The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business. You will find references to the story throughout the chapter.
Many students who take this course do not plan to be accountants. If you are in that group, you might be thinking, “If I'm not going to be an accountant, why do I need to know accounting?” Well, consider this quote from Harold Geneen, the former chairman of IT&T: “To be good at your business, you have to know the numbers—cold.” In business, accounting and financial statements are the means for communicating the numbers. If you don't know how to read financial statements, you can't really know your business.
Many businesses agree with this view. They see the value of their employees being able to read financial statements and understand how their actions affect the company's financial results. For example, consider Clif Bar & Company. The original Clif Bar® energy bar was created in 1990 by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees.
Clif Bar is guided by what it calls its Five Aspirations—Sustaining Our Business, Our Brands, Our People, Our Community, and the Planet. Its website documents its efforts and accomplishments in these five areas. Just a few examples include the company's use of organic products to protect soil, water, and biodiversity; the “smart” solar array (the largest in North America), which provides nearly all the electrical needs for its 115,000-square foot building; and the incentives Clif Bar provides to employees to reduce their personal environmental impact, such as $6,500 toward the purchase of an efficient car or $1,000 per year for eco-friendly improvements toward their homes.
One of the company's proudest moments was the creation of an employee stock ownership plan (ESOP) in 2010. This plan gives its employees 20% ownership of the company (Gary and his wife Kit own the other 80%). The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its finances. Armed with this basic financial knowledge, employees are more aware of the financial impact of their actions, which leads to better decisions.
Many other companies have adopted this open-book management approach. But even in companies that do not practice open-book management, employers generally assume that managers in all areas of the company are “financially literate.”
The Navigator is a learning system designed to prompt you to use the learning aids in the chapter and set priorities as you study.
p. 14 p. 21 p. 26
Learning Objectives give you a framework for learning the specific concepts covered in the chapter.
Learning Objectives
After studying this chapter, you should be able to:
[1] Explain what accounting is.
[2] Identify the users and uses of accounting.
[3] Understand why ethics is a fundamental business concept.
[4] Explain generally accepted accounting principles.
[5] Explain the monetary unit assumption and the economic entity assumption.
[6] State the accounting equation, and define its components.
[7] Analyze the effects of business transactions on the accounting equation.
[8] Understand the four financial statements and how they are prepared.
Taking this course will go a long way to making you financially literate. In this textbook, you will learn how to read and prepare financial statements, and how to use basic tools to evaluate financial results. Throughout this textbook, we attempt to increase your familiarity with financial reporting by providing numerous references, questions, and exercises that encourage you to explore the financial statements of well-known companies.
Preview of Chapter 1
The Preview describes and outlines the major topics and subtopics you will see in the chapter.
The opening story about Clif Bar & Company highlights the importance of having good financial information and knowing how to use it to make effective business decisions. Whatever your pursuits or occupation, the need for financial information is inescapable. You cannot earn a living, spend money, buy on credit, make an investment, or pay taxes without receiving, using, or dispensing financial information. Good decision-making depends on good information.
The purpose of this chapter is to show you that accounting is the system used to provide useful financial information. The content and organization of Chapter 1 are as follows.
1
Explain what accounting is.
What consistently ranks as one of the top career opportunities in business? What frequently rates among the most popular majors on campus? What was the undergraduate degree chosen by Nike founder Phil Knight, Home Depot co-founder Arthur Blank, former acting director of the Federal Bureau of Investigation (FBI) Thomas Pickard, and numerous members of Congress? Accounting.1 Why did these people choose accounting? They wanted to understand what was happening financially to their organizations. Accounting is the financial information system that provides these insights. In short, to understand your organization, you have to know the numbers.
Accounting consists of three basic activities—it identifies, records, and communicates the economic events of an organization to interested users. Let's take a closer look at these three activities.
As a starting point to the accounting process, a company identifies the economic events relevant to its business. Examples of economic events are the sale of snack chips by PepsiCo, the provision of telephone services by AT&T, and the payment of wages by Ford Motor Company.
Once a company like PepsiCo identifies economic events, it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in dollars and cents. In recording, PepsiCo also classifies and summarizes economic events.
Finally, PepsiCo communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, PepsiCo reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, PepsiCo accumulates all sales transactions over a certain period of time and reports the data as one amount in the company's financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies a multitude of transactions and makes a series of activities understandable and meaningful.
A vital element in communicating economic events is the accountant's ability to analyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Appendices A–E show the financial statements of Apple Inc., PepsiCo, Inc., The Coca-Cola Company, Amazon.com, Inc., and Wal-Mart Stores, Inc., respectively. (In addition, in the A Look at IFRS section at the end of each chapter, the U.K. company Zetar plc is analyzed.) We refer to these statements at various places throughout the textbook. At this point, these financial statements probably strike you as complex and confusing. By the end of this course, you'll be surprised at your ability to understand, analyze, and interpret them.
Illustration 1-1 summarizes the activities of the accounting process.
You should understand that the accounting process includes the bookkeeping function. Bookkeeping usually involves only the recording of economic events. It is therefore just one part of the accounting process. In total, accounting involves the entire process of identifying, recording, and communicating economic events.2
Essential terms are printed in blue when they first appear, and are defined in the end-of-chapter glossary.
2
Identify the users and uses of accounting.
The financial information that users need depends upon the kinds of decisions they make. There are two broad groups of users of financial information: internal users and external users.
Internal users of accounting information are managers who plan, organize, and run the business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, internal users must answer many important questions, as shown in Illustration 1-2.
To answer these and other questions, internal users need detailed information on a timely basis. Managerial accounting provides internal reports to help users make decisions about their companies. Examples are financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year.
ACCOUNTING ACROSS THE ORGANIZATION
The Scoop on Accounting
Accounting can serve as a useful recruiting tool even for the human resources department. Rhino Foods, located in Burlington, Vermont, is a manufacturer of specialty ice cream. Its corporate website includes the following:
“Wouldn't it be great to work where you were part of a team? Where your input and hard work made a difference? Where you weren't kept in the dark about what management was thinking? … Well—it's not a dream! It's the way we do business … Rhino Foods believes in family, honesty and open communication—we really care about and appreciate our employees—and it shows. Operating results are posted and monthly group meetings inform all employees about what's happening in the Company. Employees also share in the Company's profits, in addition to having an excellent comprehensive benefits package.”
Source: www.rhinofoods.com/workforus/workforus.html.
What are the benefits to the company and to the employees of making the financial statements available to all employees? (See page 49.)
Accounting Across the Organization boxes demonstrate applications of accounting information in various business functions.
External users are individuals and organizations outside a company who want financial information about the company. The two most common types of external users are investors and creditors. Investors (owners) use accounting information to decide whether to buy, hold, or sell ownership shares of a company. Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money. Illustration 1-3 shows some questions that investors and creditors may ask.
Financial accounting answers these questions. It provides economic and financial information for investors, creditors, and other external users. The information needs of external users vary considerably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with tax laws. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like General Motors will continue to honor product warranties and support its product lines. Labor unions such as the Major League Baseball Players Association want to know whether the owners have the ability to pay increased wages and benefits.
3
Understand why ethics is a fundamental business concept.
A doctor follows certain standards in treating a patient's illness. An architect follows certain standards in designing a building. An accountant follows certain standards in reporting financial information. For these standards to work, a fundamental business concept must be at work—ethical behavior.
People won't gamble in a casino if they think it is “rigged.” Similarly, people won't play the stock market if they think stock prices are rigged. In recent years, the financial press has been full of articles about financial scandals at Enron, WorldCom, HealthSouth, AIG, and other companies. As the scandals came to light, mistrust of financial reporting in general grew. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting.
United States regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting. In response, Congress passed the Sarbanes-Oxley Act (SOX). Its intent is to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now certify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Also, SOX increased the independence requirements of the outside auditors who review the accuracy of corporate financial statements and increased the oversight role of boards of directors.
Ethics Note
Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.
Ethics Notes help sensitize you to some of the ethical issues in accounting.
The standards of conduct by which actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations in business and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook:
When analyzing these various ethics cases, as well as experiences in your own life, it is useful to apply the three steps outlined in Illustration 1-4.
Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers are provided near the end of the chapter.
ETHICS INSIGHT
The Numbers Behind Not-for-Profit Organizations
Accounting plays an important role for a wide range of business organizations worldwide. Just as the integrity of the numbers matters for business, it matters at least as much at not-for-profit organizations. Proper control and reporting help ensure that money is used the way donors intended. Donors are less inclined to give to an organization if they think the organization is subject to waste or theft. The accounting challenges of some large international not-for-profits rival those of the world's largest businesses. For example, after the Haitian earthquake, the Haitian-born musician Wyclef Jean was criticized for the poor accounting controls in a relief fund that he founded. In response, he hired a new accountant and improved the transparency regarding money raised and spent.
What benefits does a sound accounting system provide to a not-for-profit organization? (See page 49.)
4
Explain generally accepted accounting principles.
The accounting profession has developed standards that are generally accepted and universally practiced. This common set of standards is called generally accepted accounting principles (GAAP). These standards indicate how to report economic events.
The primary accounting standard-setting body in the United States is the Financial Accounting Standards Board (FASB). The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies. The SEC relies on the FASB to develop accounting standards, which public companies must follow. Many countries outside of the United States have adopted the accounting standards issued by the International Accounting Standards Board (IASB). These standards are called International Financial Reporting Standards (IFRS).
International Note
Over 100 countries use International Financial Reporting Standards (called IFRS). For example, all companies in the European Union follow international standards. The differences between U.S. and international standards are not generally significant.
International Notes highlight differences between U.S. and international accounting standards.
As markets become more global, it is often desirable to compare the results of companies from different countries that report using different accounting standards. In order to increase comparability, in recent years the two standard-setting bodies have made efforts to reduce the differences between U.S. GAAP and IFRS. This process is referred to as convergence. As a result of these convergence efforts, it is likely that someday there will be a single set of high-quality accounting standards that are used by companies around the world. Because convergence is such an important issue, we highlight any major differences between GAAP and IFRS in International Notes (as shown in the margin here) and provide a more in-depth discussion in the A Look at IRFS section at the end of each chapter.
GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation. Relevance means that financial information is capable of making a difference in a decision. Faithful representation means that the numbers and descriptions match what really existed or happened—they are factual.
Helpful Hint
Relevance and faithful representation are two primary qualities that make accounting information useful for decision-making.
Helpful Hints further clarify concepts being discussed.
The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held. For example, if Best Buy purchases land for $360,000, the company initially reports it in its accounting records at $360,000. But what does Best Buy do if, by the end of the next year, the fair value of the land has increased to $400,000? Under the historical cost principle, it continues to report the land at $360,000.
The fair value principle states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is usually readily available for these types of assets. In determining which measurement principle to use, companies weigh the factual nature of cost figures versus the relevance of fair value. In general, most companies choose to use cost. Only in situations where assets are actively traded, such as investment securities, do companies apply the fair value principle extensively.
The Korean Discount
If you think that accounting standards don't matter, consider recent events in South Korea. For many years, international investors complained that the financial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in stock price was often referred to as the “Korean discount.”
In response, Korean regulators decided that, beginning in 2011, companies would comply with international accounting standards. This change was motivated by a desire to “make the country's businesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.
Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).
What is meant by the phrase “make the country's businesses more transparent”? Why would increasing transparency spur economic growth? (See page 49.)
5
Explain the monetary unit assumption and the economic entity assumption.
Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit assumption and the economic entity assumption.
The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables accounting to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle.
This assumption prevents the inclusion of some relevant information in the accounting records. For example, the health of a company's owner, the quality of service, and the morale of employees are not included. The reason: Companies cannot quantify this information in money terms. Though this information is important, companies record only events that can be measured in money.
Ethics Note
The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees' financial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.
An economic entity can be any organization or unit in society. It may be a company (such as Crocs, Inc.), a governmental unit (the state of Ohio), a municipality (Seattle), a school district (St. Louis District 48), or a church (Southern Baptist). The economic entity assumption requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. To illustrate, Sally Rider, owner of Sally's Boutique, must keep her personal living costs separate from the expenses of her business. Similarly, McDonald's, Coca-Cola, and Cadbury-Schweppes are segregated into separate economic entities for accounting purposes.
PROPRIETORSHIP A business owned by one person is generally a proprietorship. The owner is often the manager/operator of the business. Small service-type businesses (plumbing companies, beauty salons, and auto repair shops), farms, and small retail stores (antique shops, clothing stores, and used-book stores) are often proprietorships. Usually, only a relatively small amount of money (capital) is necessary to start in business as a proprietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for all debts of the business. There is no legal distinction between the business as an economic unit and the owner, but the accounting records of the business activities are kept separate from the personal records and activities of the owner.
PARTNERSHIP A business owned by two or more persons associated as partners is a partnership. In most respects a partnership is like a proprietorship except that more than one owner is involved. Typically, a partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the partnership transactions must be kept separate from the personal activities of the partners. Partnerships are often used to organize retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants).
CORPORATION A business organized as a separate legal entity under state corporation law and having ownership divided into transferable shares of stock is a corporation. The holders of the shares (stockholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. Stockholders may transfer all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with which ownership can change adds to the attractiveness of investing in a corporation. Because ownership can be transferred without dissolving the corporation, the corporation enjoys an unlimited life.
Although the combined number of proprietorships and partnerships in the United States is more than five times the number of corporations, the revenue produced by corporations is eight times greater. Most of the largest companies in the United States—for example, ExxonMobil, Ford, Wal-Mart Stores, Inc., Citigroup, and Apple—are corporations.
The DO IT! exercises ask you to put newly acquired knowledge to work. They outline the Action Plan necessary to complete the exercise, and they show a Solution.
> DO IT!
Basic Concepts
Indicate whether each of the five statements presented below is true or false. If false, indicate how to correct the statement.
Review the basic concepts learned to date.
Develop an understanding of the key terms used.
Solution
1. True 2. False. The two most common types of external users are investors and creditors. 3. True. 4. True. 5. False. The historical cost principle dictates that companies record assets at their cost. Under the historical cost principle, the company must also use cost in later periods.
Related exercise material: E1-1, E1-2, E1-3, E1-4, and DO IT! 1-1.
ACCOUNTING ACROSS THE ORGANIZATION
Spinning the Career Wheel
How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every field of business. Some examples of how accounting is used in business careers include:
General management: Managers of Ford Motors, Massachusetts General Hospital, California State University—Fullerton, a McDonald's franchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions.
Marketing: A marketing specialist at Procter & Gamble must be sensitive to costs and benefits, which accounting helps them quantify and understand. Making a sale is meaningless unless it is a profitable sale.
Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These fields rely heavily on accounting knowledge to analyze financial statements. In fact, it is difficult to get a good job in a finance function without two or three courses in accounting.
Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank—is almost always involved in financing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash flow from an industrial property justify the purchase price? What are the tax benefits of the purchase?
How might accounting help you? (See page 49.)
6
State the accounting equation, and define its components.
The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. For example, Google has total assets of approximately $93.8 billion. Liabilities and stockholders' equity are the rights or claims against these resources. Thus, Google has $93.8 billion of claims against its $93.8 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called stockholders' equity. Google has liabilities of $22.1 billion and stockholders' equity of $71.7 billion.
We can express the relationship of assets, liabilities, and stockholders' equity as an equation, as shown in Illustration 1-5.
This relationship is the basic accounting equation. Assets must equal the sum of liabilities and stockholders' equity. Liabilities appear before stockholders' equity in the basic accounting equation because they are paid first if a business is liquidated.
The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization. It applies to a small proprietorship such as a corner grocery store as well as to a giant corporation such as PepsiCo. The equation provides the underlying framework for recording and summarizing economic events.
Let's look in more detail at the categories in the basic accounting equation.
As noted above, assets are resources a business owns. The business uses its assets in carrying out such activities as production and sales. The common characteristic possessed by all assets is the capacity to provide future services or benefits. In a business, that service potential or future economic benefit eventually results in cash inflows (receipts). For example, consider Campus Pizza, a local restaurant. It owns a delivery truck that provides economic benefits from delivering pizzas. Other assets of Campus Pizza are tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.
Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all sizes usually borrow money and purchase merchandise on credit. These economic activities result in payables of various sorts:
All of these persons or entities to whom Campus Pizza owes money are its creditors.
Creditors may legally force the liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before ownership claims.
The ownership claim on a corporation's total assets is stockholders' equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or stockholders. To find out what belongs to stockholders, we subtract creditors' claims (the liabilities) from the assets. The remainder is the stockholders' claim on the assets—stockholders' equity. It is often referred to as residual equity— that is, the equity “left over” after creditors' claims are satisfied.
Helpful Hint
In some situations, accountants use the term owner's equity and in others owners' equity. Owner's refers to one owner (the case with a sole proprietorship), and owners' refers to multiple owners (the case with partnerships). The term stockholders' equity refers to ownership in corporations.
The stockholders' equity section of a corporation's balance sheet generally, consists of (1) common stock and (2) retained earnings.
A corporation may obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase.
The retained earnings section of the balance sheet is determined by three items: revenues, expenses, and dividends.
The effect of revenues is positive—an increase in stockholders' equity coupled with an increase in assets or a decrease in liabilities.
REVENUES Revenues are the gross increases in stockholders' equity resulting from business activities entered into for the purpose of earning income. Generally, revenues result from selling merchandise, performing services, renting out property, and lending money.
Revenues usually result in an increase in an asset. They may arise from different sources and are called various names depending on the nature of the business. Campus Pizza, for instance, has two categories of sales revenues—pizza sales and beverage sales. Other titles for and sources of revenue common to many businesses are sales, fees, services, commissions, interest, dividends, royalties, and rent.
Helpful Hint
The effect of expenses is negative—a decrease in stockholders' equity coupled with a decrease in assets or an increase in liabilities.
EXPENSES Expenses are the cost of assets consumed or services used in the process of earning revenue. They are decreases in stockholders' equity that result from operating the business. Like revenues, expenses take many forms and are called various names depending on the type of asset consumed or service used. For example, Campus Pizza recognizes the following types of expenses: cost of ingredients (flour, cheese, tomato paste, meat, mushrooms, etc.); cost of beverages; wages expense; utilities expense (electric, gas, and water expense); telephone expense; delivery expense (gasoline, repairs, licenses, etc.); supplies expense (napkins, detergents, aprons, etc.); rent expense; interest expense; and property tax expense.
DIVIDENDS Net income represents an increase in net assets which are then available to distribute to stockholders. The distribution of cash or other assets to stockholders is called a dividend. Dividends reduce retained earnings. However, dividends are not an expense. A corporation first determines its revenues and expenses and then computes net income or net loss. If it has net income and decides it has no better use for that income, a corporation may decide to distribute a dividend to its owners (the stockholders).
In summary, the principal sources (increases) of stockholders' equity are investments by stockholders and revenues from business operations. In contrast, reductions (decreases) in stockholders' equity result from expenses and dividends. These relationships are shown in Illustration 1-6.
> DO IT!
Stockholders' Equity Effects
Action Plan
Understand the sources of revenue.
Understand what causes expenses.
Review the rules for changes in stockholders' equity: Investments and revenues increase stockholders' equity. Expenses and dividends decrease stockholders' equity.
Recognize that dividends are distributions of cash or other assets to stockholders.
Classify the following items as issuance of stock (I), dividends (D), revenues (R), or expenses (E). Then indicate whether each item increases or decreases stockholders' equity.
(1) Rent Expense
(2) Service Revenue
(3) Dividends
(4) Salaries and Wages Expense
Solution
1. Rent Expense is an expense (E); it decreases stockholders' equity. 2. Service Revenue is a revenue (R); it increases stockholders' equity. 3. Dividends is a distribution to stockholders (D); it decreases stockholders' equity. 4. Salaries and Wages Expense is an expense (E); it decreases stockholders' equity.
Related exercise material: BE1-1, BE1-2, BE1-3, BE1-4, BE1-5, E1-5, E1-6, E1-7, and DO IT! 1-2.
7
Analyze the effects of business transactions on the accounting equation.
Transactions (business transactions) are a business's economic events recorded by accountants. Transactions may be external or internal. External transactions involve economic events between the company and some outside enterprise. For example, Campus Pizza's purchase of cooking equipment from a supplier, payment of monthly rent to the landlord, and sale of pizzas to customers are external transactions. Internal transactions are economic events that occur entirely within one company. The use of cooking and cleaning supplies are internal transactions for Campus Pizza.
Companies carry on many activities that do not represent business transactions. Examples are hiring employees, answering the telephone, talking with customers, and placing merchandise orders. Some of these activities may lead to business transactions: Employees will earn wages, and suppliers will deliver ordered merchandise. The company must analyze each event to find out if it affects the components of the accounting equation. If it does, the company will record the transaction. Illustration 1-7 demonstrates the transaction-identification process.
Each transaction must have a dual effect on the accounting equation. For example, if an asset is increased, there must be a corresponding (1) decrease in another asset, (2) increase in a specific liability, or (3) increase in stockholders' equity.
Two or more items could be affected. For example, as one asset is increased $10,000, another asset could decrease $6,000 and a liability could increase $4,000. Any change in a liability or ownership claim is subject to similar analysis.
To demonstrate how to analyze transactions in terms of the accounting equation, we will review the business activities of Softbyte Inc., a computer programming business, during its first month of operations. As part of this analysis, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transactions on stockholders' equity. Recall that stockholders' equity is comprised of two parts: common stock and retained earnings. Common stock is affected when the company issues new shares of stock in exchange for cash. Retained earnings is affected when the company earns revenue, incurs expenses, or pays dividends. Illustration 1-8 shows the expanded accounting equation.
Helpful Hint
You will want to study these transactions until you are sure you understand them. They are not difficult, but understanding them is important to your success in this course. The ability to analyze transactions in terms of the basic accounting equation is essential in accounting.
If you are tempted to skip ahead after you've read a few of the following transaction analyses, don't do it. Each has something unique to teach, something you'll need later. (We assure you that we've kept them to the minimum needed!)
TRANSACTION 1. INVESTMENT BY STOCKHOLDERS Ray and Barbara Neal decide to open a computer programming company that they incorporate as Softbyte Inc. On September 1, 2015, they invest $15,000 cash in the business in exchange for $15,000 of common stock. The common stock indicates the ownership interest that the Neals have in Softbyte Inc. This transaction results in an equal increase in both assets and stockholders' equity.
Observe that the equality of the basic equation has been maintained. Note also that the source of the increase in stockholders' equity (in this case, issued stock) is indicated. Why does this matter? Because investments by stockholders do not represent revenues, and they are excluded in determining net income. Therefore, it is necessary to make clear that the increase is an investment rather than revenue from operations. Additional investments (i.e., investments made by stock-holders after the corporation has been initially formed) have the same effect on stockholders' equity as the initial investment.
TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte Inc. purchases computer equipment for $7,000 cash. This transaction results in an equal increase and decrease in total assets, though the composition of assets changes.
Observe that total assets are still $15,000. Common stock also remains at $15,000, the amount of the original investment.
TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc. purchases for $1,600 from Acme Supply Company computer paper and other supplies expected to last several months. Acme agrees to allow Softbyte to pay this bill in October. This transaction is a purchase on account (a credit purchase). Assets increase because of the expected future benefits of using the paper and supplies, and liabilities increase by the amount due Acme Company.
Total assets are now $16,600. This total is matched by a $1,600 creditor's claim and a $15,000 ownership claim.
TRANSACTION 4. SERVICES PERFORMED FOR CASH Softbyte Inc. receives $1,200 cash from customers for programming services it has performed. This transaction represents Softbyte's principal revenue-producing activity. Recall that revenue increases stockholders' equity.
The two sides of the equation balance at $17,800. Service Revenue is included in determining Softbyte's net income.
Note that we do not have room to give details for each individual revenue and expense account in this illustration. Thus, revenues (and expenses when we get to them) are summarized under one column heading for Revenues and one for Expenses. However, it is important to keep track of the category (account) titles affected (e.g., Service Revenue) as they will be needed when we prepare financial statements later in the chapter.
TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte Inc. receives a bill for $250 from the Daily News for advertising but postpones payment until a later date. This transaction results in an increase in liabilities and a decrease in stockholders' equity.
The two sides of the equation still balance at $17,800. Retained Earnings decreases when Softbyte incurs the expense. Expenses do not have to be paid in cash at the time they are incurred. When Softbyte pays at a later date, the liability Accounts Payable will decrease and the asset Cash will decrease (see Transaction 8). The cost of advertising is an expense (rather than an asset) because Softbyte has used the benefits. Advertising Expense is included in determining net income.
TRANSACTION 6. SERVICES PERFORMED FOR CASH AND CREDIT Softbyte Inc. performs $3,500 of programming services for customers. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on account. This transaction results in an equal increase in assets and stockholders' equity.
Softbyte recognizes $3,500 in revenues when it performs the service. In exchange for this service, it received $1,500 in Cash and Accounts Receivable of $2,000. This Accounts Receivable represents customers' promises to pay $2,000 to Softbyte in the future. When it later receives collections on account, Softbyte will increase Cash and will decrease Accounts Receivable (see Transaction 9).
TRANSACTION 7. PAYMENT OF EXPENSES Softbyte Inc. pays the following expenses in cash for September: store rent $600, salaries and wages of employees $900, and utilities $200. These payments result in an equal decrease in assets and stockholders' equity.
The two sides of the equation now balance at $19,600. Three lines are required in the analysis to indicate the different types of expenses that have been incurred.
TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte Inc. pays its $250 Daily News bill in cash. The company previously (in Transaction 5) recorded the bill as an increase in Accounts Payable and a decrease in stockholders' equity.
Observe that the payment of a liability related to an expense that has previously been recorded does not affect stockholders' equity. Softbyte recorded the expense (in Transaction 5) and should not record it again.
TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT Softbyte Inc. receives $600 in cash from customers who had been billed for services (in Transaction 6). Transaction 9 does not change total assets, but it changes the composition of those assets.
Note that the collection of an account receivable for services previously billed and recorded does not affect stockholders' equity. Softbyte already recorded this revenue (in Transaction 6) and should not record it again.
TRANSACTION 10. DIVIDENDS The corporation pays a dividend of $1,300 in cash to Ray and Barbara Neal, the stockholders of Softbyte Inc. This transaction results in an equal decrease in assets and stockholders' equity.
Note that the dividend reduces retained earnings, which is part of stockholders' equity. Dividends are not expenses. Like stockholders' investments, dividends are excluded in determining net income.
Illustration 1-9 summarizes the September transactions of Softbyte Inc. to show their cumulative effect on the basic accounting equation. It also indicates the transaction number and the specific effects of each transaction. Finally, Illustration 1-9 demonstrates a number of significant facts:
There! You made it through transaction analysis. If you feel a bit shaky on any of the transactions, it might be a good idea at this point to get up, take a short break, and come back again for a brief (10- to 15-minute) review of the transactions, to make sure you understand them before you go on to the next section.
> DO IT!
Tabular Analysis
Transactions made by Virmari & Co., a public accounting firm, for the month of August are shown below. Prepare a tabular analysis which shows the effects of these transactions on the expanded accounting equation, similar to that shown in Illustration 1-9.
Action Plan
Analyze the effects of each transaction on the accounting equation.
Use appropriate category names (not descriptions).
Keep the accounting equation in balance.
Related exercise material: BE1-6, BE1-7, BE1-8, BE1-9, E1-6, E1-7, E1-8, E1-9, E1-10, and DO IT! 1-3.
8
Understand the four financial statements and how they are prepared.
Companies prepare four financial statements from the summarized accounting data:
International Note
The primary types of financial statements required by GAAP and IFRS are the same. In practice, some format differences do exist in presentations employed by GAAP companies compared to IFRS companies.
These statements provide relevant financial data for internal and external users. Illustration 1-10 shows the financial statements of Softbyte Inc. Note that the statements shown in Illustration 1-10 are interrelated:
Helpful Hint
The income statement, retained earnings statement, and statement of cash flows are all for a period of time, whereas the balance sheet is for a point in time.
Also, explanatory notes and supporting schedules are an integral part of every set of financial statements. We illustrate these notes and schedules in later chapters of this textbook.
Be sure to carefully examine the format and content of each statement in Illustration 1-10. We describe the essential features of each in the following sections.
The income statement reports the success or profitability of the company's operations over a specific period of time. For example, Softbyte Inc.'s income statement is dated “For the Month Ended September 30, 2015.” It is prepared from the data appearing in the revenue and expense columns of Illustration 1-9 (page 21).
Helpful Hint
The heading of each statement identifies the company, the type of statement, and the specific date or time period covered by the statement.
Helpful Hint
Note that final sums are double-underlined, and negative amounts (in the statement of cash flows) are presented in parentheses.
Helpful Hint
The arrows in this illustration show the interrelationships of the four financial statements.
1. Net income is computed first and is needed to determine the ending balance in retained earnings.
2. The ending balance in retained earnings is needed in preparing the balance sheet.
3. The cash shown on the balance sheet is needed in preparing the statement of cash flows.
The heading of the statement identifies the company, the type of statement, and the time period covered by the statement.
The income statement lists revenues first, followed by expenses. Finally, the statement shows net income (or net loss). When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.
Alternative Terminology
The income statement is sometimes referred to as the statement of operations, earnings statement, or profit and loss statement.
Alternative Terminology notes present synonymous terms that you may come across in practice.
Although practice varies, we have chosen in our illustrations and homework solutions to list expenses in order of magnitude. (We will consider alternative formats for the income statement in later chapters.)
Note that the income statement does not include investment and dividend transactions between the stockholders and the business in measuring net income. For example, as explained earlier, the cash dividend from Softbyte Inc. was not regarded as a business expense. This type of transaction is considered a reduction of retained earnings, which causes a decrease in stockholders' equity.
Softbyte Inc.'s retained earnings statement reports the changes in retained earnings for a specific period of time. The time period is the same as that covered by the income statement (“For the Month Ended September 30, 2015”). Data for the preparation of the retained earnings statement come from the retained earnings columns of the tabular summary (Illustration 1-9) and from the income statement (Illustration 1-10, page 23).
The first line of the statement shows the beginning retained earnings amount. Then comenet income and dividends. The retained earnings ending balance is the final amount on the statement. The information provided by this statement indicates the reasons why retained earnings increased or decreased during the period. If there is a net loss, it is deducted with dividends in the retained earnings statement.
Softbyte Inc.'s balance sheet reports the assets, liabilities, and stockholders' equity at a specific date (September 30, 2015). The company prepares the balance sheet from the column headings and the month-end data shown in the last line of the tabular summary (Illustration 1-9).
Observe that the balance sheet lists assets at the top, followed by liabilities and stockholders' equity. Total assets must equal total liabilities and stockholders' equity. Softbyte Inc. reports only one liability, Accounts Payable, on its balance sheet. In most cases, there will be more than one liability. When two or more liabilities are involved, a customary way of listing is as shown in Illustration 1-11.
The balance sheet is like a snapshot of the company's financial condition at a specific moment in time (usually the month-end or year-end).
The statement of cash flows provides information on the cash receipts and payments for a specific period of time. The statement of cash flows reports (1) the cash effects of a company's operations during a period, (2) its investing activities, (3) its financing activities, (4) the net increase or decrease in cash during the period, and (5) the cash amount at the end of the period.
Helpful Hint
Investing activities pertain to investments made by the company, not investments made by the owners.
Reporting the sources, uses, and change in cash is useful because investors, creditors, and others want to know what is happening to a company's most liquid resource. The statement of cash flows provides answers to the following simple but important questions.
As shown in Softbyte Inc.'s statement of cash flows in Illustration 1-10, cash increased $8,050 during the period. Net cash provided by operating activities increased cash $1,350. Cash flow from investing activities decreased cash $7,000, while cash flow from financing activities increased cash $13,700. At this time, you need not be concerned with how these amounts are determined. Chapter 13 will examine in detail how the statement is prepared.
PEOPLE, PLANET, AND PROFIT INSIGHT
Beyond Financial Statements
Should we expand our financial statements beyond the income statement, retained earnings statement, balance sheet, and statement of cash flows? Some believe we should take into account ecological and social performance, in addition to financial results, in evaluating a company. The argument is that a company's responsibility lies with anyone who is influenced by its actions. In other words, a company should be interested in benefiting many different parties, instead of only maximizing stockholders' interests.
A socially responsible business does not exploit or endanger any group of individuals. It follows fair trade practices, provides safe environments for workers, and bears responsibility for environmental damage. Granted, measurement of these factors is difficult. How to report this information is also controversial. But, many interesting and useful efforts are underway. Throughout this textbook, we provide additional insights into how companies are attempting to meet the challenge of measuring and reporting their contributions to society, as well as their financial results, to stockholders.
Why might a company's stockholders be interested in its environmental and social performance? (See page 49.)
Financial Statement Items
Presented below is selected information related to Flanagan Corporation at December 31, 2015. Flanagan reports financial information monthly.
Action Plan
Remember the basic accounting equation: assets must equal liabilities plus stockholders' equity.
Review previous financial statements to determine how total assets, net income, and stockholders' equity are computed.
Solution
Note that it is not possible to determine the corporation's stockholders' equity in any other way, because the beginning total for stockholders' equity is not provided.
Related exercise material: BE1-10, BE1-11, E1-9, E1-12, E1-13, E1-14, E1-15, E1-16, and DO IT! 1-4.
The Comprehensive DO IT! is a final review of the chapter. The Action Plan gives tips about how to approach the problem, and the Solution demonstrates both the form and content of complete answers.
> Comprehensive DO IT!
Legal Services Inc. was incorporated on July 1, 2015. During the first month of operations, the following transactions occurred.
Instructions
Solution to Comprehensive DO IT!
Action Plan
Make sure that assets equal liabilities plus stockholders' equity after each transaction.
Investments and revenues increase stockholders' equity. Dividends and expenses decrease stockholders' equity.
Prepare the financial statements in the order listed.
The income statement shows revenues and expenses for a period of time.
The retained earnings statement shows the changes in retained earnings for the same period of time as the income statement.
The balance sheet reports assets, liabilities, and stockholders' equity at a specific date.
1 Explain what accounting is. Accounting is an information system that identifies, records, and communicates the economic events of an organization to interested users.
2 Identify the users and uses of accounting. The major users and uses of accounting are as follows. (a) Management uses accounting information to plan, organize, and run the business. (b) Investors (owners) decide whether to buy, hold, or sell their financial interests on the basis of accounting data. (c) Creditors (suppliers and bankers) evaluate the risks of granting credit or lending money on the basis of accounting information. Other groups that use accounting information are taxing authorities, regulatory agencies, customers, and labor unions.
3 Understand why ethics is a fundamental business concept. Ethics are the standards of conduct by which actions are judged as right or wrong. Effective financial reporting depends on sound ethical behavior.
4 Explain generally accepted accounting principles. Generally accepted accounting principles are a common set of standards used by accountants.
5 Explain the monetary unit assumption and the economic entity assumption. The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption requires that the activities of each economic entity be kept separate from the activities of its owner(s) and other economic entities.
6 State the accounting equation, and define its components. The basic accounting equation is:
Assets = Liabilities + Stockholders' Equity
Assets are resources a business owns. Liabilities are creditorship claims on total assets. Stockholders' equity is the ownership claim on total assets.
The expanded accounting equation is:
Common stock is affected when the company issues new shares of stock in exchange for cash. Revenues are increases in assets resulting from income-earning activities. Expenses are the costs of assets consumed or services used in the process of earning revenue. Dividends are payments the company makes to its stockholders.
7 Analyze the effects of business transactions on the accounting equation. Each business transaction must have a dual effect on the accounting equation. For example, if an individual asset increases, there must be a corresponding (1) decrease in another asset, or (2) increase in a specific liability, or (3) increase in stockholders' equity.
8 Understand the four financial statements and how they are prepared. An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time. A retained earnings statement summarizes the changes in retained earnings for a specific period of time. A balance sheet reports the assets, liabilities, and stockholders' equity at a specific date. A statement of cash flows summarizes information about the cash inflows (receipts) and out-flows (payments) for a specific period of time.
Accounting The information system that identifies, records, and communicates the economic events of an organization to interested users. (p. 4).
Assets Resources a business owns. (p. 13).
Balance sheet A financial statement that reports the assets, liabilities, and stockholders' equity at a specific date. (p. 22).
Basic accounting equation Assets = Liabilities + Stockholders' Equity. (p. 13).
Bookkeeping A part of accounting that involves only the recording of economic events. (p. 5).
Common stock Term used to describe the total amount paid in by stockholders for the shares they purchase. (p. 13).
Convergence The process of reducing the differences between U.S. GAAP and IFRS. (p. 9).
Corporation A business organized as a separate legal entity under state corporation law, having ownership divided into transferable shares of stock. (p. 11).
Dividend A distribution by a corporation to its stock-holders. (p. 14).
Economic entity assumption An assumption that requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. (p. 10).
Ethics The standards of conduct by which one's actions are judged as right or wrong, honest or dishonest, fair or not fair. (p. 7).
Expanded accounting equation Assets = Liabilities + Common Stock + Revenues − Expenses − Dividends. (p. 16).
Expenses The cost of assets consumed or services used in the process of earning revenue. (p. 14).
Fair value principle An accounting principle stating that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). (p. 9).
Faithful representation Numbers and descriptions match what really existed or happened—they are factual. (p. 9).
Financial accounting The field of accounting that provides economic and financial information for investors, creditors, and other external users. (p. 6).
Financial Accounting Standards Board (FASB) A private organization that establishes generally accepted accounting principles in the United States (GAAP). (p. 9).
Generally accepted accounting principles (GAAP) Common standards that indicate how to report economic events. (p. 8).
Historical cost principle An accounting principle that states that companies should record assets at their cost. (p. 9).
Income statement A financial statement that presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time. (p. 22).
International Accounting Standards Board (IASB) An accounting standard-setting body that issues standards adopted by many countries outside of the United States. (p. 9).
International Financial Reporting Standards (IFRS)
International accounting standards set by the International Accounting Standards Board (IASB). (p. 9).
Liabilities Creditor claims against total assets. (p. 13).
Managerial accounting The field of accounting that provides internal reports to help users make decisions about their companies. (p. 6).
Monetary unit assumption An assumption stating that companies include in the accounting records only transaction data that can be expressed in terms of money. (p. 10).
Net income The amount by which revenues exceed expenses. (p. 24).
Net loss The amount by which expenses exceed revenues. (p. 24).
Partnership A business owned by two or more persons associated as partners. (p. 11).
Proprietorship A business owned by one person. (p. 10).
Relevance Financial information that is capable of making a difference in a decision. (p. 9).
Retained earnings statement A financial statement that summarizes the changes in retained earnings for a specific period of time. (p. 22).
Revenues The gross increase in stockholders' equity resulting from business activities entered into for the purpose of earning income. (p. 14).
Sarbanes-Oxley Act (SOX) Law passed by Congress intended to reduce unethical corporate behavior. (p. 7).
Securities and Exchange Commission (SEC) A governmental agency that oversees U.S. financial markets and accounting standard-setting bodies. (p. 9).
Statement of cash flows A financial statement that summarizes information about the cash inflows (receipts) and cash outflows (payments) for a specific period of time. (p. 22).
Stockholders' equity The ownership claim on a corporation's total assets. (p. 13).
Transactions The economic events of a business that are recorded by accountants. (p. 15).
9
Explain the career opportunities in accounting.
Why is accounting such a popular major and career choice? First, there are a lot of jobs. In many cities in recent years, the demand for accountants exceeded the supply. Not only are there a lot of jobs, but there are a wide array of opportunities. As one accounting organization observed, “accounting is one degree with 360 degrees of opportunity.”
Accounting is also hot because it is obvious that accounting matters. Interest in accounting has increased, ironically, because of the attention caused by the accounting failures of companies such as Enron and WorldCom. These widely publicized scandals revealed the important role that accounting plays in society. Most people want to make a difference, and an accounting career provides many opportunities to contribute to society. Finally, the Sarbanes-Oxley Act (SOX) (see page 7) significantly increased the accounting and internal control requirements for corporations. This dramatically increased demand for professionals with accounting training.
Accountants are in such demand that it is not uncommon for accounting students to have accepted a job offer a year before graduation. As the following discussion reveals, the job options of people with accounting degrees are virtually unlimited.
Individuals in public accounting offer expert service to the general public, in much the same way that doctors serve patients and lawyers serve clients. A major portion of public accounting involves auditing. In auditing, a certified public accountant (CPA) examines company financial statements and provides an opinion as to how accurately the financial statements present the company's results and financial position. Analysts, investors, and creditors rely heavily on these “audit opinions,” which CPAs have the exclusive authority to issue.
Taxation is another major area of public accounting. The work that tax specialists perform includes tax advice and planning, preparing tax returns, and representing clients before governmental agencies such as the Internal Revenue Service.
A third area in public accounting is management consulting. It ranges from installing basic accounting software or highly complex enterprise resource planning systems, to performing support services for major marketing projects and merger and acquisition activities.
Many CPAs are entrepreneurs. They form small- or medium-sized practices that frequently specialize in tax or consulting services.
Instead of working in public accounting, you might choose to be an employee of a for-profit company such as Starbucks, Google, or PepsiCo. In private (or managerial) accounting, you would be involved in activities such as cost accounting (finding the cost of producing specific products), budgeting, accounting information system design and support, and tax planning and preparation. You might also be a member of your company's internal audit team. In response to SOX, the internal auditors' job of reviewing the company's operations to ensure compliance with company policies and to increase efficiency has taken on increased importance.
Alternatively, many accountants work for not-for-profit organizations such as the Red Cross or the Bill and Melinda Gates Foundation, or for museums, libraries, or performing arts organizations.
Another option is to pursue one of the many accounting opportunities in governmental agencies. For example, the Internal Revenue Service (IRS), Federal Bureau of Investigation (FBI), and the Securities and Exchange Commission (SEC) all employ accountants. The FBI has a stated goal that at least 15 percent of its new agents should be CPAs. There is also a very high demand for accounting educators at public colleges and universities and in state and local governments.
Forensic accounting uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud. It is listed among the top 20 career paths of the future. The job of forensic accountants is to catch the perpetrators of the estimated $600 billion per year of theft and fraud occurring at U.S. companies. This includes tracing money-laundering and identity-theft activities as well as tax evasion. Insurance companies hire forensic accountants to detect frauds such as arson, and law offices employ forensic accountants to identify marital assets in divorces. Forensic accountants often have FBI, IRS, or similar government experience.
How much can a new accountant make? Take a look at the average salaries for college graduates in public and private accounting. Keep in mind if you also have a CPA license, you'll make 10–15% more when you start out.
Serious earning potential over time gives CPAs great job security. Here are some examples of upper-level salaries for managers in corporate accounting. Note that geographic region, experience, education, CPA certification, and company size each play a role in determining salary.
For up-to-date salary estimates, as well as a wealth of additional information regarding accounting as a career, check out www.startheregoplaces.com.
Auditing The examination of financial statements by a certified public accountant in order to express an opinion as to how accurately the financial statements present the company's results and financial position. (p. 30).
Forensic accounting An area of accounting that uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud. (p. 31).
Management consulting An area of public accounting ranging from development of accounting and computer systems to support services for marketing projects and merger and acquisition activities. (p. 30).
Private (or managerial) accounting An area of accounting within a company that involves such activities as cost accounting, budgeting, design and support of accounting information systems, and tax planning and preparation. (p. 30).
Public accounting An area of accounting in which the accountant offers expert service to the general public. (p. 30).
Taxation An area of public accounting involving tax advice, tax planning, preparing tax returns, and representing clients before governmental agencies. (p. 30).
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are available for practice in WileyPLUS.
Answers are on page 49.
(LO 1) 1. | Which of the following is not a step in the accounting process?
(a) Identification. (b) Verification. (c) Recording. (d) Communication. |
(LO 2) 2. | Which of the following statements about users of accounting information is incorrect?
(a) Management is an internal user. (b) Taxing authorities are external users. (c) Present creditors are external users. (d) Regulatory authorities are internal users. |
(LO 4) 3. | The historical cost principle states that:
(a) assets should be initially recorded at cost and adjusted when the fair value changes. (b) activities of an entity are to be kept separate and distinct from its owner. (c) assets should be recorded at their cost. (d) only transaction data capable of being expressed in terms of money be included in the accounting records. |
(LO 5) 4. | Which of the following statements about basic assumptions is correct?
(a) Basic assumptions are the same as accounting principles. (b) The economic entity assumption states that there should be a particular unit of accountability. (c) The monetary unit assumption enables accounting to measure employee morale. (d) Partnerships are not economic entities. |
(LO 5) 5. | The three types of business entities are:
(a) proprietorships, small businesses, and partnerships. (b) proprietorships, partnerships, and corporations. (c) proprietorships, partnerships, and large businesses. (d) financial, manufacturing, and service companies. |
(LO 6) 6. | Net income will result during a time period when:
(a) assets exceed liabilities. (b) assets exceed revenues. (c) expenses exceed revenues. (d) revenues exceed expenses. |
(LO 6) 7. | As of December 31, 2015, Reed Company has assets of $3,500 and stockholders' equity of $1,500. What are the liabilities for Reed Company as of December 31, 2015?
(a) $1,500. (b) $1,000. (c) $2,500. (d) $2,000. |
(LO 7) 8. | Performing services on account will have the following effects on the components of the basic accounting equation:
(a) increase assets and decrease stockholders' equity. (b) increase assets and increase stockholders' equity. (c) increase assets and increase liabilities. (d) increase liabilities and increase stockholders' equity. |
(LO 7) 9. | Which of the following events is not recorded in the accounting records?
(a) Equipment is purchased on account. (b) An employee is terminated. (c) A cash investment is made into the business. (d) The company pays a cash dividend. |
(LO 7) 10. | During 2015, Seisor Company's assets decreased $50,000 and its liabilities decreased $90,000. Its stockholders' equity therefore:
(a) increased $40,000. (b) decreased $140,000. (c) decreased $40,000. (d) increased $140,000. |
(LO 7) 11. | Payment of an account payable affects the components of the accounting equation in the following way.
(a) Decreases stockholders' equity and decreases liabilities. (b) Increases assets and decreases liabilities. (c) Decreases assets and increases stockholders' equity. (d) Decreases assets and decreases liabilities. |
(LO 8) 12. | Which of the following statements is false?
(a) A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time. (b) A balance sheet reports the assets, liabilities, and stockholders' equity at a specific date. (c) An income statement presents the revenues, expenses, changes in stockholders' equity, and resulting net income or net loss for a specific period of time. (d) A retained earnings statement summarizes the changes in retained earnings for a specific period of time. |
(LO 8) 13. | On the last day of the period, Alan Cesska Company buys a $900 machine on credit. This transaction will affect the:
(a) income statement only. (b) balance sheet only. (c) income statement and retained earnings statement only. (d) income statement, retained earnings statement, and balance sheet. |
(LO 8) 14. | The financial statement that reports assets, liabilities, and stockholders' equity is the:
(a) income statement. (b) retained earnings statement. (c) balance sheet. (d) statement of cash flows. |
(LO 9) *15. | Services performed by a public accountant include:
(a) auditing, taxation, and management consulting. (b) auditing, budgeting, and management consulting. (c) auditing, budgeting, and cost accounting. (d) internal auditing, budgeting, and management consulting. |
Go to the book's companion website, www.wiley.com/college/weygandt, for additional Self-Test Questions.
1. “Accounting is ingrained in our society and it is vital to our economic system.” Do you agree? Explain.
2. Identify and describe the steps in the accounting process.
3. (a) Who are internal users of accounting data?
(b) How does accounting provide relevant data to these users?
4. What uses of financial accounting information are made by (a) investors and (b) creditors?
5. “Bookkeeping and accounting are the same.” Do you agree? Explain.
6. Harper Travel Agency purchased land for $85,000 cash on December 10, 2015. At December 31, 2015, the land's value has increased to $93,000. What amount should be reported for land on Harper's balance sheet at December 31, 2015? Explain.
7. What is the monetary unit assumption?
8. What is the economic entity assumption?
9. What are the three basic forms of profit-oriented business organizations?
10. Juana Perez is the owner of a successful printing shop. Recently, her business has been increasing, and Juana has been thinking about changing the organization of her business from a proprietorship to a corporation. Discuss some of the advantages Juana would enjoy if she were to incorporate her business.
11. What is the basic accounting equation?
12. (a) Define the terms assets, liabilities, and stockholders' equity.
(b) What items affect stockholders' equity?
13. Which of the following items are liabilities of jewelry stores?
(a) Cash.
(b) Accounts payable.
(c) Dividends.
(d) Accounts receivable.
(e) Supplies.
(f) Equipment.
(h) Service revenue.
(g) Salaries and wages payable.
(i) Rent expense.
14. Can a business enter into a transaction in which only the left side of the basic accounting equation is affected? If so, give an example.
15. Are the following events recorded in the accounting records? Explain your answer in each case.
(a) The president of the company dies.
(b) Supplies are purchased on account.
(c) An employee is fired.
16. Indicate how the following business transactions affect the basic accounting equation.
(a) Paid cash for janitorial services.
(b) Purchased equipment for cash.
(c) Invested cash in the business for stock.
(d) Paid accounts payable in full.
17. Listed below are some items found in the financial statements of Jonas Co. Indicate in which financial statement(s) the following items would appear.
(a) Service revenue.
(b) Equipment.
(c) Advertising expense.
(d) Accounts receivable.
(e) Retained earnings.
(f) Salaries and wages payable.
18. In February 2015, Rachel Paige invested an additional $10,000 in Drumlin Company. Drumlin's accountant, Liz Cooke, recorded this receipt as an increase in cash and revenues. Is this treatment appropriate? Why or why not?
19. “A company's net income appears directly on the income statement and the retained earnings statement, and it is included indirectly in the company's balance sheet.” Do you agree? Explain.
20. Monique Enterprises had a stockholders' equity balance of $158,000 at the beginning of the period. At the end of the accounting period, the stockholders' equity balance was $198,000.
(a) Assuming no additional investment or distributions during the period, what is the net income for the period?
(b) Assuming an additional investment of $16,000 but no distributions during the period, what is the net income for the period?
21. Summarized operations for Lakeview Co. for the month of July are as follows.
Revenues recognized: for cash $30,000; on account $70,000.
Expenses incurred: for cash $26,000; on account $38,000.
Indicate for Lakeview Co. (a) the total revenues, (b) the total expenses, and (c) net income for the month of July.
22. The basic accounting equation is Assets = Liabilities + Stockholders' Equity. Replacing the words in that equation with dollar amounts, what is Apple's accounting equation at September 24, 2011?
Use basic accounting equation.
(LO 6) |
BE1-1 Presented below is the basic accounting equation. Determine the missing amounts. | ||||||||
Use basic accounting equation.
(LO 6) |
BE1-2 Given the accounting equation, answer each of the following questions.
(a) The liabilities of Holland Company are $120,000 and its stockholders' equity is $232,000. What is the amount of Holland Company's total assets? (b) The total assets of Holland Company are $190,000 and its stockholders' equity is $86,000. What is the amount of its total liabilities? (c) The total assets of Holland Company are $600,000 and its liabilities are equal to one-half of its total assets. What is the amount of Holland Company's stockholders' equity? |
||||||||
Use basic accounting equation.
(LO 6) |
BE1-3 At the beginning of the year, Canon Company had total assets of $870,000 and total liabilities of $500,000. Answer the following questions.
(a) If total assets increased $150,000 during the year and total liabilities decreased $80,000, what is the amount of stockholders' equity at the end of the year? (b) During the year, total liabilities increased $100,000 and stockholders' equity decreased $66,000. What is the amount of total assets at the end of the year? (c) If total assets decreased $80,000 and stockholders' equity increased $120,000 during the year, what is the amount of total liabilities at the end of the year? |
||||||||
Solve accounting equation.
(LO 6) |
BE1-4 Use the accounting equation to answer each of the following questions.
(a) The liabilities of Olga Company are $90,000. Common stock account is $150,000; dividends are $40,000; revenues, $450,000; and expenses, $320,000. What is the amount of Olga Company's total assets? (b) The total assets of Lafayette Company are $57,000. Common stock account is $23,000; dividends are $7,000; revenues, $50,000; and expenses, $35,000. What is the amount of the company's total liabilities? (c) The total assets of Dierdorf Co. are $600,000 and its liabilities are equal to two-thirds of its total assets. What is the amount of Dierdorf Co.'s stockholders' equity? |
||||||||
Identify assets, liabilities, and stockholders' equity.
(LO 6) |
BE1-5 Indicate whether each of the following items is an asset (A), liability (L), or part of stockholders' equity (SE).
_______ (a) Accounts receivable _______ (b) Salaries and wages payable _______ (c) Equipment _______ (d) Supplies _______ (e) Owner's investment _______ (f) Notes payable |
||||||||
Determine effect of transactions on basic accounting equation.
(LO 7) |
BE1-6 Presented on the next page are three business transactions. On a sheet of paper, list the letters (a), (b), and (c) with columns for assets, liabilities, and stockholders' equity. For each column, indicate whether the transactions increased (+), decreased (−), or had no effect (NE) on assets, liabilities, and stockholders' equity.
(a) Purchased supplies on account. (b) Received cash for performing a service. (c) Paid expenses in cash. |
||||||||
Determine effect of transactions on accounting equation.
(LO 7) |
BE1-7 Follow the same format as BE1-6 above. Determine the effect on assets, liabilities, and stockholders' equity of the following three transactions.
(a) Stockholders invested cash in the business for common stock. (b) Paid a cash dividend. (c) Received cash from a customer who had previously been billed for services performed. |
||||||||
Classify items affecting stockholders' equity.
(LO 6) |
BE1-8 Classify each of the following items as dividends (D), revenue (R), or expense (E).
_______ (a) Advertising expense _______ (b) Service revenue _______ (c) Insurance expense _______ (d) Salaries and wages expense _______ (e) Dividends _______ (f) Rent revenue _______ (g) Utilities expense |
||||||||
Determine effect of transactions on stockholders' equity.
(LO 6) |
BE1-9 Presented below are three transactions. Mark each transaction as affecting common stock (C), dividends (D), revenue (R), expense (E), or not affecting stockholders' equity (NSE).
_______ (a) Received cash for services performed. _______ (b) Paid cash to purchase equipment. _______ (c) Paid employee salaries. |
||||||||
Prepare a balance sheet.
(LO 8) |
BE1-10 In alphabetical order below are balance sheet items for Ellerby Company at December 31, 2015. Prepare a balance sheet, following the format of Illustration 1-10.
|
||||||||
Determine where items appear on financial statements.
(LO 8) |
BE1-11 Indicate whether the following items would appear on the income statement (IS), alance sheet (BS), or retained earnings statement (RE).
_______ (a) Notes payable _______ (b) Advertising expense _______ (c) Common stock _______ (d) Cash _______ (e) Service revenue _______ (f) Dividends |
> DO IT! Review
Review basic concepts.
(LO 1, 2, 4)
DO IT! 1-1 Indicate whether each of the five statements presented below is true or false If false, indicate how to correct the statement.
Evaluate effects of transactions on stockholders' equity.
(LO 6)
DO IT! 1-2 Classify the following items as issuance of stork (I) dividends (D) revenues (R), or expenses (E). Then indicate whether each item increases or decreases stockholders' equity.
Prepare tabular analysis.
(LO 7)
DO IT! 1-3 Transactions made by Morlan and Co., a law firm for the month of March are shown on the next page. Prepare a tabular analysis which shows the effects of these transactions on the accounting equation, similar to that shown in Illustration 1-9 (page 21).
Calculate effects of transactions on financial statement items.
(LO 8)
DO IT! 1-4 Presented below is selected information related to Garryowen Company at December 31, 2015. Garryowen reports financial information monthly.
(a) Determine the total assets of Garryowen Company at December 31, 2015.
(b) Determine the net income that Garryowen Company reported for December 2015.
(c) Determine the stockholders' equity of Garryowen Company at December 31, 2015.
Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
Analyze transactions and compute net income.
(LO 6, 7) |
P1-1A Fredonia Repair Inc. was started on May 1. A summary of May transactions is presented below.
|
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Total assets $13,560
Check figures let you know if you are on the right track with your solution. |
(a) Prepare a tabular analysis of the transactions using the following column headings: Cash, Accounts Receivable, Supplies, Equipment, Accounts Payable, Common Stock, and Retained Earnings (with separate columns for Revenues, Expenses, and Dividends). Include margin explanations for any changes in Retained Earnings. Revenue is called Service Revenue. | ||||||||||||||||||||||||||
(b) Net income $4,010 | (b) From an analysis of the Retained Earnings columns, compute the net income or net loss for May. | ||||||||||||||||||||||||||
Analyze transactions and prepare income statement, retained earnings statement, and balance sheet.
(LO 6, 7, 8) |
P1-2A On August 31, the balance sheet of La Brava Veterinary Clinic showed Cash $9,000, Accounts Receivable $1,700, Supplies $600, Equipment $6,000, Accounts Payable $3,600, Common Stock $13,000, and Retained Earnings $700. During September, the following transactions occurred.
|
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Ending cash $15,900 | (a) Prepare a tabular analysis of the September transactions beginning with August 31 balances. The column headings should be as follows: Cash + Accounts Receivable + Supplies + Equipment = Notes Payable + Accounts Payable + Common Stock + Retained Earnings + Revenues − Expenses − Dividends. | ||||||||||||||||||||||||||
(b) Net income $4,330
Total assets $29,800 |
(b) Prepare an income statement for September, a retained earnings statement for September, and a balance sheet at September 30. | ||||||||||||||||||||||||||
Prepare income statement, retained earnings statement, and balance sheet.
(LO 8) |
P1-3A On May 1, Nimbus Flying School, a company that provides flying lessons, was started with an investment of $45,000 cash in the business. Following are the assets and liabilities of the company on May 31, 2015, and the revenues and expenses for the month of May.
No additional investments were made in May, but the company paid dividends of $500 during the month. |
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Net income $2,150
Total assets $76,050 |
(a) Prepare an income statement and a retained earnings statement for the month of May and a balance sheet at May 31. | ||||||||||||||||||||||||||
(b) Net income $1,550 | (b) Prepare an income statement and a retained earnings statement for May assuming the following data are not included above: (1) $900 worth of services were performed and billed but not collected at May 31, and (2) $1,500 of gasoline expense was incurred but not paid. | ||||||||||||||||||||||||||
Analyze transactions and prepare financial statements.
(LO 6, 7, 8) |
P1-4A Nancy Tercek started a delivery service, Tercek Deliveries, on June 1, 2015. The following transactions occurred during the month of June.
|
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Total assets $25,800 | (a) Show the effects of the previous transactions on the accounting equation using the following format.
Include margin explanations for any changes in the Retained Earnings account in your analysis. |
||||||||||||||||||||||||||
(b) Net income $4,450 | (b) Prepare an income statement for the month of June. | ||||||||||||||||||||||||||
(c) Cash $8,100 | (c) Prepare a balance sheet at June 30, 2015. | ||||||||||||||||||||||||||
Determine financial statement amounts and prepare retained earnings statement.
(LO 7, 8) |
P1-5A Financial statement information about four different companies is as follows.
Instructions (a) Determine the missing amounts. (Hint: For example, to solve for (a), Assets − Liabilities = Stockholders' Equity = $27,000.) (b) Prepare the retained earnings statement for Leonardo Company. Assume beginning retained earnings was $20,000. (c) Write a memorandum explaining the sequence for preparing financial statements and the interrelationship of the retained earnings statement to the income statement and balance sheet. |
Analyze transactions and compute net income.
(LO 6, 7) |
P1-1B On April 1, Bill Taylor established Taylor Made Travel Agency. The following transactions were completed during the month.
|
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Ending cash $9,800 | (a) Prepare a tabular analysis of the transactions using the following column headings: Cash, Accounts Receivable, Supplies, Equipment, Accounts Payable, Common Stock, and Retained Earnings (with separate columns for Revenues, Expenses, and Dividends). Include margin explanation for any changes in Retained Earnings. | ||||||||||||||||||||||||||
(b) Net income $5,800 | (b) From an analysis of the Retained Earnings columns, compute the net income or net loss for April. | ||||||||||||||||||||||||||
Analyze transactions and prepare income statement, retained earnings statement, and balance sheet.
(LO 6, 7, 8) |
P1-2B Randy Coburn opened a law office, Randy Coburn, Attorney at Law, on July 1, 2015. On July 31, the balance sheet showed Cash $4,000, Accounts Receivable $1,500, Supplies $400, Equipment $5,000, Accounts Payable $4,200, Common Stock $6,000, and Retained Earnings $700. During August, the following transactions occurred.
|
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Ending expenses $4,330 | (a) Prepare a tabular analysis of the August transactions beginning with July 31 balances. The column headings should be as follows: Cash + Accounts Receivable + Supplies + Equipment = Notes Payable + Accounts Payable + Common Stock + Retained Earnings + Revenues − Expenses − Dividends. | ||||||||||||||||||||||||||
(b) Net income $3,570 Total assets $14,100 | (b) Prepare an income statement for August, a retained earnings statement for August, and a balance sheet at August 31. | ||||||||||||||||||||||||||
Prepare income statement, retained earnings statement, and balance sheet.
(LO 8) |
P1-3B Blushe Cosmetics Co., a company that provides individual skin care treatment, was started on June 1 with an investment of $22,000 cash. Following are the assets and liabilities of the company at June 30 and the revenues and expenses for the month of June.
Stockholders made no additional investments in June. The company paid a cash dividend of $800 during the month. |
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Net income $1,900 Total assets $38,300 | (a) Prepare an income statement and a retained earnings statement for the month of June and a balance sheet at June 30, 2015. | ||||||||||||||||||||||||||
(b) Net income $3,400 | (b) Prepare an income statement and a retained earnings statement for June assuming the following data are not included above: (1) $800 worth of services were performed and billed but not collected at June 30, and (2) $100 of gasoline expense was incurred but not paid. | ||||||||||||||||||||||||||
Analyze transactions and prepare financial statements.
(LO 6, 7, 8) |
P1-4B Gloria Rodd started a consulting firm, Rodd Consulting, on May 1, 2015. The following transactions occurred during the month of May.
|
||||||||||||||||||||||||||
Instructions | |||||||||||||||||||||||||||
(a) Total assets $18,260 | (a) Show the effects of the previous transactions on the accounting equation using the following format.
Include margin explanations for any changes in the Retained Earnings account in your analysis. |
||||||||||||||||||||||||||
(b) Net income $3,360 | (b) Prepare an income statement for the month of May | ||||||||||||||||||||||||||
(c) Cash $14,160 | (c) Prepare a balance sheet at May 31, 2015. | ||||||||||||||||||||||||||
Determine financial statement amounts and prepare retained earnings statement.
(LO 7, 8) |
P1-5B Financial statement information about four different companies is shown below. | ||||||||||||||||||||||||||
Instructions
(a) Determine the missing amounts. (Hint: For example, to solve for (a), Assets − Liabilities = Stockholders' Equity = $28,000.) (b) Prepare the retained earnings statement for Chico Company. Assume beginning retained earnings was $0. (c) Write a memorandum explaining the sequence for preparing financial statements and the interrelationship of the retained earnings statement to the income statement and balance sheet. |
Visit the book's website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Problem Set C.
CCC1 Natalie Koebel spent much of her childhood learning the art of cookie-making from her grandmother. They passed many happy hours mastering every type of cookie imaginable and later creating new recipes that were both healthy and delicious. Now at the start of her second year in college, Natalie is investigating various possibilities for starting her own business as part of the requirements of the entrepreneurship program in which she is enrolled.
A long-time friend insists that Natalie has to somehow include cookies in her business plan. After a series of brainstorming sessions, Natalie settles on the idea of operating a cookie-making school. She will start on a part-time basis and offer her services in people's homes. Now that she has started thinking about it, the possibilities seem endless. During the fall, she will concentrate on holiday cookies. She will offer individual lessons and group sessions (which will probably be more entertainment than education for the participants). Natalie also decides to include children in her target market.
The first difficult decision is coming up with the perfect name for her business. In the end, she settles on “Cookie Creations” and then moves on to more important issues.
The Continuing Cookie Chronicle starts in this chapter and continues in every chapter. You also can find this problem at the book's companion website.
Instructions
Broadening Your PERSPECTIVE
BYP1-1 The actual financial statements of Apple Inc. for 2011 are presented in Appendix A. Instructions for accessing and using the company's complete annual report, including the notes to the financial statements, are also provided in Appendix A.
Instructions
Refer to Apple's financial statements and answer the following questions.
(a) What were Apple's total assets at September 24, 2011? At September 25, 2010?
(b) How much cash (and cash equivalents) did Apple have on September 24, 2011?
(c) What amount of accounts payable did Apple report on September 24, 2011? On September 25, 2010?
(d) What were Apple's net sales in 2009? In 2010? In 2011?
(e) What is the amount of the change in Apple's net income from 2010 to 2011?
BYP1-2 PepsiCo's financial statements are presented in Appendix B. Financial statements of The Coca-Cola Company are presented in Appendix C. Instructions for accessing and using the complete annual reports of PepsiCo and Coca-Cola, including the notes to the financial statements, are also provided in Appendices B and C, respectively.
Instructions
BYP1-3 Amazon.com, Inc.'s financial statements are presented in Appendix D. Financial statements for Wal-Mart Stores, Inc. are presented in Appendix E. Instructions for accessing and using the complete annual reports of Amazon and Wal-Mart, including the notes to the financial statements, are also provided in Appendices D and E, respectively.
Instructions
BYP1-4 This exercise will familiarize you with skill requirements, job descriptions, and salaries for accounting careers.
Address: www.careers-in-accounting.com, or go to www.wiley.com/college/weygandt
Instructions
Go to the site shown above. Answer the following questions.
(a) What are the three broad areas of accounting (from “Skills and Talents”)?
(b) List eight skills required in accounting.
(c) How do the three accounting areas differ in terms of these eight required skills?
(d) Explain one of the key job options in accounting.
(e) What is the overall salary range for a junior staff accountant?
BYP1-5 Kathy and James Mohr, local golf stars, opened the Chip-Shot Driving Range Company on March 1, 2015. They invested $25,000 cash and received common stock in exchange for their investment. A caddy shack was constructed for cash at a cost of $8,000, and $800 was spent on golf balls and golf clubs. The Mohrs leased five acres of land at a cost of $1,000 per month and paid the first month's rent. During the first month, advertising costs totaled $750, of which $150 was unpaid at March 31, and $400 was paid to members of the high-school golf team for retrieving golf balls. All revenues from customers were deposited in the company's bank account. On March 15, Kathy and James received a dividend of $1,000. A $100 utility bill was received on March 31 but was not paid. On March 31, the balance in the company's bank account was $18,900.
Kathy and James thought they had a pretty good first month of operations. But, their estimates of profitability ranged from a loss of $6,100 to net income of $2,450.
Instructions
With the class divided into groups, answer the following.
(a) How could the Mohrs have concluded that the business operated at a loss of $6,100? Was this a valid basis on which to determine net income?
(b) How could the Mohrs have concluded that the business operated at a net income of $2,450? (Hint: Prepare a balance sheet at March 31.) Was this a valid basis on which to determine net income?
(c) Without preparing an income statement, determine the actual net income for March.
(d) What was the revenue recognized in March?
BYP1-6 Ashley Hirano, the bookkeeper for New York Company, has been trying to get the balance sheet to balance. The company's balance sheet is shown below.
Instructions
Explain to Ashley Hirano in a memo why the original balance sheet is incorrect, and what should be done to correct it.
BYP1-7 After numerous campus interviews, Greg Thorpe, a senior at Great Northern College, received two office interview invitations from the Baltimore offices of two large firms. Both firms offered to cover his out-of-pocket expenses (travel, hotel, and meals). He scheduled the interviews for both firms on the same day, one in the morning and one in the afternoon. At the conclusion of each interview, he submitted to both firms his total out-of-pocket expenses for the trip to Baltimore: mileage $112 (280 miles at $0.40), hotel $130, meals $36, and parking and tolls $18, for a total of $296. He believes this approach is appropriate. If he had made two trips, his cost would have been two times $296. He is also certain that neither firm knew he had visited the other on that same trip. Within 10 days, Greg received two checks in the mail, each in the amount of $296.
Instructions
(a) Who are the stakeholders (affected parties) in this situation?
(b) What are the ethical issues in this case?
(c) What would you do in this situation?
BYP1-8 Some people are tempted to make their finances look worse to get financial aid. Companies sometimes also manage their financial numbers in order to accomplish certain goals. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. In managing earnings, companies' actions vary from being within the range of ethical activity, to being both unethical and illegal attempts to mislead investors and creditors.
Instructions
Provide responses for each of the following questions.
BYP1-9 When companies need money, they go to investors or creditors. Before investors or creditors will give a company cash, they want to know the company's financial position and performance. They want to see the company's financial statements—the balance sheet and the income statement. When students need money for school, they often apply for financial aid. When you apply for financial aid, you must submit your own version of a financial statement—the Free Application for Federal Student Aid (FAFSA) form.
Suppose you have $4,000 in cash and $4,000 in credit card bills. The more cash and other assets that you have, the less likely you are to get financial aid. Also, if you have a lot of consumer debt (credit card bills), schools are not more likely to loan you money. To increase your chances of receiving aid, should you use the cash to pay off your credit card bills and therefore make yourself look “worse off” to the financial aid decision-makers?
YES: You are playing within the rules. You are not hiding assets. You are simply restructuring your assets and liabilities to best conform with the preferences that are built into the federal aid formulas.
NO: You are engaging in a transaction solely to take advantage of a loophole in the federal aid rules. In doing so, you are potentially depriving someone who is actually worse off than you from receiving aid.
Instructions
Write a response indicating your position regarding this situation. Provide support for your view.
BYP1-10 The FASB has developed the Financial Accounting Standards Board Accounting Standards Codification (or more simply “the Codification”). The FASB's primary goal in developing the Codification is to provide in one place all the authoritative literature related to a particular topic. To provide easy access to the Codification, the FASB also developed the Financial Accounting Standards Board Codification Research System (CRS). CRS is an online, real-time database that provides easy access to the Codification. The Codification and the related CRS provide a topically organized structure, subdivided into topic, subtopics, sections, and paragraphs, using a numerical index system.
You may find this system useful in your present and future studies, and so we have provided an opportunity to use this online system as part of the Broadening Your Perspective section.
Instructions
Academic access to the FASB Codification is available through university subscriptions, obtained from the American Accounting Association (at http://aaahq.org/FASB/Access.cfm), for an annual fee of $250. This subscription covers an unlimited number of students within a single institution. Once this access has been obtained by your school, you should log in (at http://aaahq.org/ascLogin.cfm) and familiarize yourself with the resources that are accessible at the FASB Codification site.
BYP1-11 This chapter's Feature Story discusses the fact that although Clif Bar & Company is not a public company, it does share its financial information with its employees as part of its open-book management approach. Further, although it does not publicly share its financial information, it does provide a different form of an annual report to external users. In this report, the company provides information regarding its sustainability efforts.
Address: www.clifbar.com/uploads/default/ClifBar_AA2010.pdf
Instructions
Access the 2010 annual report of Clif Bar & Company at the site shown above and then answer the following questions.
Answers to Insight and Accounting Across the Organization Questions
p. 6 The Scoop on Accounting Q: What are the benefits to the company and to the employees of making the financial statements available to all employees? A: If employees can read and use financial reports, a company will benefit in the following ways. The marketing department will make better decisions about products to offer and prices to charge. The finance department will make better decisions about debt and equity financing and how much to distribute in dividends. The production department will make better decisions about when to buy new equipment and how much inventory to produce. The human resources department will be better able to determine whether employees can be given raises. Finally, all employees will be better informed about the basis on which they are evaluated, which will increase employee morale.
p. 8 The Numbers Behind Not-for-Profit Organizations Q: What benefits does a sound accounting system provide to a not-for-profit organization? A: Accounting provides at least two benefits to not-for-profit organizations. First, it helps to ensure that money is used in the way that donors intended. Second, it assures donors that their money is not going to waste and thus increases the likelihood of future donations.
p. 10 The Korean Discount Q: What is meant by the phrase “make the country's businesses more transparent”? Why would increasing transparency spur economic growth? A: Transparency refers to the extent to which outsiders have knowledge regarding a company's financial performance and financial position. If a company lacks transparency, its financial reports do not adequately inform investors of critical information that is needed to make investment decisions. If corporate transparency is increased, investors would be more willing to supply the financial capital that businesses need in order to grow, which would spur the country's economic growth.
p. 12 Spinning the Career Wheel Q: How might accounting help you? A: You will need to understand financial reports in any enterprise with which you are associated. Whether you become a manager, a doctor, a lawyer, a social worker, a teacher, an engineer, an architect, or an entrepreneur, a working knowledge of accounting is relevant.
p. 25 Beyond Financial Statements Q: Why might a company's stockholders be interested in its environmental and social performance? A: Many companies now recognize that being a socially responsible organization is not only the right thing to do, but it also is good for business. Many investment professionals understand, for example, that environmental, social, and proper corporate governance of companies affects the performance of their investment portfolios. For example, British Petroleum's oil spill disaster is a classic example of the problems that can occur for a company and its stockholders. BP's stock price was slashed, its dividend reduced, its executives replaced, and its reputation badly damaged. It is interesting that socially responsible investment funds are now gaining momentum in the marketplace such that companies now recognize this segment as an important investment group.
Answers to Self-Test Questions
1. b 2. d 3. c 4. b 5. b 6. d 7. d ($3,500 − $1,500) 8. b 9. b 10. a ($90,000 − $50,000)
11. d 12. c 13. b 14. c *15. a
10
Describe the impact of international accounting standards on U.S. financial reporting.
Most agree that there is a need for one set of international accounting standards. Here is why:
Multinational corporations. Today's companies view the entire world as their market. For example, Coca-Cola, Intel, and McDonald's generate more than 50% of their sales outside the United States, and many foreign companies, such as Toyota, Nestlé, and Sony, find their largest market to be the United States.
Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann suggest that we will see even more such business combinations of companies from different countries in the future.
Information technology. As communication barriers continue to topple through advances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another.
Financial markets. Financial markets are of international significance today. Whether it is currency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.
Source: http://www.pwc.com/us/en/issues/ifrs-reporting/country-adoption/index.html.
Assets. A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Liabilities. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law, but need not be, i.e., they can arise due to normal business practice or customs.
Equity. A residual interest in the assets of the entity after deducting all its liabilities.
Income. Increases in economic benefits that result in increases in equity (other than those related to contributions from shareholders). Income includes both revenues (resulting from ordinary activities) and gains.
Expenses. Decreases in economic benefits that result in decreases in equity (other than those related to distributions to shareholders). Expenses includes losses that are not the result of ordinary activities.
Both the IASB and the FASB are hard at work developing standards that will lead to the elimination of major differences in the way certain transactions are accounted for and reported. In fact, at one time the IASB stated that no new major standards would be issued for a period of time. The major reason for this policy was to provide companies the time to translate and implement IFRS into practice, as much has happened in a very short period of time. Consider, for example, that as a result of a joint project on the conceptual framework, the definitions of the most fundamental elements (assets, liabilities, equity, revenues, and expenses) may actually change. However, whether the IASB adopts internal control provisions similar to those in SOX remains to be seen.
(a) Mergers and acquisition activity.
(b) Financial markets.
(c) Multinational corporations.
(d) GAAP is widely considered to be a superior reporting system.
(a) international tax regulations.
(b) internal control standards as enforced by the IASB.
(c) internal control standards of U.S. publicly traded companies.
(d) U.S. tax regulations.
(a) principles-based and less rules-based than GAAP.
(b) rules-based and less principles-based than GAAP.
(c) detailed than GAAP.
(d) None of the above.
(a) IFRS is based on a conceptual framework that is similar to that used to develop GAAP.
(b) Assets are defined by the IASB as resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
(c) Non-U.S. companies that trade shares in U.S. markets must reconcile their accounting with GAAP.
(d) Proprietorships, partnerships, and corporations are also found in countries that use IFRS.
(a) Under IFRS, the term income refers to what would be called revenues and gains under GAAP.
(b) The term income is not used under IFRS.
(c) The term income refers only to gains on investments.
(d) Under IFRS, expenses include distributions to owners.
IFRS1-1 Who are the two key international players in the development of international accounting standards? Explain their role.
IFRS1-2 What might explain the fact that different accounting standard-setters have developed accounting standards that are sometimes quite different in nature?
IFRS1-3 What is the benefit of a single set of high-quality accounting standards?
IFRS1-4 Discuss the potential advantages and disadvantages that countries outside the United States should consider before adopting regulations, such as those in the Sarbanes-Oxley Act, that increase corporate internal control requirements.
IFRS1-5 The financial statements of Zetar plc are presented in Appendix F. Instructions for accessing and using the company's complete annual report, including the notes to its financial statements, are also provided in Appendix F.
Instructions
Visit Zetar's corporate website and answer the following questions from Zetar's 2011 annual report.
(a) What accounting firm performed the audit of Zetar's financial statements?
(b) What is the address of the company's corporate headquarters?
(c) What is the company's reporting currency?
(d) What two segments does the company operate in, and what were the sales for each segment in the year ended April 30, 2011?
Answers to IFRS Self-Test Questions
1. d 2. c 3. a 4. c 5. a
1The appendix to this chapter describes job opportunities for accounting majors and explains why accounting is such a popular major.
2The origins of accounting are generally attributed to the work of Luca Pacioli, an Italian Renaissance mathematician. Pacioli was a close friend and tutor to Leonardo da Vinci and a contemporary of Christopher Columbus. In his 1494 text Summa de Arithmetica, Geometria, Proportione et Proportionalite, Pacioli described a system to ensure that financial information was recorded efficiently and accurately.
*Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.