.

Yukon Delivery Service is owned and operated by Betty Pasha. The following selected transactions were completed by Yukon Delivery Service during June: 1. Received cash from owner as additional investment, $10,000. 2. Paid creditors on account, $1,500. 3. Billed customers for delivery services on account, $11,500. 4. Received cash from customers on account, $2,700. 5. Paid cash to owner for personal use, $2,000. Indicate the effect of each transaction on the accounting equation elements (Assets, Liabilities, Owner’s Equity, Drawing, Revenue, and Expense) by listing the numbers identifying the transactions, (1) through (5). Also, indicate the specific item within the accounting equation element that is affected. To illustrate, the answer to (1) is shown below. (1) Asset (Cash) increases by $10,000; Owner’s Equity (Betty Pasha, Capital) increases by $10,000.

The assets and liabilities of Impeccable Travel Service at November 30, 2010, the end of the current year, and its revenue and expenses for the year are listed below. The capital of the owner, Charly Maves, was $380,000 at December 1, 2009, the beginning of the current year. Accounts payable Accounts receivable Cash Fees earned Land

$ 42,000 75,500 45,400 754,000 290,000

Miscellaneous expense Office expense Supplies Wages expense

$ 12,700 313,300 5,100 450,000

Prepare an income statement for the current year ended November 30, 2010. PE 1-4B Income statement

obj. 5 EE 1-4

p. 16

The assets and liabilities of Express Travel Service at June 30, 2010, the end of the current year, and its revenue and expenses for the year are listed at the top of the following page. The capital of the owner, Janis Paisley, was $125,000 at July 1, 2009, the beginning of the current year.

Chapter 1

Accounts payable Accounts receivable Cash Fees earned Land

$ 12,000 32,000 78,000 475,000 150,000

Introduction to Accounting and Business

Miscellaneous expense Office expense Supplies Wages expense

29

$ 8,000 111,000 6,000 239,000

Prepare an income statement for the current year ended June 30, 2010. PE 1-5A Statement of owner’s equity

obj. 5 EE 1-5

p. 17

PE 1-5B Statement of owner’s equity

obj. 5 EE 1-5

Using the data for Impeccable Travel Service shown in Practice Exercise 1-4A, prepare a statement of owner’s equity for the current year ended November 30, 2010. Charly Maves invested an additional $36,000 in the business during the year and withdrew cash of $20,000 for personal use.

Using the data for Express Travel Service shown in Practice Exercise 1-4B, prepare a statement of owner’s equity for the current year ended June 30, 2010. Janis Paisley invested an additional $30,000 in the business during the year and withdrew cash of $18,000 for personal use.

p. 17

PE 1-6A Balance sheet

Using the data for Impeccable Travel Service shown in Practice Exercises 1-4A and 1-5A, prepare the balance sheet as of November 30, 2010.

obj. 5 EE 1-6

p. 19

PE 1-6B Balance sheet

Using the data for Express Travel Service shown in Practice Exercises 1-4B and 1-5B, prepare the balance sheet as of June 30, 2010.

obj. 5 EE 1-6

p. 19

PE 1-7A Statement of cash flows

obj. 5 EE 1-7

p. 20

A summary of cash flows for Impeccable Travel Service for the year ended November 30, 2010, is shown below. Cash receipts: Cash received from customers . . . . . . . . . . . . . . . Cash received from additional investment of owner Cash payments: Cash paid for operating expenses . . . . . . . . . . . . . Cash paid for land . . . . . . . . . . . . . . . . . . . . . . . . Cash paid to owner for personal use . . . . . . . . . . .

...... ......

$700,000 36,000

...... ...... ......

730,000 54,000 20,000

The cash balance as of December 1, 2009, was $113,400. Prepare a statement of cash flows for Impeccable Travel Service for the year ended November 30, 2010. PE 1-7B Statement of cash flows

obj. 5 EE 1-7

p. 20

A summary of cash flows for Express Travel Service for the year ended June 30, 2010, is shown below. Cash receipts: Cash received from customers . . . . . . . . . . . . . . . Cash received from additional investment of owner Cash payments: Cash paid for operating expenses . . . . . . . . . . . . . Cash paid for land . . . . . . . . . . . . . . . . . . . . . . . . Cash paid to owner for personal use . . . . . . . . . . .

...... ......

$460,000 30,000

...... ...... ......

355,000 104,000 18,000

The cash balance as of July 1, 2009, was $65,000. Prepare a statement of cash flows for Express Travel Service for the year ended June 30, 2010.

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Introduction to Accounting and Business

Exercises EX 1 1-1

Types of businesses

obj. 1

EX 1 1-2

Professional ethics

obj. 1

EX 2 1-3

Business entity concept

obj. 2

Indicate whether each of the following companies is primarily a service, merchandise, or manufacturing business. If you are unfamiliar with the company, use the Internet to locate the company’s home page or use the finance Web site of Yahoo. 1. 2. 3. 4. 5. 6. 7. 8.

H&R Block eBay Inc. Wal-Mart Stores, Inc. Ford Motor Company Citigroup Boeing SunTrust Alcoa Inc.

9. 10. 11. 12. 13. 14. 15.

Procter & Gamble FedEx Gap Inc. Hilton Hospitality, Inc. CVS Caterpillar The Dow Chemical Company

A fertilizer manufacturing company wants to relocate to Collier County. A 13-year-old report from a fired researcher at the company says the company’s product is releasing toxic by-products. The company has suppressed that report. A second report commissioned by the company shows there is no problem with the fertilizer. Should the company’s chief executive officer reveal the context of the unfavorable report in discussions with Collier County representatives? Discuss.

Chalet Sports sells hunting and fishing equipment and provides guided hunting and fishing trips. Chalet Sports is owned and operated by Cliff Owen, a well-known sports enthusiast and hunter. Cliff’s wife, Judy, owns and operates Joliet Boutique, a women’s clothing store. Cliff and Judy have established a trust fund to finance their children’s college education. The trust fund is maintained by City Bank in the name of the children, John and Morgan. For each of the following transactions, identify which of the entities listed should record the transaction in its records. Entities C B J X

Chalet Sports City Bank Trust Fund Joliet Boutique None of the above

1. Cliff paid a local doctor for his annual physical, which was required by the workmen’s compensation insurance policy carried by Chalet Sports. 2. Cliff received a cash advance from customers for a guided hunting trip. 3. Judy paid her dues to the YWCA. 4. Cliff paid a breeder’s fee for an English springer spaniel to be used as a hunting guide dog. 5. Judy deposited a $5,000 personal check in the trust fund at City Bank. 6. Cliff paid for an advertisement in a hunters’ magazine. 7. Judy authorized the trust fund to purchase mutual fund shares. 8. Judy donated several dresses from inventory for a local charity auction for the benefit of a women’s abuse shelter. 9. Cliff paid for dinner and a movie to celebrate their fifteenth wedding anniversary. 10. Judy purchased two dozen spring dresses from a Seattle designer for a special spring sale.

Chapter 1

EX 3 1-4

Accounting equation

Introduction to Accounting and Business

31

The total assets and total liabilities of Coca-Cola and PepsiCo are shown below.

obj. 3

Coca-Cola (in millions)

PepsiCo (in millions)

$ 29,963 13,043

$29,930 14,483

Assets Liabilities

Determine the owners’ equity of each company. ✔ Coca-Cola, $16,920

EX 3 1-5

Accounting equation

The total assets and total liabilities of eBay and Google are shown below.

obj. 3

eBay (in millions)

Google (in millions)

$13,494 2,589

$18,473 1,433

Assets Liabilities

Determine the owners’ equity of each company. ✔ eBay, $10,905

3 EX 1-6

Accounting equation

Determine the missing amount for each of the following: Assets

obj. 3 ✔ a. 1,030,000

3

EX 1-7 Accounting equation

objs. 3, 4 ✔ b. $568,000

EX 3 1-8

Asset, liability, owner’s equity items

obj. 3

EX 4 1-9

Effect of transactions on accounting equation

obj. 4

a. b. c.

 Liabilities  Owner’s Equity

  $125,000  60,000 

$250,000    7,500 

$780,000 39,500 

Donna Ahern is the owner and operator of Omega, a motivational consulting business. At the end of its accounting period, December 31, 2009, Omega has assets of $760,000 and liabilities of $240,000. Using the accounting equation and considering each case independently, determine the following amounts: a. Donna Ahern, capital, as of December 31, 2009. b. Donna Ahern, capital, as of December 31, 2010, assuming that assets increased by $120,000 and liabilities increased by $72,000 during 2010. c. Donna Ahern, capital, as of December 31, 2010, assuming that assets decreased by $60,000 and liabilities increased by $21,600 during 2010. d. Donna Ahern, capital, as of December 31, 2010, assuming that assets increased by $100,000 and liabilities decreased by $38,400 during 2010. e. Net income (or net loss) during 2010, assuming that as of December 31, 2010, assets were $960,000, liabilities were $156,000, and there were no additional investments or withdrawals.

Indicate whether each of the following is identified with (1) an asset, (2) a liability, or (3) owner’s equity: a. accounts payable b. cash c. fees earned d. land e. supplies f. wages expense

Describe how the following business transactions affect the three elements of the accounting equation. a. Invested cash in business. (continued) b. Received cash for services performed.

32

Chapter 1

Introduction to Accounting and Business

c. Paid for utilities used in the business. d. Purchased supplies for cash. e. Purchased supplies on account.

EX 4 1-10

Effect of transactions on accounting equation

obj. 4 ✔ a. (1) increase $140,000

EX 4 1-11

Effect of transactions on owner’s equity

obj. 4

EX 4 1-12

Transactions

obj. 4

a. A vacant lot acquired for $150,000 is sold for $290,000 in cash. What is the effect of the sale on the total amount of the seller’s (1) assets, (2) liabilities, and (3) owner’s equity? b. Assume that the seller owes $80,000 on a loan for the land. After receiving the $290,000 cash in (a), the seller pays the $80,000 owed. What is the effect of the payment on the total amount of the seller’s (1) assets, (2) liabilities, and (3) owner’s equity?

Indicate whether each of the following types of transactions will either (a) increase owner’s equity or (b) decrease owner’s equity: 1. expenses 2. revenues 3. owner’s investments 4. owner’s withdrawals

The following selected transactions were completed by Lindbergh Delivery Service during October: 1. Received cash from owner as additional investment, $75,000. 2. Paid rent for October, $4,200. 3. Paid advertising expense, $4,000. 4. Received cash for providing delivery services, $39,750. 5. Purchased supplies for cash, $2,500. 6. Billed customers for delivery services on account, $81,200. 7. Paid creditors on account, $9,280. 8. Received cash from customers on account, $25,600. 9. Determined that the cost of supplies on hand was $900; therefore, $1,600 of supplies had been used during the month. 10. Paid cash to owner for personal use, $3,000. Indicate the effect of each transaction on the accounting equation by listing the numbers identifying the transactions, (1) through (10), in a column, and inserting at the right of each number the appropriate letter from the following list: a. Increase in an asset, decrease in another asset. b. Increase in an asset, increase in a liability. c. Increase in an asset, increase in owner’s equity. d. Decrease in an asset, decrease in a liability. e. Decrease in an asset, decrease in owner’s equity.

EX 4 1-13

Nature of transactions

obj. 4 ✔ d. $6,000

Murray Kiser operates his own catering service. Summary financial data for February are presented in equation form as follows. Each line designated by a number indicates the effect of a transaction on the equation. Each increase and decrease in owner’s equity, except transaction (5), affects net income.

Chapter 1

 Liabilities 

Assets Cash  Supplies  Land Bal. 30,000 1. 35,000 2. 15,000 3. 26,000 4. 5. 2,000 6. 7,200 7. Bal. 14,800

4,000

Net income and owner’s withdrawals

obj. 5

5 1-15 EX Net income and owner’s equity for four businesses

75,000

33

Owner’s Equity

Accounts Murray Kiser, Murray Kiser, Fees  Payable  Capital  Drawing  Earned  Expenses 8,000

101,000 35,000

15,000 1,500 3,000 2,500

a. b. c. d. e.

EX 5 1-14

Introduction to Accounting and Business

26,000

1,500

2,000

7,200 90,000

2,300

101,000

2,000

35,000

3,000 29,000

Describe each transaction. What is the amount of net decrease in cash during the month? What is the amount of net increase in owner’s equity during the month? What is the amount of the net income for the month? How much of the net income for the month was retained in the business?

The income statement of a proprietorship for the month of December indicates a net income of $75,000. During the same period, the owner withdrew $100,000 in cash from the business for personal use. Would it be correct to say that the business incurred a net loss of $25,000 during the month? Discuss.

Four different proprietorships, Jupiter, Mercury, Saturn, and Venus, show the same balance sheet data at the beginning and end of a year. These data, exclusive of the amount of owner’s equity, are summarized as follows:

obj. 5 Beginning of the year End of the year

✔ Saturn: Net income, $108,000

Total Assets

Total Liabilities

$ 810,000 1,296,000

$324,000 540,000

On the basis of the above data and the following additional information for the year, determine the net income (or loss) of each company for the year. (Hint: First determine the amount of increase or decrease in owner’s equity during the year.)

EX 5 1-16

Balance sheet items

obj. 5

Jupiter:

The owner had made no additional investments in the business and had made no withdrawals from the business.

Mercury:

The owner had made no additional investments in the business but had withdrawn $72,000.

Saturn:

The owner had made an additional investment of $162,000 but had made no withdrawals.

Venus:

The owner had made an additional investment of $162,000 and had withdrawn $72,000.

From the following list of selected items taken from the records of Hoosier Appliance Service as of a specific date, identify those that would appear on the balance sheet: 1. Accounts Payable 6. Supplies 2. Cash 7. Supplies Expense 3. Fees Earned 8. Utilities Expense 4. Land 9. Wages Expense 5. Sarah Neil, Capital 10. Wages Payable

34

Chapter 1

EX 5 1-17

Income statement items

Introduction to Accounting and Business

Based on the data presented in Exercise 1-16, identify those items that would appear on the income statement.

obj. 5 EX 5 1-18

Statement of owner’s equity

obj. 5

Financial information related to Teflon Company, a proprietorship, for the month ended April 30, 2010, is as follows: Net income for April Hedi Fry’s withdrawals during April Hedi Fry, capital, April 1, 2010

$ 93,780 10,000 715,320

Prepare a statement of owner’s equity for the month ended April 30, 2010. ✔ Hedi Fry, capital, April 30, 2010: $799,100

EX 5 1-19

Income statement

obj. 5

✔ Net income: $116,600

5

EX 1-20

Missing amounts from balance sheet and income statement data

obj. 5 ✔ (a) $46,890

Relax Services was organized on May 1, 2010. A summary of the revenue and expense transactions for May follows: Fees earned Wages expense Rent expense Supplies expense Miscellaneous expense

$363,200 187,000 36,000 11,500 12,100

Prepare an income statement for the month ended May 31. One item is omitted in each of the following summaries of balance sheet and income statement data for the following four different proprietorships:

Beginning of the year: Assets Liabilities End of the year: Assets Liabilities During the year: Additional investment in the business Withdrawals from the business Revenue Expenses

Earth

Mars

Neptune

Pluto

$216,000 129,600

$250,000 130,000

$100,000 76,000

(d) $120,000

268,200 117,000

350,000 110,000

90,000 80,000

248,000 136,000

(a) 14,400 71,190 38,880

50,000 16,000 (b) 64,000

10,000 (c) 115,000 122,500

40,000 60,000 112,000 128,000

Determine the missing amounts, identifying them by letter. (Hint: First determine the amount of increase or decrease in owner’s equity during the year.) EX 5 1-21

Balance sheets, net income

Financial information related to the proprietorship of Plexiglass Interiors for October and November 2010 is as follows:

obj. 5

✔ b. $136,275

Accounts payable Accounts receivable Claudia Symonds, capital Cash Supplies

October 31, 2010

November 30, 2010

$ 46,200 102,000 ? 180,000 9,000

$ 49,800 117,375 ? 306,000 7,500

a. Prepare balance sheets for Plexiglass Interiors as of October 31 and as of November 30, 2010. b. Determine the amount of net income for November, assuming that the owner made no additional investments or withdrawals during the month. c. Determine the amount of net income for November, assuming that the owner made no additional investments but withdrew $37,500 during the month.

Chapter 1

Introduction to Accounting and Business

35

EX 5 1-22

Financial statements

Each of the following items is shown in the financial statements of ExxonMobil Corporation. Identify the financial statement (balance sheet or income statement) in

obj. 5

which each item would appear. a. b. c. d. e. f. g. h.

EX 5 1-23

Statement of cash flows

obj. 5

EX 5 1-24

Statement of cash flows

obj. 5

i. Marketable securities j. Notes and loans payable k. Notes receivable l. Operating expenses m. Prepaid taxes n. Sales o. Selling expenses

Accounts payable Cash equivalents Crude oil inventory Equipment Exploration expenses Income taxes payable Investments Long-term debt

Indicate whether each of the following activities would be reported on the statement of cash flows as (a) an operating activity, (b) an investing activity, or (c) a financing activity: 1. Cash received as owner’s investment 2. Cash paid for land 3. Cash received from fees earned 4. Cash paid for expenses

A summary of cash flows for Pickerel Consulting Group for the year ended March 31, 2010, is shown below. Cash receipts: Cash received from customers . . . . . . . . . . . . . . . Cash received from additional investment of owner Cash payments: Cash paid for operating expenses . . . . . . . . . . . . . Cash paid for land . . . . . . . . . . . . . . . . . . . . . . . . Cash paid to owner for personal use . . . . . . . . . . .

...... ......

$239,100 50,000

...... ...... ......

162,900 75,000 10,000

The cash balance as of April 1, 2009, was $30,800. Prepare a statement of cash flows for Pickerel Consulting Group for the year ended March 31, 2010.

EX 5 1-25

Financial statements

obj. 5

Driftwood Realty, organized July 1, 2010, is owned and operated by Steffy Owen. How many errors can you find in the following statements for Driftwood Realty, prepared after its second month of operations? Driftwood Realty Income Statement August 31, 2010

✔ Correct amount of total assets is $176,400 Sales commissions. . . . . . Expenses: Office salaries expense . Rent expense. . . . . . . . Automobile expense . . . Miscellaneous expense . Supplies expense . . . . . Total expenses . . . . . Net income . . . . . . . . . . .

............................. . . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

$467,100 $291,600 99,000 22,500 7,200 2,700 423,000 $134,100

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Chapter 1

Introduction to Accounting and Business

Steffy Owen Statement of Owner’s Equity August 31, 2009 Steffy Owen, capital, August 1, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 93,600 Less withdrawals during August . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 $ 75,600 Additional investment during August . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500 $ 98,100 Net income for the month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,100 Steffy Owen, capital, August 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $232,200

Balance Sheet For the Month Ended August 31, 2010

EX 1-26

Ratio of liabilities to stockholders’ equity

Assets Cash. . . . . . . . . . . . . . . . . . . . . Accounts payable. . . . . . . . . . . .

$29,700 34,200

Total assets. . . . . . . . . . . . . . . .

$63,900

Liabilities Accounts receivable. . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . Owner’s Equity Steffy Owen, capital . . . . . . . . . . Total liabilities and owner’s equity .

... ...

$128,700 18,000

... ...

232,200 $378,900

The Home Depot, Inc., is the world’s largest home improvement retailer and one of the largest retailers in the United States based on net sales volume. The Home Depot operates over 2,000 Home Depot® stores that sell a wide assortment of building materials and home improvement and lawn and garden products. The Home Depot also operates over 30 EXPO Design Center stores that offer interior design products, such as kitchen and bathroom cabinetry, tiles, flooring, and lighting fixtures, and installation services. The Home Depot reported the following balance sheet data (in millions):

Total assets Total stockholders’ equity

Jan. 28, 2007

Jan. 29, 2006

$52,263 25,030

$44,405 26,909

a. Determine the total liabilities as of January 28, 2007, and January 29, 2006. b. Determine the ratio of liabilities to stockholders’ equity for 2007 and 2006. Round to two decimal places. c. What conclusions regarding the margin of protection to the creditors can you draw from (b)?

EX 1-27 Ratio of liabilities to stockholders’ equity

Lowe’s, a major competitor of The Home Depot in the home improvement business, operates over 1,300 stores. For the years ending February 2, 2007, and February 3, 2006, Lowe’s reported the following balance sheet data (in millions):

Total assets Total liabilities

2007

2006

$27,767 12,042

$24,639 10,343

a. Determine the total stockholders’ equity as of February 2 , 2007, and February 3, 2006. b. Determine the ratio of liabilities to stockholders’ equity for 2007 and 2006. Round to two decimal places. c. What conclusions regarding the margin of protection to the creditors can you draw from (b)? d. Using the balance sheet data for The Home Depot in Exercise 1-26, how does the ratio of liabilities to stockholders’ equity of Lowe’s compare to that of The Home Depot?

Chapter 1

Introduction to Accounting and Business

37

Problems Series A PR 1-1A

4

Transactions

obj. 4 ✔ Cash bal. at end of July: $50,450

Jean Howard established an insurance agency on July 1 of the current year and completed the following transactions during July: a. Opened a business bank account with a deposit of $50,000 from personal funds. b. Purchased supplies on account, $1,600. c. Paid creditors on account, $500. d. Received cash from fees earned on insurance commissions, $9,250. e. Paid rent on office and equipment for the month, $2,500. f. Paid automobile expenses for month, $900, and miscellaneous expenses, $300. g. Paid office salaries, $1,900. h. Determined that the cost of supplies on hand was $550; therefore, the cost of supplies used was $1,050. i. Billed insurance companies for sales commissions earned, $11,150. j. Withdrew cash for personal use, $2,700. Instructions 1. Indicate the effect of each transaction and the balances after each transaction, using the following tabular headings:

Assets

 Liabilities 

Owner’s Equity

Jean Jean Accounts Accounts Howard, Howard, Fees Rent Salaries Supplies Auto Misc. Cash  Receivable  Supplies  Payable  Capital  Drawing  Earned  Expense  Expense  Expense  Expense  Expense

2.

PR 5 1-2A

Financial statements

obj. 5

✔ 1. Net income: $208,860

Briefly explain why the owner’s investment and revenues increased owner’s equity, while withdrawals and expenses decreased owner’s equity.

The amounts of the assets and liabilities of Heavenly Travel Service at April 30, 2010, the end of the current year, and its revenue and expenses for the year are listed below. The capital of Jennifer Burch, owner, was $45,540 at May 1, 2009, the beginning of the current year, and the owner withdrew $25,000 during the current year. Accounts payable Accounts receivable Cash Fees earned Miscellaneous expense Rent expense

$ 14,600 78,000 159,200 600,000 5,000 80,900

Supplies Supplies expense Taxes expense Utilities expense Wages expense

$

6,800 13,200 10,250 49,150 232,640

Instructions 1. Prepare an income statement for the current year ended April 30, 2010. 2. Prepare a statement of owner’s equity for the current year ended April 30, 2010. 3. Prepare a balance sheet as of April 30, 2010.

PR 5 1-3A

Financial statements

obj. 5

✔ 1. Net income: $22,975

Doug Van Buren established Ohm Computer Services on July 1, 2010. The effect of each transaction and the balances after each transaction for July are shown at the top of the following page. Instructions 1. Prepare an income statement for the month ended July 31, 2010. 2. Prepare a statement of owner’s equity for the month ended July 31, 2010. 3. Prepare a balance sheet as of July 31, 2010. 4. (Optional). Prepare a statement of cash flows for the month ending July 31, 2010.

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Chapter 1

Introduction to Accounting and Business

 Liabilities 

Assets

Owner’s Equity

Doug Doug Van Van Accounts Accounts Buren Buren Fees Salaries Rent Auto Supplies Misc. Cash  Receivable  Supplies  Payable  Capital  Drawing  Earned  Expense  Expense  Expense  Expense  Expense a. b. Bal. c. Bal. d. Bal. e. Bal. f. Bal. g. Bal. h. Bal. i. Bal. j. Bal.

30,000 30,000 29,500 59,500 8,000 51,500 1,250 50,250 50,250 5,750 44,500 12,000 32,500

30,000

2,600 2,600

2,600 2,600

2,600

2,600

30,000

29,500 29,500

2,600

30,000

29,500

30,000

8,000 8,000

3,875 3,875

8,000

3,875

30,000

2,600

2,600 1,250 1,350

20,750 20,750

2,600

1,350

30,000

29,500 20,750 50,250

20,750

2,600

1,350

30,000

50,250

20,750

2,600 1,525 1,075

1,350

30,000

50,250

32,500 7,500 25,000

20,750 20,750

PR 1-4A Transactions; financial statements

objs. 4, 5

✔ 2. Net income: $14,450

1,075

1,350 1,350

30,000 30,000

7,500 7,500

8,000 8,000 8,000

12,000 12,000

1,875 1,875

50,250

12,000

8,000

3,875

1,525 1,525

50,250

12,000

8,000

3,875

1,525

1,875 1,875 1,875

On April 1, 2010, Ryan Barnes established Coyote Realty. Ryan completed the following transactions during the month of April: a. Opened a business bank account with a deposit of $25,000 from personal funds. b. Paid rent on office and equipment for the month, $3,200. c. Paid automobile expenses (including rental charge) for month, $1,200, and miscellaneous expenses, $800. d. Purchased supplies (pens, file folders, and copy paper) on account, $900. e. Earned sales commissions, receiving cash, $24,000. f. Paid creditor on account, $400. g. Paid office salaries, $3,600. h. Withdrew cash for personal use, $3,000. i. Determined that the cost of supplies on hand was $150; therefore, the cost of supplies used was $750. Instructions 1. Indicate the effect of each transaction and the balances after each transaction, using the following tabular headings:

Assets

Cash

 Liabilities 

Owner’s Equity

Ryan Ryan Office Accounts Barnes, Barnes, Sales Salaries Rent Auto Supplies Misc.  Supplies  Payable  Capital  Drawing  Commissions  Expense  Expense  Expense  Expense  Expense

2. Prepare an income statement for April, a statement of owner’s equity for April, and a balance sheet as of April 30.

PR 1-5A Transactions; financial statements

objs. 4, 5

✔ 3. Net income: $13,950

Colfax Dry Cleaners is owned and operated by Maria Acosta. A building and equipment are currently being rented, pending expansion to new facilities. The actual work of dry cleaning is done by another company at wholesale rates. The assets and the liabilities of the business on November 1, 2010, are as follows: Cash, $34,200; Accounts Receivable, $40,000; Supplies, $5,000; Land, $50,000; Accounts Payable, $16,400. Business transactions during November are summarized as follows: a. Maria Acosta invested additional cash in the business with a deposit of $35,000 in the business bank account.

Chapter 1

39

Introduction to Accounting and Business

b. c. d. e. f. g. h. i.

Purchased land for use as a parking lot, paying cash of $30,000. Paid rent for the month, $4,500. Charged customers for dry cleaning revenue on account, $18,250. Paid creditors on account, $9,000. Purchased supplies on account, $2,800. Received cash from cash customers for dry cleaning revenue, $31,750. Received cash from customers on account, $27,800. Received monthly invoice for dry cleaning expense for November (to be paid on December 10), $14,800. j. Paid the following: wages expense, $8,200; truck expense, $1,875; utilities expense, $1,575; miscellaneous expense, $850. k. Determined that the cost of supplies on hand was $3,550; therefore, the cost of supplies used during the month was $4,250. l. Withdrew $10,000 for personal use. Instructions 1. Determine the amount of Maria Acosta’s capital as of November 1. 2. State the assets, liabilities, and owner’s equity as of November 1 in equation form similar to that shown in this chapter. In tabular form below the equation, indicate increases and decreases resulting from each transaction and the new balances after each transaction. 3. Prepare an income statement for November, a statement of owner’s equity for November, and a balance sheet as of November 30. 4. (Optional) Prepare a statement of cash flows for November.

PR 1-6A Missing amounts from financial statements

The financial statements at the end of Four Corners Realty’s first month of operations are shown below and on the next page. Four Corners Realty Income Statement For the Month Ended July 31, 2010

obj. 5

✔ i. $515,610

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expenses: Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$239,700 $ (a) 24,480 20,400 13,770 8,415 121,890 (b)

Four Corners Realty Statement of Owner’s Equity For the Month Ended July 31, 2010 Jeremy Parks, capital, July 1, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment on July 1, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income for July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in owner’s equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Jeremy Parks, capital, July 31, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . .

$ $

(c)

(d) (e) (f) (g) (h) (i)

Four Corners Realty Balance Sheet July 31, 2010 Cash . . . . . Supplies . . . Land . . . . . Total assets

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

Assets ...... ...... ...... ......

. . . .

. . . .

. . . .

$150,450 10,200 (j) (k)

Liabilities Accounts payable. . . . . . . . . . . . . . . Owner’s Equity Jeremy Parks, capital . . . . . . . . . . . . Total liabilities and owner’s equity . . .

$12,240 (l) (m)

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Chapter 1

Introduction to Accounting and Business

Four Corners Realty Statement of Cash Flows For the Month Ended July 31, 2010 Cash flows from operating activities: Cash received from customers . . . . . . . . . . . . . . . Deduct cash payments for expenses and payments Net cash flow from operating activities . . . . . . . . . Cash flows from investing activities: Cash payments for acquisition of land . . . . . . . . . . Cash flows from financing activities: Cash received as owner’s investment . . . . . . . . . . Deduct cash withdrawal by owner. . . . . . . . . . . . . Net cash flow from financing activities . . . . . . . . . Net cash flow and July 31, 2010, cash balance . . . . .

............. to creditors . . . . .............

$ (n) 119,850 $

............. . . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

(o)

(367,200) 459,000 61,200 (p) (q)

Instructions By analyzing the interrelationships among the four financial statements, determine the proper amounts for (a) through (q).

Problems Series B PR 1-1B

Transactions

obj. 4 ✔ Cash bal. at end of November: $28,100

On November 1 of the current year, Rhea Quade established a business to manage rental property. She completed the following transactions during November: a. Opened a business bank account with a deposit of $30,000 from personal funds. b. Purchased supplies (pens, file folders, and copy paper) on account, $1,750. c. Received cash from fees earned for managing rental property, $3,600. d. Paid rent on office and equipment for the month, $1,300. e. Paid creditors on account, $500. f. Billed customers for fees earned for managing rental property, $4,800. g. Paid automobile expenses (including rental charges) for month, $500, and miscellaneous expenses, $200. h. Paid office salaries, $1,000. i. Determined that the cost of supplies on hand was $800; therefore, the cost of supplies used was $950. j. Withdrew cash for personal use, $2,000. Instructions 1. Indicate the effect of each transaction and the balances after each transaction, using the following tabular headings:

Assets

 Liabilities 

Rhea Rhea Accounts Accounts Quade, Quade, Cash  Receivable  Supplies  Payable  Capital  Drawing

2.

PR 1-2B

Financial statements

obj. 5

Owner’s Equity



Fees Rent Salaries Supplies Auto Misc. Earned  Expense  Expense  Expense  Expense  Expense

Briefly explain why the owner’s investment and revenues increased owner’s equity, while withdrawals and expenses decreased owner’s equity.

Following are the amounts of the assets and liabilities of St. Kitts Travel Agency at December 31, 2010, the end of the current year, and its revenue and expenses for the year. The capital of Robin Egan, owner, was $45,000 on January 1, 2010, the beginning of the current year. During the current year, Robin withdrew $7,500.

Chapter 1

Accounts payable Accounts receivable Cash Fees earned Miscellaneous expense

✔ 1. Net income: $68,750

Introduction to Accounting and Business

$ 6,250 21,150 90,000 125,000 750

Rent expense Supplies Supplies expense Utilities expense Wages expense

41

$12,500 1,350 1,400 9,100 32,500

Instructions 1. Prepare an income statement for the current year ended December 31, 2010. 2. Prepare a statement of owner’s equity for the current year ended December 31, 2010. 3. Prepare a balance sheet as of December 31, 2010.

PR 1-3B Financial statements

obj. 5

✔ 1. Net income: $8,800

Ashley Rhymer established Fair Play Financial Services on January 1, 2010. Fair Play Financial Services offers financial planning advice to its clients. The effect of each transaction and the balances after each transaction for January are shown below. Instructions 1. Prepare an income statement for the month ended January 31, 2010. 2. Prepare a statement of owner’s equity for the month ended January 31, 2010. 3. Prepare a balance sheet as of January 31, 2010. 4. (Optional). Prepare a statement of cash flows for the month ending January 31, 2010.

 Liabilities 

Assets

Owner’s Equity

Ashley Ashley Accounts Accounts Rhymer, Rhymer, Fees Salaries Rent Auto Supplies Misc. Cash  Receivable  Supplies  Payable  Capital  Drawing  Earned  Expense  Expense  Expense  Expense  Expense a. b. Bal. c. Bal. d. Bal. e. Bal. f. Bal. g. Bal. h. Bal. i. Bal. j. Bal.

15,000

2,180 2,180

15,000 600 14,400 28,000 42,400  7,500 34,900  5,700 29,200 16,000 13,200

2,180 2,180

1,580

15,000

28,000 28,000

2,180

1,580

15,000

28,000

7,500 7,500

2,180

1,580

15,000

28,000

7,500

4,500 4,500

2,180 1,500 680

1,580

15,000

28,000

7,500

4,500

1,580

15,000

680

1,580

15,000



13,200 13,200  5,000 8,200

11,500 11,500 11,500

PR 1-4B Transactions; financial statements

objs. 4, 5

✔ 2. Net income: $9,200

15,000

2,180 2,180 600 1,580

680

1,580

15,000 15,000

15,000

5,000 5,000

16,000 16,000

1,200 1,200 1,200

28,000 11,500 39,500

16,000

7,500

4,500

1,500 1,500

16,000

7,500

4,500

1,500

1,200

39,500

16,000

7,500

4,500

1,500

1,200

1,200

On August 1, 2010, Tanja Zier established Royal Realty. Tanja completed the following transactions during the month of August: a. Opened a business bank account with a deposit of $20,000 from personal funds. b. Purchased supplies (pens, file folders, paper, etc.) on account, $2,650. c. Paid creditor on account, $1,600. d. Earned sales commissions, receiving cash, $28,750. e. Paid rent on office and equipment for the month, $4,200. f. Withdrew cash for personal use, $5,000. g. Paid automobile expenses (including rental charge) for month, $2,500, and miscellaneous expenses, $1,200. (continued)

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Chapter 1

Introduction to Accounting and Business

h. Paid office salaries, $10,000. i. Determined that the cost of supplies on hand was $1,000; therefore, the cost of supplies used was $1,650. Instructions 1. Indicate the effect of each transaction and the balances after each transaction, using the following tabular headings: Assets

Cash

 Liabilities 

Owner’s Equity

Office Accounts Tanja Zier, Tanja Zier, Sales Salaries Rent Auto Supplies Misc.  Supplies  Payable  Capital  Drawing  Commissions  Expense  Expense  Expense  Expense  Expense

2. Prepare an income statement for August, a statement of owner’s equity for August, and a balance sheet as of August 31.

PR 1-5B Transactions; financial statements

objs. 4, 5

✔ 3. Net income: $22,050

Swan Dry Cleaners is owned and operated by Peyton Keyes. A building and equipment are currently being rented, pending expansion to new facilities. The actual work of dry cleaning is done by another company at wholesale rates. The assets and the liabilities of the business on July 1, 2010, are as follows: Cash, $17,000; Accounts Receivable, $31,000; Supplies, $3,200; Land, $36,000; Accounts Payable, $10,400. Business transactions during July are summarized as follows: a. Peyton Keyes invested additional cash in the business with a deposit of $25,000 in the business bank account. b. Paid $24,000 for the purchase of land as a future building site. c. Received cash from cash customers for dry cleaning revenue, $19,500. d. Paid rent for the month, $3,000. e. Purchased supplies on account, $1,550. f. Paid creditors on account, $5,100. g. Charged customers for dry cleaning revenue on account, $24,750. h. Received monthly invoice for dry cleaning expense for July (to be paid on August 10), $8,200. i. Paid the following: wages expense, $5,100; truck expense, $1,200; utilities expense, $800; miscellaneous expense, $950. j. Received cash from customers on account, $26,750. k. Determined that the cost of supplies on hand was $1,800; therefore, the cost of supplies used during the month was $2,950. l. Withdrew $18,000 cash for personal use. Instructions 1. Determine the amount of Peyton Keyes’ capital as of July 1 of the current year. 2. State the assets, liabilities, and owner’s equity as of July 1 in equation form similar to that shown in this chapter. In tabular form below the equation, indicate increases and decreases resulting from each transaction and the new balances after each transaction. 3. Prepare an income statement for July, a statement of owner’s equity for July, and a balance sheet as of July 31. 4. (Optional). Prepare a statement of cash flows for July.

PR 1-6B Missing amounts from financial statements

obj. 5

The financial statements at the end of Palo Duro Realty’s first month of operations are shown at the top of the next page.

Chapter 1

43

Introduction to Accounting and Business

Palo Duro Realty Income Statement For the Month Ended November 30, 2010

✔ k. $180,000

Fees earned . . . . . . . . . . Expenses: Wages expense . . . . . Rent expense . . . . . . . Supplies expense . . . . Utilities expense . . . . . Miscellaneous expense Total expenses . . . . Net income . . . . . . . . . .

................................... . . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

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. . . . . . .

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. . . . . . .

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. . . . . . .

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. . . . . . .

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. . . . . . .

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. . . . . . .

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. . . . . . .

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$

(a)

$51,000 19,200 (b) 10,800 6,600 105,600 $ 74,400

Palo Duro Realty Statement of Owner’s Equity For the Month Ended November 30, 2010 Laura Biddle, capital, November 1, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . Investment on November 1, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income for November . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in owner’s equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Laura Biddle, capital, November 30, 2010 . . . . . . . . . . . . . . . . . . . . . . . .

$

(c)

$240,000 (d) (e) 36,000 (f) (g)

Palo Duro Realty Balance Sheet November 30, 2010 Cash . . . . . Supplies . . . Land. . . . . . Total assets.

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

Assets ...... ...... ...... ......

$ 26,700 21,300 240,000 (h)

Liabilities Accounts payable . . . . . . . . . . . . . . . Owner’s Equity Laura Biddle, capital . . . . . . . . . . . . . Total liabilities and owner’s equity . . .

$ 9,600 (i) (j)

Palo Duro Realty Statement of Cash Flows For the Month Ended November 30, 2010 Cash flows from operating activities: Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . Deduct cash payments for expenses and payments to creditors Net cash flow from operating activities . . . . . . . . . . . . . . . . . . Cash flows from investing activities: Cash payments for acquisition of land . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Cash received as owner’s investment . . . . . . . . . . . . . . . . . . . Deduct cash withdrawal by owner . . . . . . . . . . . . . . . . . . . . . Net cash flow from financing activities . . . . . . . . . . . . . . . . . . Net cash flow and November 30, 2010, cash balance . . . . . . . . .

...... ...... ......

$ (k) 117,300 $

...... . . . .

. . . .

. . . .

. . . .

. . . .

. . . .

(l) (m)

(n) (o) (p) (q)

Instructions By analyzing the interrelationships among the four financial statements, determine the proper amounts for (a) through (q).

Continuing Problem

✔ 2.Net income: $1,480

Lee Chang enjoys listening to all types of music and owns countless CDs. Over the years, Lee has gained a local reputation for knowledge of music from classical to rap and the ability to put together sets of recordings that appeal to all ages. During the last several months, Lee served as a guest disc jockey on a local radio station. In addition, Lee has entertained at several friends’ parties as the host deejay.

44

Chapter 1

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On June 1, 2010, Lee established a proprietorship known as Music Depot. Using an extensive collection of music CDs, Lee will serve as a disc jockey on a fee basis for weddings, college parties, and other events. During June, Lee entered into the following transactions: June 1. Deposited $8,000 in a checking account in the name of Music Depot. 2. Received $2,400 from a local radio station for serving as the guest disc jockey for June. 2. Agreed to share office space with a local real estate agency, Upstairs Realty. Music Depot will pay one-fourth of the rent. In addition, Music Depot agreed to pay a portion of the salary of the receptionist and to pay one-fourth of the utilities. Paid $750 for the rent of the office. 4. Purchased supplies (blank CDs, poster board, extension cords, etc.) from City Office Supply Co. for $350. Agreed to pay $100 within 10 days and the remainder by July 5, 2010. 6. Paid $600 to a local radio station to advertise the services of Music Depot twice daily for two weeks. 8. Paid $500 to a local electronics store for renting digital recording equipment. 12. Paid $250 (music expense) to Cool Music for the use of its current music demos to make various music sets. 13. Paid City Office Supply Co. $100 on account. 16. Received $400 from a dentist for providing two music sets for the dentist to play for her patients. 22. Served as disc jockey for a wedding party. The father of the bride agreed to pay $1,350 the 1st of July. 25. Received $500 from a friend for serving as the disc jockey for a cancer charity ball hosted by the local hospital. 29. Paid $240 (music expense) to Galaxy Music for the use of its library of music demos. 30. Received $1,000 for serving as disc jockey for a local club’s monthly dance. 30. Paid Upstairs Realty $400 for Music Depot’s share of the receptionist’s salary for June. 30. Paid Upstairs Realty $300 for Music Depot’s share of the utilities for June. 30. Determined that the cost of supplies on hand is $170. Therefore, the cost of supplies used during the month was $180. 30. Paid for miscellaneous expenses, $150. 30. Paid $800 royalties (music expense) to National Music Clearing for use of various artists’ music during the month. 30. Withdrew $200 of cash from Music Depot for personal use. Instructions 1. Indicate the effect of each transaction and the balances after each transaction, using the following tabular headings:

Assets

 Liabilities 

Owner’s Equity

Lee Lee Office Equipment Accounts Accounts Chang, Chang, Fees Music Rent Rent Advertising Wages Utilities Supplies Misc. Cash  Receivable  Supplies  Payable  Capital  Drawing  Earned  Expense  Expense  Expense  Expense  Expense  Expense  Expense  Expense

2. Prepare an income statement for Music Depot for the month ended June 30, 2010. 3. Prepare a statement of owner’s equity for Music Depot for the month ended June 30, 2010. 4. Prepare a balance sheet for Music Depot as of June 30, 2010.

Chapter 1

Introduction to Accounting and Business

45

Special Activities SA 1-1 Ethics and professional conduct in business Group Project

SA 1-2 Net income

Blake Gillis, president of Wayside Enterprises, applied for a $175,000 loan from American National Bank. The bank requested financial statements from Wayside Enterprises as a basis for granting the loan. Blake has told his accountant to provide the bank with a balance sheet. Blake has decided to omit the other financial statements because there was a net loss during the past year. In groups of three or four, discuss the following questions: 1. Is Blake behaving in a professional manner by omitting some of the financial statements? 2. a. What types of information about their businesses would owners be willing to provide bankers? What types of information would owners not be willing to provide? b. What types of information about a business would bankers want before extending a loan? c. What common interests are shared by bankers and business owners?

On August 1, 2009, Dr. Dana Hendley established Med, a medical practice organized as a proprietorship. The following conversation occurred the following February between Dr. Hendley and a former medical school classmate, Dr. Elyse Monti, at an American Medical Association convention in New York City. Dr. Monti: Dana, good to see you again. Why didn’t you call when you were in Denver? We could have had dinner together. Dr. Hendley: Actually, I never made it to Denver this year. My husband and kids went up to our Vail condo twice, but I got stuck in Fort Lauderdale. I opened a new consulting practice this August and haven’t had any time for myself since. Dr. Monti: I heard about it . . . Med . . . something . . . right? Dr. Hendley: Yes, Med. My husband chose the name. Dr. Monti: I’ve thought about doing something like that. Are you making any money? I mean, is it worth your time? Dr. Hendley: You wouldn’t believe it. I started by opening a bank account with $30,000, and my January bank statement has a balance of $75,000. Not bad for six months—all pure profit. Dr. Monti: Maybe I’ll try it in Denver! Let’s have breakfast together tomorrow and you can fill me in on the details.

Comment on Dr. Hendley’s statement that the difference between the opening bank balance ($30,000) and the January statement balance ($75,000) is pure profit.

SA 1-3 Transactions and financial statements

Amber Keck, a junior in college, has been seeking ways to earn extra spending money. As an active sports enthusiast, Amber plays tennis regularly at the North Fulton Tennis Club, where her family has a membership. The president of the club recently approached Amber with the proposal that she manage the club’s tennis courts. Amber’s primary duty would be to supervise the operation of the club’s four indoor and six outdoor courts, including court reservations. In return for her services, the club would pay Amber $200 per week, plus Amber could keep whatever she earned from lessons and the fees from the use of the ball machine. The club and Amber agreed to a one-month trial, after which both would consider an arrangement for the remaining two years of Amber’s college career. On this basis, Amber organized Deuce. During June 2009, Amber managed the tennis courts and entered into the following transactions: a. Opened a business account by depositing $1,250. b. Paid $250 for tennis supplies (practice tennis balls, etc.).

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Chapter 1

Introduction to Accounting and Business

c. Paid $150 for the rental of video equipment to be used in offering lessons during June. d. Arranged for the rental of two ball machines during June for $200. Paid $100 in advance, with the remaining $100 due July 1. e. Received $1,500 for lessons given during June. f. Received $400 in fees from the use of the ball machines during June. g. Paid $600 for salaries of part-time employees who answered the telephone and took reservations while Amber was giving lessons. h. Paid $120 for miscellaneous expenses. i. Received $800 from the club for managing the tennis courts during June. j. Determined that the cost of supplies on hand at the end of the month totaled $150; therefore, the cost of supplies used was $100. k. Withdrew $270 for personal use on June 30. As a friend and accounting student, you have been asked by Amber to aid her in assessing the venture. 1. Indicate the effect of each transaction and the balances after each transaction, using the following tabular headings: Assets

 Liabilities 

Owner’s Equity

Amber Amber Accounts Keck, Keck, Service Salary Rent Supplies Misc. Cash  Supplies  Payable  Capital  Drawing  Revenue  Expense  Expense  Expense  Expense

2. 3. 4. 5.

SA 1-4 Certification requirements for accountants Internet Project

Prepare an income statement for June. Prepare a statement of owner’s equity for June. Prepare a balance sheet as of June 30. a. Assume that Amber Keck could earn $8 per hour working 30 hours a week as a waitress. Evaluate which of the two alternatives, working as a waitress or operating Deuce, would provide Amber with the most income per month. b. Discuss any other factors that you believe Amber should consider before discussing a long-term arrangement with the North Fulton Tennis Club.

By satisfying certain specific requirements, accountants may become certified as public accountants (CPAs), management accountants (CMAs), or internal auditors (CIAs). Find the certification requirements for one of these accounting groups by accessing the appropriate Internet site listed below. Site

Description

http://www.ais-cpa.com

This site lists the address and/or Internet link for each state’s board of accountancy. Find your state’s requirements. This site lists the requirements for becoming a CMA. This site lists the requirements for becoming a CIA.

http://www.imanet.org http://www.theiia.org

SA 1-5

Amazon.com, an Internet retailer, was incorporated and began operation in the mid-

Cash flows

90s. On the statement of cash flows, would you expect Amazon.com’s net cash flows from operating, investing, and financing activities to be positive or negative for its first three years of operations? Use the following format for your answers, and briefly explain your logic. First Year Net cash flows from operating activities Net cash flows from investing activities Net cash flows from financing activities

negative

Second Year

Third Year

Chapter 1

SA 1-6 Financial analysis of Enron Corporation

Introduction to Accounting and Business

47

The now defunct Enron Corporation, once headquartered in Houston, Texas, provided products and services for natural gas, electricity, and communications to wholesale and retail customers. Enron’s operations were conducted through a variety of subsidiaries and affiliates that involved transporting gas through pipelines, transmitting electricity, and managing energy commodities. The following data were taken from Enron’s financial statements: In millions

Internet Project

Total revenues Total costs and expenses Operating income Net income

$100,789 98,836 1,953 979

Total assets Total liabilities Total owners’ equity

65,503 54,033 11,470

Net Net Net Net

4,779 (4,264) 571 1,086

cash flows cash flows cash flows increase in

from operating activities from investing activities from financing activities cash

The market price of Enron’s stock was approximately $83 per share when the prior financial statement data were taken. However, eventually Enron’s stock was selling for $0.22 per share. Review the preceding financial statement data and search the Internet for articles on Enron Corporation. Briefly explain why Enron’s stock dropped so dramatically.

Answers to Self-Examination Questions 1. D A corporation, organized in accordance with state or federal statutes, is a separate legal entity in which ownership is divided into shares of stock (answer D). A proprietorship (answer A) is an unincorporated business owned by one individual. A service business (answer B) provides services to its customers. It can be organized as a proprietorship, partnership, corporation, or limited liability company. A partnership (answer C) is an unincorporated business owned by two or more individuals. 2. A The resources owned by a business are called assets (answer A). The debts of the business are called liabilities (answer B), and the equity of the owners is called owner’s equity (answer D). The relationship between assets, liabilities, and owner’s equity is expressed as the accounting equation (answer C). 3. A The balance sheet is a listing of the assets, liabilities, and owner’s equity of a business at a specific date (answer A). The income statement (answer B) is a summary of the revenue and expenses of a business for a specific period of time. The statement of owner’s equity (answer C)

summarizes the changes in owner’s equity for a proprietorship or partnership during a specific period of time. The statement of cash flows (answer D) summarizes the cash receipts and cash payments for a specific period of time. 4. C The accounting equation is: Assets  Liabilities  Owner’s Equity

Therefore, if assets increased by $20,000 and liabilities increased by $12,000, owner’s equity must have increased by $8,000 (answer C), as indicated in the following computation: Assets

 Liabilities  Owner’s Equity

$20,000  $12,000  Owner’s Equity $20,000  $12,000  Owner’s Equity $8,000  Owner’s Equity

5. B Net income is the excess of revenue over expenses, or $7,500 (answer B). If expenses exceed revenue, the difference is a net loss. Withdrawals by the owner are the opposite of the owner’s investing in the business and do not affect the amount of net income or net loss.